Options
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General Information Can I trade options on any listed stocks/Index? You can only trade options on a fixed number of underlyers (stocks , Index etc). This list is maintained by exchanges and updated from time to time. In NSE website www.nseindia.com you can get the list under FnO section. Is it possible to trade option contract in any quantity I want? There is a trading size defined by exchanges called ‘lot’. You can trade in multiple of lots. For example one lot of NIFTY holds 50 contracts. At a minimum you need to trade 1 lot. Number of lots should be in whole numbers like 2, 3 4 and so on but not fractions. So if you have traded 3 lots of NIFTY you actually hold 3 * 50 (No of lots * Nifty lot size) = 150 contracts. Where can I get the lot size information? Refer exchange web-site for details. In NSE you can find the details under FnO section. Where can I see the list of tradable options and their strike prices? Refer exchange web-site for details. In NSE you can find the details under FnO section. Where can I find the historical options prices? Refer exchange web-site for details. In NSE you can find the details under FnO section. Also, there are some tools and data services available that can be used to study historic prices. Do I need knowledge of advanced mathematics to understand options? This is a very common myth. For trading/investing purpose you do not need knowledge of scientific formulas. Simple strategies like buying options are similar to buying stocks to large extent. You need to pick a good strategy according to perceived market trend and understand the risk.. If you want to further study the pricing models and volatility related topics you may require good background in mathematics. Options Basics What is an Option? • An option is a contract to buy/sell a stock (underlyer). • Contract defines a fixed price at which stocks would be traded. This is called strike price. • Contract has a maturity date which is the last date until the contract is valid. • The seller sells the contract to Buyer. • Buyer pays the price of the contract called premium to seller. • Buyer has the right, but not the obligation to buy/sell the stock(underlyer) at a fixed price (strike price). • The contract also obligates the seller or writer to meet the terms of delivery if the contract right is exercised by the contract buyer. If you have not fully understood the concept of Option please don’t loose heart. Continue to read the FAQ section; many of your doubles will get cleared after reading subsequent sections. What is a strike price? It is the fixed price at which owner (buyer) of the CALL option can buy the underlying
asset from option seller, no matter whatever is the current price of the underlying asset. Example, If strike price of Reliance CALL option is 1300 that means buyer of this option can buy Reliance stock at 1300 even if the current market price of the stock is higher (say 1500). In case of Put options, strike price is the price at which owner (buyer) of the PUT option can sell the underlying asset to the option seller, no matter whatever is the current price of the underlying asset. Example, if strike price of Reliance PUT option is 1300 that means buyer of this option can sell Reliance stock at 1300 even if the current market price of the stock is lower (say 1100). What is a premium? What is a lot size? Options are traded in pre-defined lots. For example if you want to buy NIFTY options you have to buy in lots. In case of NIFTY, 1 lot = 50 contracts. You can trade only whole number contracts like 1, 2, 3 and so on but not in fractions. What is options expiry? Options expiry is a date after which the contract is no longer valid. Every contract has a expiration date. What is a call options? A call is an option contract that gives the owner the right to buy the underlying stock at a specified price (strike price) for a certain, fixed period of time (until its expiration). What is a put option? A call is an option contract that gives the owner the right to sell the underlying stock at a specified price (strike price) for a certain, fixed period of time (until its expiration). How to decide whether I should buy/sell call or Put options? If you are bullish • You may consider BUY-ing CALL options • You may consider SELL-ing PUT options (remember that selling naked option is a risky strategy and mostly used by expert traders) If you are bearish • You may consider BUY-ing PUT options • You may consider SELL-ing CALL option How can I benefit from buying a call option? People buy CALL option when they are bullish i.e. they anticipate that price of the underlying stock will move up. Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy a RELIANCE CALL option (strike=2500, maturity June 2008) @ Rs. 50 per contract when RELIANCE stock was getting traded at 2400. Let’s see what happens after options expiration. Case I : Reliance stock price greater than the strike price. Reliance stock trading at 2600 on expiry day cut-off time Net profit = (current price – strike price) - premium = (2600 – 2500) -50= Rs. 50 per contract
Case II : Reliance stock price less than strike price (2500) on expiry day cut-off time Net loss = Premium paid = Rs. 50 per contract So when you buy a CALL option you have unlimited profit potential but limited risk or downside. How can I benefit from buying Put option? People buy PUT option when they are bearish i.e they anticipate that price of the underlying stock will go down. Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy a Reliance PUT option (strike=2500, maturity June 2008) @ Rs. 50 per contract when RELIANCE stock was TRADING at 2600. Let’s see what happens after options expiration. Case I : Reliance stock price is less than the strike price. Reliance stock trading at 2400 on expiry day cut-off time Net Profit = (Strike Price – Current Price) – premium = 2500 – 2400 – 50 = 50 Case II : Reliance stock price >= strike price (2500) on expiry day cut-off time Net loss = Premium paid = Rs 50 per contract So, when you buy a PUT option you have unlimited profit potential but limited risk or downside. How can I benefit from selling a call option? This is a bearish strategy. It has unlimited loss and limited profit potential. Selling options is not recommended for beginner level traders. Let’s understand it using an example. Suppose you want to SELL NIFTY call option (strike=5000 expiration June 2008) on 1-MAY-2008 at 50 Rs per contract and NIFTY was trading at 4900 at that time. When you get a buyer for this contract you get paid @ Rs. 50 per contract and are credited to your account. Let’s see what happens after options expiration. Case I: NIFTY price <= strike price on expiry day cut-off time Net Profit = 50 (Premium credited to your account when the trade was executed) Case II : NIFTY price > strike price on expiry day cut-off time Net = STRIKE price – Nifty cut-off PRICE + PREMIUM Net = 5000 – 50◊Example : If NIFTY cut-off price = 5025 25 + 50 = Rs. 25 per contract(Profit)
Net = 5000 – 5100 + 50 = Rs. -50 per contract◊If NIFTY cut-off price = 5100 (Loss) How can I benefit from selling put option? This is a bullish strategy. It has unlimited loss and limited profit potential. Selling options is not recommended for beginner level traders. Let’s understand it using an example. Support you SELL a NIFTY PUT option (strike=5000, expiration June 2008) on 1-MAY-2008 at 50 Rs per contract when NIFTY was trading at 5050. When you get a buyer for this contract you get paid @ Rs. 50 per contract and are credited to your account. Let’s see what happens after options expiration Case I: NIFTY price >= strike price on expiry day cut-off time Net Profit = 50 (Premium credited to your account when the trade was executed) Case II: NIFTY price < strike price on expiry day cut-off time Loss : STRIKE – Nifty cut-off price - PREMIUM Example : If NIFTY cut-off price = 4950, Loss = 5000 – 4900 - 50 = 50 (LOSS) If Nifty cut-off price = 4975, Loss = 5000 – 4975 - 50 = -25 (PROFIT) Who is an option writer? A person who Sells options is a writer. They offer to sell options and buyers in the market buys them. Can anyone write(sell) options? Yes, any investor can sell option though his broker. If buyer of the call option has right to buy the stock and seller of the call option has the obligation to deliver the stock does that mean seller cannot close out his/her position before expiry? That’s not correct. An option writer can close the SELL option transaction if he/she wants by squaring off. Owner/Buyer of the option need not worry about the opposite party as there will always be equal number of buyers and sellers available all the time for a given contract. How is employee stock option different than standardized (ordinary) options? Employee stock options are not tradable in exchanges unlike standardized options. Employee stock option terms are not standard for example company X gives employee A an option to own 100 stocks of the company @ 50 Rs. The same company gives employee B an option to own 2000 stocks of the company @ 35 Rs. Exchange traded options have standardized terms i.e lot size and strike price of a given contract is same for all investors. What is the difference between Futures and Options? The main difference between options and futures is described below:
Options contract gives the buyer the right, but not the obligation to buy (or sell) the underlying asset (stock, Index etc) at a specified price at any time during the life of the contract On the other hand futures contract gives the buyer the obligation to buy underlying asset (index, stock etc) at a specified price at any time during the life of the contract What is ’Buy to open’ and ‘Sell to close’ mean? Each trade comprises two transactions, opening transaction and closing transaction. When you go long i.e BUY call (or put) option as opening transaction it is called as “Buy to open”. You will close this position by taking opposite position i.e. by selling the same amount of call (or put) option. Closing transaction in this case would be called as “Sell to close”. What is ’Sell to open’ and ‘Buy to close’ mean? Each trade comprises two transactions, opening transaction and closing transaction. When your opening transaction is SELL short call (or put) option it is known as “Sell to open”. You will close this position by taking opposite position i.e. by buying the same amount of call (or put) option. Closing transaction in this case would be called as “Buy to close”. What is the difference between American & European style options? If you own(bought) an American style option, you can exercise your right to buy (in case of call options) or right to sell (in case of put options) underlying asset anytime between the purchase date and expiry date. If you own(bought) an European style option, you can exercise your right to buy (in case of call options) or right to sell (in case of put options) underlying asset only on the expiry date. What is the difference between Stock and Index options? The underlying asset covered by index options is not shares in a company, but rather, an underlying Rupee value equal to the index level multiplied by Lot size. The amount of cash received at upon exercise or expiration depends on the settlement value of the index in comparison to the strike price of the index option. In India Index options have EUROPEAN exercise style and Stock options are AMERICAN exercise style. For more details refer question on difference between EUROPEAN & AMERICAL exercise styles. For questions regarding option exercise & exercise styles please refer OPTION EXERCISE section. How can I find out if a particular option is American style or European style? Refer www.nseindia.com. Under F&O section you can see contract information. If Option type is CE means CALL European style option, CA means CALL American style option, PE means PUT European style option, PA means PUT American style option. Are both American style and European style options available for trading in Indian markets? Yes. In NSE Index options are of European style whereas stock options are of American style. Options moneyness & value
What are in-the-money options? A call option is in-the-money if its strike price is below the current market price of the underlier (stock,Index etc) . For example, if you bought a 4000 strike NIFTY CALL OPTION and NIFTY is trading at 4200 the call option is in-the-money. A Put option is in the money when its strike price is above the current market price of the underlier (stock, Index etc.) . For example, if you bought a 5000 NIFTY PUT OPTION and NIFTY is trading at 4900 the put option is in-the-money. What are out-of-money options? A call option is out-of-money when its strike price is above the current market price of the underlier (stock) . For example, if you bought a 5000 NIFTY CALL OPTION and NIFTY is trading at 4900 the call option is out of money. A Put option is out-of-money when its strike price is below the current market price of the underlier (stock) . For example, if you bought a 5000 NIFTY PUT OPTION and NIFTY is trading at 5100 the put option is in-the-money. What are at-the-money options? An option is at-the-money if the strike price of the option equals (or nearly equals) the market price of the underlying security(stock). What is intrinsic value of the option? Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money . Some people view it as the value that any given option would have if it were exercised today For Call options, Intrinsic value = Current Stock price – Strike Price For Put Options, Intrinsic value = Strike Price - Current Stock price Note intrinsic value cannot have negative value so minimum intrinsic value is 0 for an option What is time value of the option? Time Value = Option Price - Intrinsic Value Lets take an example: If stock XYZ is trading at Rs 105 and the XYZ 100 call option is trading at Rs 7, Intrinsic value = 105 – 100 = 5 Time Value = 7 – 5 = 2 So, we would say that this option has time value = Rs 2 Open Interest and Trading Volume What is open interest? The total number of options contracts on an underlyer that have not yet been closed i.e. they have not been exercised, expired or squared off. Is increased open interest bullish?
Different people view it in different manner. Generalizing it may not be a good idea. Many people interpret open interest as described below: Rise or fall in the open interest may be interpreted as an indicator of the future expectations of the market. A rising open interest number indicates that the present trend is likely to continue. If the open interest number is stagnant, then it may suggest that the market is in a cautious mode. If Open interest starts declining, then the market suggests a trend reversal mood. In a rising market, continuous decline of open interest indicates an expectation of downward movement. Similarly, in a falling market, the decline of open interest indicates that the market expects an upward trend. What is the difference between volume and open interest? Volume is the number of contracts of a particular option contract that have traded on a given day, similar to it meaning the number of shares traded on a particular stock on a given day. Open interest is the number of option contracts for a particular stock at a specific strike price and a specific expiration date that were open at the close of trading on the prior trading day. While some traders look at this information as an indication of liquidity of a particular option or option chain, a more reliable indicator may be the tightness of the bid / ask spread. A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct, as demonstrated in the following example
Time
Jan1 Jan2 Jan3 Jan4
Trading Activity Open Interest A buys 1 option and B sells 1 option contract C buys 5 option and D sells 5 option 1 contracts 6 A sells his 1 option and D buys 1 option 5 contract 5 E buys 5 options from C who sells 5 options contracts
-On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1. -On January 2, C and D create trading volume of 5 and there are also five more options left open. -On January 3, A takes an offsetting position, open interest is reduced by 1 and trading volume is 1. -On January 4, E simply replaces C and open interest does not change, trading volume increases by 5. What does liquidity mean? Ability of an option or other tradable security to get bought or sold in the market without affecting the price.
What is PCR (PUT CALL RATIO)? PCR is a very popular indicator to measure the prevailing level of bullishness or bearishness in the market. Remember Put contract is bought by investors who are bearish and Call contracts are bought by people who are bullish. PCR is calculated as: PCR = No of traded Put options / no of traded call options As this ratio increases it means that investors are putting more money into put options rather than call options. There are different ways you can interpret this information to gauge market directions. Options Price Behaviour I bought 1 lot of XYZ 100 strike call option at 20 Rs when stock was trading at 90. Now the stock is trading at 120. The stock is up 30 Rs but why my option is trading at 40 (up only 20 Rs). Why the option did not move as much as the underlying stock? Although options are derived from stocks or indexes but they are traded as independent securities in the markets. The price movement pattern and extent could be different than the underlying stock/Index. Delta value is used interpret the relationship between price movement of an option and its underlyer stock/Index. Who decides on the option price (premium)? Like the stock trading price it is purely driven by Demand (buyers) and Supply (sellers). How could I know whether the price of a particular option is cheap or expensive? You can compute the fair value of options using Binomial or Black Scholes formulas. We do provide theoretical value of options in our web-site using Black-scholes model. Exercise, Assignments & Square-off What does Option exercise mean? Exercising a stock CALL option means buying the stock at the price set by the option (strike price), regardless of the stock's price at the time you exercise the option. Exercising a stock PUT option means selling the stock at the price set by the option (strike price), regardless of the stock's price at the time you exercise the option. Let’s understand it using an example: Mr. Gupta bought 2500-RELIANCE-CALL option contract. The stock is currently trading at Rs. 3000. If Mr. Gupta decides to ‘exercise’ his right he will get the stocks at the rate of 2500 even though the stock is being traded at 3000. What is the difference between square off and exercise? You square off options position when you want to close your existing position. Square off can be done by taking the exactly opposite position for e.g. if you have initially
bought 1 lot of CALL (or PUT) option you can square off by selling 1 lot of CALL (or PUT) option with same strike and expiry. Similarly, if you have initially sold 1 lot of CALL (or PUT) option you can square off by buying 1 lot of CALL (or PUT) option. You may want to exercise your option when you want to take delivery of underlying stock or Index. Under what circumstances I should square off vs. exercise? You may want to exercise if you want to take the delivery of underlying stock and you have long/medium term interest in the stock. If you want to book profit or cut your losses, you may want to close out your position by squaring off. Can I exercise anytime or I need have to wait until the expiration day? If the option is of American style then it can be exercised any day (when the market is open) before its expiration. In case of European options it can be only exercised on the expiration day. I have taken a position on an European style option. We know European style options can’t be exercised before expiry, so can’t I close my position before expiration day if I want? Yes, you can close out your position by squaring off which in short means taking the reverse position. If I exercise an in-the-money call option, how soon I can sell the underlying stock? You can sell the underlying stock as soon as you give instructions to your broker to exercise. We suggest you also double check with your broker if there are any deviations and special rules apply. If I am holding an option and its value has increased i.e. I am making profit right now, Do I need to hold it until expiration? Will be a good move to book close out the position and book profits? It all depends on your outlook of stock and your risk/reward appetite. If you believe that the stock has made its move to large extent and there is not much scope of further movement in your anticipated direction then it you may want close out the position by squaring off. On the other hand if you believe that there is lot more steam left and the stock will go a long way, you can continue to hold your position. What is options assignment? When the holder (buyer) of options exercise the option writer(seller) is said to be assigned the obligation to deliver the terms of option contract. If it is a CALL option the writer(seller) needs to deliver the obligated quantity of the underlying security at the strike price. In case of PUT option the writer(seller) needs to buy the obligated quantity of the underlying security at the strike price. Assignment is done on a random basis. The clearing house picks short positions that ae eligible to be assigned and then allocates the exercised positions to any one or more short positions. What will happen if I have an open option position during options expiration day and I have neither closed my position not excised? All in the money options whether American or European style are automatically exercised by the clearing house. Can I revoke my order to exercise options?
No, once an order is accepted by clearing house it cannot be ordinarily revoked. How do I know if I could get assigned (or exercised)? What is the likely hood of getting assigned? There is no way to know if you could get assigned. If you have sold an option there is always a possibility of getting assigned on any business day before expiration (in case the option is American style) to fulfill your obligation to receive (and pay for) or deliver (and get paid for) shares of underlyer stock . There are some general rules that you should keep in your mind: 1. Only small portion of options actually get exercised 2. Majority of options get exercised when they get closer to expiration Option exercise statistics are published in NSE website www.nseindia.com Can I avoid being exercised or assigned? I you continue to hold your option sell position you cannot eliminate the posibility of being assigned. I bought an index option which is a European style option. Does this mean I cannot close my position until expiration? You can close your position any time by squaring off your position i.e taking the exact opposite position. If I initially shorted an option and later covered my short that is bought back my call option. Can I still get assigned? No, you have closed out your position and there is no way you can get assigned. If I hold options until the expiration day will I get exercised automatically? All in the money options are exercised automatically during the expiration day. For details please contact your broker. Corporate Actions (Split, Merger, Dividend) I own a Call option on a stock. A dividend was announced on the stock. What will happen in this case? SEBI regulation says that if the value of the declared dividend is more than 10% of the spot price of the underlyer stock on the dividend announcement day then the strike price of the stock options are refuced by the dividend amount. If the decalred dividend is less than 10% then there is no adjustment of for the dividend by the exchange. In this case market adjusts the price of the options considering the dividend announcement. What will happen if I hold an stock option and a decision is taken to remove that stock from Futures and options category? All active contracts will continue to exist until the last day (as declared). After that no more contracts on this stock will available for trading. If you are holding such an option your position will be exercised and settled on last day. It is always advisable to check with your broker regarding such announcements. Options Strategies Both ‘Buy Call’ and “Sell Put” are bullish strategies. Which one should I choose?
‘Buy Call’ is capital gain strategy which involves uncapped profit potential and limited loss, where as “Sell Call” is an income generation strategy which involves limited profit and unlimited loss potential. Selling options are only recommended for experienced investors. Both ‘Buy Put” and “Sell Call” are bearish strategies. Which one should I choose? ‘Buy Put’ is capital gain strategy which involves uncapped profit potential and limited loss, where as “Sell Put” is an income generation strategy which involves limited profit and unlimited loss potential. Selling options are only recommended for experienced investors. I sold a call option and received a premium for that. If I get exercised do I need to give back the premium to the buyer? No, you keep the premium but you still need need to deliver the underlying stocks to the options holder. What are options spreads? Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. Refer our StrategyFinder tool to see real tradable strategies which also includes spreads. Can an individual person be both long and short the exact same option at the same time? If you do it from the same trading account it will offset each other. If you do it from different accounts then you will have a flat position from economic perspective. There is no visible advantage in doing so. Margins What is margin and why there is a need for it? Margin is the amount of cash you need to deposit with your broker as a collateral if you want to write an uncovered (naked) option. You also need to maintain margin to cover your daily position valuation and reasonably foreseeable intra-day price changes. When you short sell an option there is unlimited risk involved if the stock moves in opposite of your expected market direction. There is always a possibility that the seller will not be able to fulfill his obligation to deliver the terms of the contract due to lack of funds. If the options price has increased significantly and the seller wants to close out his position by buying out the option there is possibility that he may not have sufficient funds in his account. This kind of situations will prevent markets from functioning efficiently as the counter party wont be able to get his payement. To avoid these kind of circumstances the concept of margins were introduced in all markets across the world. What is options volatility? Does change in volatility affect margins? If yes how? Volatility is a measure of the rate and magnitude of the change of prices (whether up or down) of the underlying. To put it simply you can view volatility as the speed at which price of underlying can move in either direction. If volatility is high, the premium on
the option will be relatively high, and vice versa. How can I find out how much margin is applicable for an options? You can find out the applicable margin from your broker. Many online brokers like www.hdfcsec.com , www.icicidirect.com etc. do provide tools to calculate margin requirements. Will I get margin benefits if I have positions on different underlying? No, you will not get margin benefits in this case. Will I get margin benefits if I have positions in both futures and options on same underlying? Yes, you will get benefits in this case. Will I get margin benefit if I have counter positions in different months on same underlying? Yes, you will get margin benefits in this case. However, the benefit will be removed three days prior to expiry if the near month contract. Options Geeks What is option DELTA? Delta can be defined as amount by which an option’s price will change for corresponding 1 point change in price of the underlying stock or index. Long Call options have positive deltas, whereas Long put options have negative delta whereas Short Call options have negative delta, and Short put options have positive delta. Let understand using couple of examples. • Delta of NIFTY Mar-2009 3000 CALL is 0.50. Theoretically, this means that if NIFTY moves up by 1 point, this option’s price will go up by 0.5 point. Similarly, if NIFTY moves down by 1 point, this options price will go down by 0.5 point • Delta of NIFTY Mar-2009 2800 PUT is -0.75. Theoretically, this means that if NIFTY moves up by 1 point, this option’s price will go down by 0.75 point. Similarly, if NIFTY moves down by 1 point, this options price will go up by 0.75 point Note that DELTA values are dynamic and changes almost everyday. What is option GAMMA? If Delta is viewed as the ‘speed’ of price movement of option relative to underlying then option Gamma can be viewed as the acceleration. Basically, Gamma measures the amount by which delta changes for a 1 point change in the stock price. For example, if Gamma of an option is 0.5, that means theoretically that with 1 point price movement of underlying the delta will move 0.5. Long calls and long puts have positive gamma whereas short calls and short puts have negative gamma. What is an option VEGA? Vega can be interpreted as the amount by which the price of an option will change with 1% change in implied volatility of the underlying. One common scenario when option Vega changes is when there is a large movement in underlying price. Long calls and long puts both have positive vega where as short calls and short puts will always have negative Vega. What is an option THETA?
Option theta can be interpreted as change in the price of the option with one day decrease in the remaining life of the option. To put is simply it is a measure of time decay. Note that longer the life of an option, the higher will be the premium and vice versa. With each passing day the value of option decreases (considering all factors equal). What is theoretical value of an option? When you want to buy an option you probably want to know what is the fair value of the option and what should be the fair price of an option, whether the option is undervalued, over valued or rightly valued. You can get answers to these questions by calculating the theoretical value of an option. There are many mathematical models and formulas available which can be used. What are Binomial and Black-holes equations? These are mathematical models that can be used to calculate the theoretical value and greeks of an options. How important is it to use options geeks? If you consider option Greeks in taking decisions to buy or sell options you are basically increasing your probability to make a profit in your trades.
asset from option seller, no matter whatever is the current price of the underlying asset. Example, If strike price of Reliance CALL option is 1300 that means buyer of this option can buy Reliance stock at 1300 even if the current market price of the stock is higher (say 1500). In case of Put options, strike price is the price at which owner (buyer) of the PUT option can sell the underlying asset to the option seller, no matter whatever is the current price of the underlying asset. Example, if strike price of Reliance PUT option is 1300 that means buyer of this option can sell Reliance stock at 1300 even if the current market price of the stock is lower (say 1100). What is a premium? What is a lot size? Options are traded in pre-defined lots. For example if you want to buy NIFTY options you have to buy in lots. In case of NIFTY, 1 lot = 50 contracts. You can trade only whole number contracts like 1, 2, 3 and so on but not in fractions. What is options expiry? Options expiry is a date after which the contract is no longer valid. Every contract has a expiration date. What is a call options? A call is an option contract that gives the owner the right to buy the underlying stock at a specified price (strike price) for a certain, fixed period of time (until its expiration). What is a put option? A call is an option contract that gives the owner the right to sell the underlying stock at a specified price (strike price) for a certain, fixed period of time (until its expiration). How to decide whether I should buy/sell call or Put options? If you are bullish • You may consider BUY-ing CALL options • You may consider SELL-ing PUT options (remember that selling naked option is a risky strategy and mostly used by expert traders) If you are bearish • You may consider BUY-ing PUT options • You may consider SELL-ing CALL option How can I benefit from buying a call option? People buy CALL option when they are bullish i.e. they anticipate that price of the underlying stock will move up. Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy a RELIANCE CALL option (strike=2500, maturity June 2008) @ Rs. 50 per contract when RELIANCE stock was getting traded at 2400. Let’s see what happens after options expiration. Case I : Reliance stock price greater than the strike price. Reliance stock trading at 2600 on expiry day cut-off time Net profit = (current price – strike price) - premium = (2600 – 2500) -50= Rs. 50 per contract
Case II : Reliance stock price less than strike price (2500) on expiry day cut-off time Net loss = Premium paid = Rs. 50 per contract So when you buy a CALL option you have unlimited profit potential but limited risk or downside. How can I benefit from buying Put option? People buy PUT option when they are bearish i.e they anticipate that price of the underlying stock will go down. Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy a Reliance PUT option (strike=2500, maturity June 2008) @ Rs. 50 per contract when RELIANCE stock was TRADING at 2600. Let’s see what happens after options expiration. Case I : Reliance stock price is less than the strike price. Reliance stock trading at 2400 on expiry day cut-off time Net Profit = (Strike Price – Current Price) – premium = 2500 – 2400 – 50 = 50 Case II : Reliance stock price >= strike price (2500) on expiry day cut-off time Net loss = Premium paid = Rs 50 per contract So, when you buy a PUT option you have unlimited profit potential but limited risk or downside. How can I benefit from selling a call option? This is a bearish strategy. It has unlimited loss and limited profit potential. Selling options is not recommended for beginner level traders. Let’s understand it using an example. Suppose you want to SELL NIFTY call option (strike=5000 expiration June 2008) on 1-MAY-2008 at 50 Rs per contract and NIFTY was trading at 4900 at that time. When you get a buyer for this contract you get paid @ Rs. 50 per contract and are credited to your account. Let’s see what happens after options expiration. Case I: NIFTY price <= strike price on expiry day cut-off time Net Profit = 50 (Premium credited to your account when the trade was executed) Case II : NIFTY price > strike price on expiry day cut-off time Net = STRIKE price – Nifty cut-off PRICE + PREMIUM Net = 5000 – 50◊Example : If NIFTY cut-off price = 5025 25 + 50 = Rs. 25 per contract(Profit)
Net = 5000 – 5100 + 50 = Rs. -50 per contract◊If NIFTY cut-off price = 5100 (Loss) How can I benefit from selling put option? This is a bullish strategy. It has unlimited loss and limited profit potential. Selling options is not recommended for beginner level traders. Let’s understand it using an example. Support you SELL a NIFTY PUT option (strike=5000, expiration June 2008) on 1-MAY-2008 at 50 Rs per contract when NIFTY was trading at 5050. When you get a buyer for this contract you get paid @ Rs. 50 per contract and are credited to your account. Let’s see what happens after options expiration Case I: NIFTY price >= strike price on expiry day cut-off time Net Profit = 50 (Premium credited to your account when the trade was executed) Case II: NIFTY price < strike price on expiry day cut-off time Loss : STRIKE – Nifty cut-off price - PREMIUM Example : If NIFTY cut-off price = 4950, Loss = 5000 – 4900 - 50 = 50 (LOSS) If Nifty cut-off price = 4975, Loss = 5000 – 4975 - 50 = -25 (PROFIT) Who is an option writer? A person who Sells options is a writer. They offer to sell options and buyers in the market buys them. Can anyone write(sell) options? Yes, any investor can sell option though his broker. If buyer of the call option has right to buy the stock and seller of the call option has the obligation to deliver the stock does that mean seller cannot close out his/her position before expiry? That’s not correct. An option writer can close the SELL option transaction if he/she wants by squaring off. Owner/Buyer of the option need not worry about the opposite party as there will always be equal number of buyers and sellers available all the time for a given contract. How is employee stock option different than standardized (ordinary) options? Employee stock options are not tradable in exchanges unlike standardized options. Employee stock option terms are not standard for example company X gives employee A an option to own 100 stocks of the company @ 50 Rs. The same company gives employee B an option to own 2000 stocks of the company @ 35 Rs. Exchange traded options have standardized terms i.e lot size and strike price of a given contract is same for all investors. What is the difference between Futures and Options? The main difference between options and futures is described below:
Options contract gives the buyer the right, but not the obligation to buy (or sell) the underlying asset (stock, Index etc) at a specified price at any time during the life of the contract On the other hand futures contract gives the buyer the obligation to buy underlying asset (index, stock etc) at a specified price at any time during the life of the contract What is ’Buy to open’ and ‘Sell to close’ mean? Each trade comprises two transactions, opening transaction and closing transaction. When you go long i.e BUY call (or put) option as opening transaction it is called as “Buy to open”. You will close this position by taking opposite position i.e. by selling the same amount of call (or put) option. Closing transaction in this case would be called as “Sell to close”. What is ’Sell to open’ and ‘Buy to close’ mean? Each trade comprises two transactions, opening transaction and closing transaction. When your opening transaction is SELL short call (or put) option it is known as “Sell to open”. You will close this position by taking opposite position i.e. by buying the same amount of call (or put) option. Closing transaction in this case would be called as “Buy to close”. What is the difference between American & European style options? If you own(bought) an American style option, you can exercise your right to buy (in case of call options) or right to sell (in case of put options) underlying asset anytime between the purchase date and expiry date. If you own(bought) an European style option, you can exercise your right to buy (in case of call options) or right to sell (in case of put options) underlying asset only on the expiry date. What is the difference between Stock and Index options? The underlying asset covered by index options is not shares in a company, but rather, an underlying Rupee value equal to the index level multiplied by Lot size. The amount of cash received at upon exercise or expiration depends on the settlement value of the index in comparison to the strike price of the index option. In India Index options have EUROPEAN exercise style and Stock options are AMERICAN exercise style. For more details refer question on difference between EUROPEAN & AMERICAL exercise styles. For questions regarding option exercise & exercise styles please refer OPTION EXERCISE section. How can I find out if a particular option is American style or European style? Refer www.nseindia.com. Under F&O section you can see contract information. If Option type is CE means CALL European style option, CA means CALL American style option, PE means PUT European style option, PA means PUT American style option. Are both American style and European style options available for trading in Indian markets? Yes. In NSE Index options are of European style whereas stock options are of American style. Options moneyness & value
What are in-the-money options? A call option is in-the-money if its strike price is below the current market price of the underlier (stock,Index etc) . For example, if you bought a 4000 strike NIFTY CALL OPTION and NIFTY is trading at 4200 the call option is in-the-money. A Put option is in the money when its strike price is above the current market price of the underlier (stock, Index etc.) . For example, if you bought a 5000 NIFTY PUT OPTION and NIFTY is trading at 4900 the put option is in-the-money. What are out-of-money options? A call option is out-of-money when its strike price is above the current market price of the underlier (stock) . For example, if you bought a 5000 NIFTY CALL OPTION and NIFTY is trading at 4900 the call option is out of money. A Put option is out-of-money when its strike price is below the current market price of the underlier (stock) . For example, if you bought a 5000 NIFTY PUT OPTION and NIFTY is trading at 5100 the put option is in-the-money. What are at-the-money options? An option is at-the-money if the strike price of the option equals (or nearly equals) the market price of the underlying security(stock). What is intrinsic value of the option? Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money . Some people view it as the value that any given option would have if it were exercised today For Call options, Intrinsic value = Current Stock price – Strike Price For Put Options, Intrinsic value = Strike Price - Current Stock price Note intrinsic value cannot have negative value so minimum intrinsic value is 0 for an option What is time value of the option? Time Value = Option Price - Intrinsic Value Lets take an example: If stock XYZ is trading at Rs 105 and the XYZ 100 call option is trading at Rs 7, Intrinsic value = 105 – 100 = 5 Time Value = 7 – 5 = 2 So, we would say that this option has time value = Rs 2 Open Interest and Trading Volume What is open interest? The total number of options contracts on an underlyer that have not yet been closed i.e. they have not been exercised, expired or squared off. Is increased open interest bullish?
Different people view it in different manner. Generalizing it may not be a good idea. Many people interpret open interest as described below: Rise or fall in the open interest may be interpreted as an indicator of the future expectations of the market. A rising open interest number indicates that the present trend is likely to continue. If the open interest number is stagnant, then it may suggest that the market is in a cautious mode. If Open interest starts declining, then the market suggests a trend reversal mood. In a rising market, continuous decline of open interest indicates an expectation of downward movement. Similarly, in a falling market, the decline of open interest indicates that the market expects an upward trend. What is the difference between volume and open interest? Volume is the number of contracts of a particular option contract that have traded on a given day, similar to it meaning the number of shares traded on a particular stock on a given day. Open interest is the number of option contracts for a particular stock at a specific strike price and a specific expiration date that were open at the close of trading on the prior trading day. While some traders look at this information as an indication of liquidity of a particular option or option chain, a more reliable indicator may be the tightness of the bid / ask spread. A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct, as demonstrated in the following example
Time
Jan1 Jan2 Jan3 Jan4
Trading Activity Open Interest A buys 1 option and B sells 1 option contract C buys 5 option and D sells 5 option 1 contracts 6 A sells his 1 option and D buys 1 option 5 contract 5 E buys 5 options from C who sells 5 options contracts
-On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1. -On January 2, C and D create trading volume of 5 and there are also five more options left open. -On January 3, A takes an offsetting position, open interest is reduced by 1 and trading volume is 1. -On January 4, E simply replaces C and open interest does not change, trading volume increases by 5. What does liquidity mean? Ability of an option or other tradable security to get bought or sold in the market without affecting the price.
What is PCR (PUT CALL RATIO)? PCR is a very popular indicator to measure the prevailing level of bullishness or bearishness in the market. Remember Put contract is bought by investors who are bearish and Call contracts are bought by people who are bullish. PCR is calculated as: PCR = No of traded Put options / no of traded call options As this ratio increases it means that investors are putting more money into put options rather than call options. There are different ways you can interpret this information to gauge market directions. Options Price Behaviour I bought 1 lot of XYZ 100 strike call option at 20 Rs when stock was trading at 90. Now the stock is trading at 120. The stock is up 30 Rs but why my option is trading at 40 (up only 20 Rs). Why the option did not move as much as the underlying stock? Although options are derived from stocks or indexes but they are traded as independent securities in the markets. The price movement pattern and extent could be different than the underlying stock/Index. Delta value is used interpret the relationship between price movement of an option and its underlyer stock/Index. Who decides on the option price (premium)? Like the stock trading price it is purely driven by Demand (buyers) and Supply (sellers). How could I know whether the price of a particular option is cheap or expensive? You can compute the fair value of options using Binomial or Black Scholes formulas. We do provide theoretical value of options in our web-site using Black-scholes model. Exercise, Assignments & Square-off What does Option exercise mean? Exercising a stock CALL option means buying the stock at the price set by the option (strike price), regardless of the stock's price at the time you exercise the option. Exercising a stock PUT option means selling the stock at the price set by the option (strike price), regardless of the stock's price at the time you exercise the option. Let’s understand it using an example: Mr. Gupta bought 2500-RELIANCE-CALL option contract. The stock is currently trading at Rs. 3000. If Mr. Gupta decides to ‘exercise’ his right he will get the stocks at the rate of 2500 even though the stock is being traded at 3000. What is the difference between square off and exercise? You square off options position when you want to close your existing position. Square off can be done by taking the exactly opposite position for e.g. if you have initially
bought 1 lot of CALL (or PUT) option you can square off by selling 1 lot of CALL (or PUT) option with same strike and expiry. Similarly, if you have initially sold 1 lot of CALL (or PUT) option you can square off by buying 1 lot of CALL (or PUT) option. You may want to exercise your option when you want to take delivery of underlying stock or Index. Under what circumstances I should square off vs. exercise? You may want to exercise if you want to take the delivery of underlying stock and you have long/medium term interest in the stock. If you want to book profit or cut your losses, you may want to close out your position by squaring off. Can I exercise anytime or I need have to wait until the expiration day? If the option is of American style then it can be exercised any day (when the market is open) before its expiration. In case of European options it can be only exercised on the expiration day. I have taken a position on an European style option. We know European style options can’t be exercised before expiry, so can’t I close my position before expiration day if I want? Yes, you can close out your position by squaring off which in short means taking the reverse position. If I exercise an in-the-money call option, how soon I can sell the underlying stock? You can sell the underlying stock as soon as you give instructions to your broker to exercise. We suggest you also double check with your broker if there are any deviations and special rules apply. If I am holding an option and its value has increased i.e. I am making profit right now, Do I need to hold it until expiration? Will be a good move to book close out the position and book profits? It all depends on your outlook of stock and your risk/reward appetite. If you believe that the stock has made its move to large extent and there is not much scope of further movement in your anticipated direction then it you may want close out the position by squaring off. On the other hand if you believe that there is lot more steam left and the stock will go a long way, you can continue to hold your position. What is options assignment? When the holder (buyer) of options exercise the option writer(seller) is said to be assigned the obligation to deliver the terms of option contract. If it is a CALL option the writer(seller) needs to deliver the obligated quantity of the underlying security at the strike price. In case of PUT option the writer(seller) needs to buy the obligated quantity of the underlying security at the strike price. Assignment is done on a random basis. The clearing house picks short positions that ae eligible to be assigned and then allocates the exercised positions to any one or more short positions. What will happen if I have an open option position during options expiration day and I have neither closed my position not excised? All in the money options whether American or European style are automatically exercised by the clearing house. Can I revoke my order to exercise options?
No, once an order is accepted by clearing house it cannot be ordinarily revoked. How do I know if I could get assigned (or exercised)? What is the likely hood of getting assigned? There is no way to know if you could get assigned. If you have sold an option there is always a possibility of getting assigned on any business day before expiration (in case the option is American style) to fulfill your obligation to receive (and pay for) or deliver (and get paid for) shares of underlyer stock . There are some general rules that you should keep in your mind: 1. Only small portion of options actually get exercised 2. Majority of options get exercised when they get closer to expiration Option exercise statistics are published in NSE website www.nseindia.com Can I avoid being exercised or assigned? I you continue to hold your option sell position you cannot eliminate the posibility of being assigned. I bought an index option which is a European style option. Does this mean I cannot close my position until expiration? You can close your position any time by squaring off your position i.e taking the exact opposite position. If I initially shorted an option and later covered my short that is bought back my call option. Can I still get assigned? No, you have closed out your position and there is no way you can get assigned. If I hold options until the expiration day will I get exercised automatically? All in the money options are exercised automatically during the expiration day. For details please contact your broker. Corporate Actions (Split, Merger, Dividend) I own a Call option on a stock. A dividend was announced on the stock. What will happen in this case? SEBI regulation says that if the value of the declared dividend is more than 10% of the spot price of the underlyer stock on the dividend announcement day then the strike price of the stock options are refuced by the dividend amount. If the decalred dividend is less than 10% then there is no adjustment of for the dividend by the exchange. In this case market adjusts the price of the options considering the dividend announcement. What will happen if I hold an stock option and a decision is taken to remove that stock from Futures and options category? All active contracts will continue to exist until the last day (as declared). After that no more contracts on this stock will available for trading. If you are holding such an option your position will be exercised and settled on last day. It is always advisable to check with your broker regarding such announcements. Options Strategies Both ‘Buy Call’ and “Sell Put” are bullish strategies. Which one should I choose?
‘Buy Call’ is capital gain strategy which involves uncapped profit potential and limited loss, where as “Sell Call” is an income generation strategy which involves limited profit and unlimited loss potential. Selling options are only recommended for experienced investors. Both ‘Buy Put” and “Sell Call” are bearish strategies. Which one should I choose? ‘Buy Put’ is capital gain strategy which involves uncapped profit potential and limited loss, where as “Sell Put” is an income generation strategy which involves limited profit and unlimited loss potential. Selling options are only recommended for experienced investors. I sold a call option and received a premium for that. If I get exercised do I need to give back the premium to the buyer? No, you keep the premium but you still need need to deliver the underlying stocks to the options holder. What are options spreads? Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. Refer our StrategyFinder tool to see real tradable strategies which also includes spreads. Can an individual person be both long and short the exact same option at the same time? If you do it from the same trading account it will offset each other. If you do it from different accounts then you will have a flat position from economic perspective. There is no visible advantage in doing so. Margins What is margin and why there is a need for it? Margin is the amount of cash you need to deposit with your broker as a collateral if you want to write an uncovered (naked) option. You also need to maintain margin to cover your daily position valuation and reasonably foreseeable intra-day price changes. When you short sell an option there is unlimited risk involved if the stock moves in opposite of your expected market direction. There is always a possibility that the seller will not be able to fulfill his obligation to deliver the terms of the contract due to lack of funds. If the options price has increased significantly and the seller wants to close out his position by buying out the option there is possibility that he may not have sufficient funds in his account. This kind of situations will prevent markets from functioning efficiently as the counter party wont be able to get his payement. To avoid these kind of circumstances the concept of margins were introduced in all markets across the world. What is options volatility? Does change in volatility affect margins? If yes how? Volatility is a measure of the rate and magnitude of the change of prices (whether up or down) of the underlying. To put it simply you can view volatility as the speed at which price of underlying can move in either direction. If volatility is high, the premium on
the option will be relatively high, and vice versa. How can I find out how much margin is applicable for an options? You can find out the applicable margin from your broker. Many online brokers like www.hdfcsec.com , www.icicidirect.com etc. do provide tools to calculate margin requirements. Will I get margin benefits if I have positions on different underlying? No, you will not get margin benefits in this case. Will I get margin benefits if I have positions in both futures and options on same underlying? Yes, you will get benefits in this case. Will I get margin benefit if I have counter positions in different months on same underlying? Yes, you will get margin benefits in this case. However, the benefit will be removed three days prior to expiry if the near month contract. Options Geeks What is option DELTA? Delta can be defined as amount by which an option’s price will change for corresponding 1 point change in price of the underlying stock or index. Long Call options have positive deltas, whereas Long put options have negative delta whereas Short Call options have negative delta, and Short put options have positive delta. Let understand using couple of examples. • Delta of NIFTY Mar-2009 3000 CALL is 0.50. Theoretically, this means that if NIFTY moves up by 1 point, this option’s price will go up by 0.5 point. Similarly, if NIFTY moves down by 1 point, this options price will go down by 0.5 point • Delta of NIFTY Mar-2009 2800 PUT is -0.75. Theoretically, this means that if NIFTY moves up by 1 point, this option’s price will go down by 0.75 point. Similarly, if NIFTY moves down by 1 point, this options price will go up by 0.75 point Note that DELTA values are dynamic and changes almost everyday. What is option GAMMA? If Delta is viewed as the ‘speed’ of price movement of option relative to underlying then option Gamma can be viewed as the acceleration. Basically, Gamma measures the amount by which delta changes for a 1 point change in the stock price. For example, if Gamma of an option is 0.5, that means theoretically that with 1 point price movement of underlying the delta will move 0.5. Long calls and long puts have positive gamma whereas short calls and short puts have negative gamma. What is an option VEGA? Vega can be interpreted as the amount by which the price of an option will change with 1% change in implied volatility of the underlying. One common scenario when option Vega changes is when there is a large movement in underlying price. Long calls and long puts both have positive vega where as short calls and short puts will always have negative Vega. What is an option THETA?
Option theta can be interpreted as change in the price of the option with one day decrease in the remaining life of the option. To put is simply it is a measure of time decay. Note that longer the life of an option, the higher will be the premium and vice versa. With each passing day the value of option decreases (considering all factors equal). What is theoretical value of an option? When you want to buy an option you probably want to know what is the fair value of the option and what should be the fair price of an option, whether the option is undervalued, over valued or rightly valued. You can get answers to these questions by calculating the theoretical value of an option. There are many mathematical models and formulas available which can be used. What are Binomial and Black-holes equations? These are mathematical models that can be used to calculate the theoretical value and greeks of an options. How important is it to use options geeks? If you consider option Greeks in taking decisions to buy or sell options you are basically increasing your probability to make a profit in your trades.
