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Introduction

  • What are "options"?
    An option is a contract, which gives the buyer (holder) the right, but not the obligation,to buy or sell specified quantity of the underlying assets,at a specific (strike) price on or before a specified time (expiration date),in consideration of a sum called the option premium. To put it in more simple terms,an option gives the holder an insurance against the risk of loss but a promise of unlimited profits if his judgment (of the future direction of the market or a particular stock) proves to be right.
     
  • What are the important terms used in options trading?

    Underlying -The specific security / asset on which an options contract is based.

    Option Premium-Premium is the price paid by the buyer (of the the option) to the seller to acquire the right to buy or sell.

    Strike Price or Exercise Price- The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.

    Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.

    Exercise Date-The date on which the option is actually exercised.

    Open Interest-The total number of options contracts outstanding in the market at any given point of time.

    Option Holder-Option Holder is the one who buys an option, which can be a call, or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential (the ability to reap profits) is unlimited while losses are limited to the premium paid by him to the option writer.

    Option Seller/ Writer-Option Seller/ Writer is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.

    Option Class-All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Nifty Call Options (or) all Nifty Put Options.

    Option Series-An option series consists of all the options of a given class with the same expiration date and strike price. e.g., Nifty-1100-February-Call is an options series which includes all Nifty Call options that are traded with strike price of 1100 and expiry in February.
     
  • What are Call Options?
    A call option gives the holder (buyer/ one who is long call), the right to buy a specified quantity of the underlying asset at the strike price on or before the expiration date.

    Note: The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

    An Illustration:
    An investor buys a call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys rises above Rs. 3500, the option can be exercised. However, the investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).

    Suppose the stock price is Rs. 3800, the option is exercised and the investor buys 1 share of Infosys from the seller of the option at Rs 3500 and sells it in the market at Rs 3800 making a profit of Rs. 200

    The profit from a long call is equivalent to {(Spot price - Strike price) - Premium}.
    In another scenario, if at the time of expiry stock price falls below Rs. 3500 e.g. if it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the buyer loses the premium (Rs. 100) paid which should be the profit earned by the seller/writer of the call option.
     
  • What are Put Options?
    A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before the expiry date.

    Note: The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

    An Illustration:
    An investor buys one Put option on Reliance at the strike price of Rs. 300, at a premium of Rs. 25. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's break-even point is Rs. 275 (strike price - premium paid) i.e., investor will earn profits if the market falls below 275.

    Suppose stock price is Rs. 260, the buyer of the Put option can immediately buy a Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15

    The profit from a long put is equivalent to {(Strike price - Spot Price) - Premium paid}.
    In another scenario, if at the time of expiry, market price of Reliance is Rs. 320, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.

    In this case the investor loses the premium paid (i.e. Rs. 25), which shall be the profit earned by the seller of the Put option.
     
  • CALL OPTIONS PUT OPTIONS
    Option buyer or option holder Buys the right to buy the underlying asset at the specified price Buys the right to sell the underlying asset at the specified price
    Option seller or option writer Has the obligation to sell the underlying asset (to the option holder) at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price
  • What are European & American Style of options?
    An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

    The European kind of option is the one which can be exercised by the buyer on the expiration day only and not anytime before that.
    In India, Index Options are European style of options whereas Individual Stock Options are American style of Options.
     
  • How are options different from futures?

    The significant differences in Futures and Options are as under:


    1) Futures are contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.

    This contract cannot be reversed at the option of any of the parties. In case of Options, the holder (buyer) of the option holds the right to exercise the option (although he is under no obligation to do so).

    2) Futures Contracts have symmetric risk profile for both the buyer as well as the seller, whereas options have asymmetric risk profile. This, in simple terms, means that the risk of a buyer of a futures contract is similar to that of one holding a stock in the spot market.

    However, in case of options, the option holder's risk is limited to the premium paid by him.

    The Option Writer/Sellers's risk is unlimited.

    3)In case of Futures, the profit profile is linear… the profit (or loss) increases or decreases in a straight line. In case of Options, for a buyer the profits may be unlimited. For a seller or writer of an option, profits are limited to the premium he has received from the buyer.
     
  • What are, "At the Money" , "In the Money" & "Out of the money" Options?
    An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price.

    This is true for both puts and calls.

    In case of call options:
    A call option is said to be in-the-money when the strike/exercise price of the option is less than the underlying asset price.

    For example, an Infosys call option with strike of 3500 is 'in-the-money', when the spot Infosys is at 3800.

    The exercise of this option leads to a positive money flow to the holder of the option.

    On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price.

    Using the earlier example of Infosys call option, if the Infosys falls to 3300, the call option no longer has positive exercise value.

    Naturally, the call holder will not exercise the option to buy Infosys at 3500 when the current price is at 3300. The option, in this case, expires worthless.

    In case of Put Options:
    A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset.

    For example, an Infosys put at strike of 4000 is in-the-money when spot Infosys is at 3800.

    When this is the case, the put option has value because the put holder can sell Infosys at 4400, an amount greater than the current market price of Infosys of 3800.

    Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Infosys put option won't exercise the option when the spot Infosys is at 4500.

    The put no longer has positive exercise value.

    Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.
     
  • What are Covered & Naked Calls?
    A call option position that is covered by an opposite position in the underlying instrument (individual stocks or a basket of index stocks) is called a covered call.
    Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.

    E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.

    Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value.

    When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call.

    The premium received on the writing, of course, to some extent mitigates this loss.