OPTIONS

Objective

This chapter introduces the readers to the concept of options

which include calls and puts. All basic concepts like option buyer
and seller, European and American options, and payoff profiles
have been elaborated in this chapter.
Options
• A call option is an option to buy a certain asset by a certain
date for a certain price
• A put option is an option to sell a certain asset by a certain
date for a certain price
• The price of the contract is known as strike price/exercise
price
• The date in the contract is known as expiration date/maturity
Difference: Options & Forward/Futures
• The holder of the option is not obliged to honor the contract,
whereas the holder of Forward/Futures Contract is obliged to
buy or sell the underlying asset
• It costs nothing to enter into Forward/ Futures Contracts, but
for buying options, upfront payment is required
Terminology

• All options of the same type (calls or puts) are referred to as

an option class
– For example, Reliance calls are one option class while Reliance puts are
another class
• An option series consists of all the options of a given class with
the same expiration date and strike price
• Reliance August calls with 1750 strike price are one option
series
Terminology
• An in-the-money option is one that would lead to a positive
cash flow to the holder if it were exercised immediately
• An at-the-money option would lead to zero cash flow if it were
exercised immediately
• An out-of-the-money option would lead to a negative cash
flow if it were exercised immediately
Options types
• An American option can be exercised at any time during its life
• An European option can be exercised only at maturity
 The terms American or European do not refer to the location of the
option
Ex:
 Index options traded in NSE are of European type
 Stock options traded in NSE are of American type
Terminology
• If S is the stock price and X is the strike price
 A call option is
o In the money when S > X
o At the money when S = X
o Out of the money when S < X
 A put option is
o In the money when S < X
o At the money when S = X
o Out of the money when S > X
• An option will only be exercised if it is in the money
• In the absence of transaction costs, an in-the-money option
will always be exercised on the expiration date if it has not
been exercised previously
Terminology
• The intrinsic value of an option is defined as the maximum of
zero and the value it would have if it were exercised
immediately
 For a call option, the intrinsic value is therefore max(S - X, 0)
 For a put option, it is max(X - S, 0)
• An in the money American option must be at least its intrinsic
value since the holder can realize the value by exercising
immediately
• Often it is optimal for the holder of an in-the-money American
option to wait rather than exercise immediately
 The option is then said to have time value
• The total value of an option can be thought of as the sum of
its intrinsic value and its time value
Risk to Option Buyer

• The buyer of the call or put has the right to exercise if the
price of the underlying is in favor
• There is no obligation to the seller of the option
• Risk is limited to the value of the premium paid (for buying
the rights)
Risk to Option Seller

• The seller of the call or put has no right to exercise

• The seller is under obligation from the buyer and may be
exercised upon, at the will of the option buyer
• Profit is limited to premium received whereas loss can extend
to any limits, in case price continue to move in same direction
Specification of Options Traded in NSE

• Underlying Instrument:
 Option contracts are available on 216 securities stipulated by the
Securities & Exchange Board of India (SEBI)
 These securities are traded in the Capital Market segment of the
Exchange
• Expiration date:
 Last Thursday of the expiry month. If the last Thursday is a trading
holiday, then the expiry day is the previous trading day
Specification of Options Traded in NSE
• Trading Cycle:
 3 month trading cycle:
1. The near month
2. The next month
3. The far month
• On expiry of the near month contract, new contracts are
introduced at new strike prices for both call and put
options, on the trading day following the expiry of the
near month contract
• The new contracts are introduced for three month
duration
Specification of Options Traded in NSE –
Strike Price Interval
• The Exchange provides a minimum of seven strike prices for
every option type (i.e Call & Put) during the trading month
 At any time, there are three contracts in-the-money (ITM), three contracts
out-of-the-money (OTM) and one contract at-the-money (ATM)
• New contracts with new strike prices for existing expiration date
are introduced for trading on the next working day based on the
previous day's underlying close values, as and when required
 In order to decide upon the at-the-money strike price, the underlying
closing value is rounded off to the nearest strike price interval
• The in-the-money strike price and the out-of-the-money strike
price are based on the at-the-money strike price interval
Strike Price Interval at NSE

Strike Price
Price of Underlying interval (Rs.)
Less than or equal to Rs. 50 2.5

> Rs.50 to less than or equal to Rs. 100 5

> Rs.100 to less than or equal to Rs. 250 10

> Rs.250 to less than or equal to Rs. 500 20
> Rs.500 to less than or equal to Rs. 1000 20
> Rs.1000 50
Position Limits and Exercise Limits
• Position Limit defines the maximum number of option
contracts that an investor can hold on one side of the market.
 For this purpose Long calls and short puts are considered to be on the
same side of the market and Short calls and long puts are considered
to be on the same side of the market
• Exercise Limit defines the maximum number of contracts that
can be exercised by any individual (or group of individuals
acting together) in any period of 5 consecutive business days
• Position limits and exercise limits are designed to prevent the
market from being unduly influenced by the activities of an
individual investor or group of investors
Example of European long call option
• Suppose an investor purchases 1 NIFTY-May-4500-Call at
premium 50
 One contract consists 50 index share.
 The contract is cash settled
• If at the end of this option life NIFTY value is more than 4500
 He exercises the option and receives the amount by which NIFTY
exceeds 4500 for one index share times Rs. 50
Example of European long call option
• Suppose the final day value of NIFTY is 4600.
 By exercising he gets (4600 – 4500) = 100 per index share or Rs. 50X100
= Rs. 5,000 for one contract
• However, if the final day value is below 4500
 He will not exercise the option
• For this privilege, he pays a fee of Rs.2500 (Rs.50 a share for 50
shares)
Example of American long call option

• Suppose an investor purchases 1 Reliance-May-1600-Call

at premium Rs.60
 Lot size is 150
 The contract is cash settled
• This contract allows him to buy 150 shares of Reliance at
Rs.1600 per share at any time between the current date
and the option expiry date of May
• If the price goes above Rs. 1600 he can exercise the option
Example of American long call option

• Suppose the price goes to 1670 and he exercises the

option
 This is equivalent to buying the option @ 1600 and selling it @
1670
 He will get Rs. (1670 – 1600) = Rs. 70 per share or Rs. 70 * 150 =
Rs. 10,500 for one contract
• If the price remains below Rs. 1600 over the life of the
option
 He will not exercise the option
• For this privilege, he pays a fee of Rs.9000 (Rs.60 a share for
150 shares)
Example of American short call option
• Suppose an investor writes/shorts 1 Reliance-May-1600-Call
at premium Rs. 60
 Lot size is 150
 The contract is cash settled
• This contract gives an obligation on him to sell 150 shares of
Reliance at Rs.1600 per share at any time between the
current date and the option expiry date of May
• If the price goes above Rs. 1600 long position holder will
exercise the option
Example of American short call option
• Suppose the price goes to 1670 and long position holder
exercises the option
 For short position holder this is equivalent to selling the option @
1600 after buying it @ 1670
 He will make loss Rs. (1670 – 1600) = 70 per share or RS. 70* 150
= Rs. 10,500 for one contract
 However, he receives a fee of Rs.9000 (Rs.60 a share for 150
shares) from long position holder
• However, if the price remains below 1590 over the life of
the option
 Long position will not exercise the option
 The entire fee of Rs.9000 (Rs.60 a share for 150 shares) is the
profit of short position holder
Payoff Diagram – Long Call
Payoff from
Long Call

K ST
-C

The payoff from a long position in a call option

= Max (ST – K, 0) - C (K = Strike price, ST = Price of the underlying security
at maturity, C = Call option premium)
Payoff Diagram – Short Call

Payoff from
Short Call

C
K ST

The payoff from a short position in a call option

= – Max (ST – K, 0)+ C = Min (K - ST, 0)+ C (K = Strike price, ST = Price of the
underlying security at maturity, C = Call option premium)
Payoff Diagram – Long Put

Payoff from
Long Put

K
ST
-P

The payoff from a long position in a put option

= Max (K – ST, 0) - P (K = Strike price, ST = Price of the underlying security
at maturity, P = Put option premium )
Payoff Diagram – Short Put
Payoff from
Short Put

P
K ST

The payoff from a short position in a put option

= – Max (K – ST, 0)+P = Min (ST – K, 0) + P (K = Strike price, ST = Price
of the underlying security at maturity, P = Put option premium )
Dividends & Stock Splits
• Suppose you own N options with a strike price of K :
 No adjustments are made to the option terms for cash dividends
• When there is an n-for-m stock split,
 the strike price is reduced to mK/n
 the no. of options is increased to nN/m
• Stock dividends are handled in a manner similar to stock
splits
Dividends & Stock Splits

• Consider a call option to buy 100 shares of a company for

Rs.30 per share. Suppose that the company makes a 2-for-1
stock split
 The terms of the option contract are then changed so that it gives
the holder the right to purchase 200 shares for Rs.15 per share
• Consider a put option to sell 100 shares of a company for
Rs.15 per share. Suppose that the company declares a 25%
stock dividend
 This is equivalent to a 5-for-4 stock split
 The terms of the option contract are changed so that it gives the
holder the right to sell 125 shares for Rs.12
Margins – For Writing Naked Options
• Margins are required when options are sold.
• When a naked option is written the margin is the greater of:
 A total of 100% of the proceeds of the sale plus 20% of the
underlying share price less the amount (if any) by which the option
is out of the money
 A total of 100% of the proceeds of the sale plus 10% of the
underlying share price
• For other trading strategies there are special rules
Margins – For Writing Covered Call Options
• Writing covered calls involves writing call options when the shares that
might have to be delivered are already owned
• Covered calls are far less risky than naked calls since the worst that can
happen is that the investor is required to sell shares already owned at
below their market value
• If covered call options are out of the money, no margin is required
 The shares owned can be purchased using a margin account as just described,
and the price received for the option can be used to partially fulfill this margin
requirement
• If the options are in the money, no margin is required for the options
 However, the extent to which the shares can be margined is reduced by the
extent to which the option is in the money
Commissions
• For retail investors commissions vary from broker to broker.
• Below is an example:
Illustration
Strike price - 1000
Premium - 50
Lot size - 600

New
Basis On premium only
Rate 1% (min 100 per contract)
Formula (Premium*Lot Size)*Rate OR Min. Rs 100/-
Charge On a Contract (50*600)*1% OR 100, Whichever is higher = 300
As per NSE circular no. NSEIL/LEGAL/8319/2007 dated 2nd January 2007 and NSE/INSP/2006/56 dated 5th January, 2007 on
brokerage charged for option contracts, the brokerage should be charged on the Premium amount at which the option
contract is bought or sold and not on the notional price (Strike price + Premium) of the option contract
In case of options positions squared off within the day of taking the same, brokerage shall be chargeable on
single leg.
Commissions
Here is another example:
Options
Effective Flat Brokerage
Total Eligible Premium Flat brokerage
On Intra Day Square
Value per month per contract lot (Rs.)
Off (Rs.)
Above Rs. 20 lacs 65 32.5

Rs. 10 Lacs - Rs. 20 lacs 70 35

Rs. 5 lacs - Rs. 10 lacs 75 37.5

Rs. 2 lacs to Rs. 5 lacs 85 42.5

Less than Rs 2 Lac 95 47.5