Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date. An option gives a person the right to buy or sell something. Option is a instruments whereby the right is given to the option buyer by the option seller to buy or sell a specific asset at a specific price on or before a specific date.
Call Option: A call option grants its purchaser the right (but not the obligation) to buy some underlying asset at a specified price on or before a specified date.
Option buyer who buys either a Call Option or Put Option & who has the right conveyed by the option is referred as Option holder.
The person who sells the option & who is obligated if and when assigned an exercise to perform according to the terms of the option is referred as option writer.
An option is a contract between two parties . There are basically two kinds of options "calls" and "puts".
When the buyer of the option receives a privilege to buy stocks , the option is referred as Call Option.
Where as when the buyer of the option receives a previlage to sell the underlying stocks , the option is referred as put option.
Call Option : This Option grants the buyer of Call Option , the right to buy underlying Stocks at a specified price on or before a specified date. However he is not under obligation to buy the stocks of the option.
Put Option : This Option grants the buyer of put option , the right to sell underlying Stocks at a specified price on or before a specified date. However he is not under obligation to sell the stocks of the option.
The buyer of Call or Put option pays a fee (premium) to receive right to buy or sell the underlying stocks and the seller of Call or Put option accepts an obligation for which he receives a fee. The Options are of two kinds referred as "calls" and "puts".
The buyer of Call Option is referred as long in the option. Ulternatively the buyer of Put Option is referred as short in the option .
Some Important terminalogy used in Future & Option Market
Options - The Option is the right either to buy or sell on or before the expiration date , a specified quantity of the underlying stocks at a fixed exercise price.
Option Holder - Option buyer who buys either a Call Option or Put Option & who has the right conveyed by the option is referred as Option holder.
Option Writer - The person who sells the option & who is obligated if and when assigned an exercise to perform according to the terms of the option is referred as option writer.
American style of Option - In this type of options , the option to call or put may be exercised at any time prior to expiration of option contract .
European style of Option - In this type of option , options can only be exercised on the expiration day.
Exercise Price - This is a price at which the option holder of the Call Option has the right to purchase or the price at which the option holder of the Put Option has the right to sell the underlying Stocks .Exercise price is also termed as ‘ Strike Price ’.
Strike Price - This is the predetermined price upon which the buyer and the seller of an option have agreed to buy or sell the underlying stocks is referred as the strike price . Striking price is also called the as exercise price . Each option on a underlying instrument shall have multiple strike prices.
Premium - This is a price which is paid by the Option buyer to the writer of the Option to receive right conveyed by the Option . The premiums are fixed by the fluctuations in response to market and economic forces. Various factors such as current value of the underlying , relationship between the value and the exercise price , current values of futures on the underlying , style of option , individual opinion and estimates of the future volatility of the underlying index , historical volatility of the underlying , the amount of time remaining until expiration , cash dividends payable on the underlying stock , current interest rates , depth of the market , available information , etc. are directly related to the premium.
Option Pricing - Prices of the Option are set by the negotiations between buyers i.e. holder of Option and sellers i.e. writer of Option. Perception by buyer & seller regarding future prices directly influence the pricing of the Option.
An option price or premium has two components - Intrinsic value and Extrinsic value.
The intrinsic value of an option depend upon its price and the strike price . The intrinsic value equals the in-the-money amount of the option.
The extrinsic value of an option is the amount that the premium exceeds the intrinsic value.
Extrinsic value = Option premium - intrinsic value.
Factors that influence option prices are:
1. Price of the underlying instrument.
2. Strike price.
3. Time remaining till expiration.
4. Risk-free rate.
5. Expected volatility.
6. Corporate action like dividend or interest payments, if any.
Expiration Day - Every Options has got finite duration .The expiration day of the option is the last day that the option owner can exercise the option. On this Date Option expires. If the buyer of Call Option or Put Option fails to excercise his option prior to its expiration, his right to Call or Put ceases to exist after the expiration date & the option holder shall no longer have any right and the option . Consecutively he is not entitled to any value under the option.
Cash Settled Options : Cash settled option gives the buyer of Call Option the right to receive a cash payment . Quantum of Cash payment is the difference between a determined value of the underlying stock at the time of exercise of the option and the fixed exercise price of the option.
NSE's Nifty options is reported to be cash settled option .
Illustration : The buyer has purchased April Call option of say Nifty index option at stike price of 1850 . Suppose on expiry of April options , the expiration level of Nifty is 1900. Then in our case the cash settlement will be Rs.50 per nifty . Accordingly the buyer is entitled to cash option of Rs. 10000/- for one contract of option comprising 200 Units.
In the money - The Call Option is termed as in the money , when underlying instrument price i.e. current market value of the underlying is higher than the strike price.
Illustration : If the current nifty is at 1480 , then Call Option with strike Price at 1450 will termed as out of the money.
The Put Option is termed as in the money , underlying instrument price i.e. current market value of the underlying is lower than the strike price.
Illustration : If the current nifty is at 1450 , then Call Option with strike Price at 1480 will termed as out of the money.
Out of the money - The Call Option is termed as out of the money , when underlying instrument price i.e. current market value of the underlying is lower than the strike price.
Illustration : If the current nifty is at 1450 , then Call Option with strike Price at 1480 will termed as out of the money.
The Put Option is termed as out of the money , when underlying instrument price i.e. current market value of the underlying is higher than the strike price.
Illustration : If the current nifty is at 1480 , then Call Option with strike Price at 1450 will termed as out of the money.
At the money - When the underlying price is equivalent to the strike price , the option is termed as at the money.
Closing Transaction - When the holder or the writer of option reduces or cancels out his previous position either as the holder or the writer of that option , the transaction is called as Closing Transaction .
The buyer can make an offsetting sale of an identical option, if he is an option holder , or the option writer can make an offsetting purchase of an identical option to close the transaction at some point prior to expiration .
The premium of the option consist of two components - intrinsic value and extrinsic value.
Intrinsic value reflects the amount, if any, by which an option is in the money.
Extrinsic value is the premium of the option, which is in addition to its intrinsic value.
Illustration : If the current nifty is 1480 . The Call Option of 1460 ( Strike Price : 1460 ) is trading at a premium of Rs.22.50 reflects an intrinsic value of Rs.20 and extrinsic value of Rs.2.50 per nifty.
Long Position & Short Position - The buyer holding option is referred as Long and the writer of the option is termed as short .
Spread - involves being the buyer and writer of the same type of option ( puts or calls) on the same underlying with the options having different exercise prices and / or expiration dates
Straddle - involves purchasing or writing both a put and a call on the same underlying with the options having the same exercise price and expiration date
Settlement of an Option
An option can be settled in following Methods :
1. Closing Transaction - When the holder or the writer of option reduces or cancels out his previous position either as the holder or the writer of that option , the transaction is called as Closing Transaction .
The buyer can make an offsetting sale of an identical option, if he is an option holder , or the option writer can make an offsetting purchase of an identical option to close the transaction at some point prior to expiration .
2. Non exercise of Right - As the option hoder has already paid premium or a price to the writer of the Option to receive right conveyed by the Option .Option buyer is at liberty according to his choice to excercise Call or Put rights .An option can be abandoned if the premium left is less than the transaction costs of liquidating the same.
3. By exercising Right - The holder of the option has got the right to buy or sell a underlying instrument at a predetermined price. The Buyer of Call option can exercise right to buy the underlying instrument. The buyer of put option can exercise right to sell the underlying instrument. Hence , exercising an option is equivalent of buying or selling the underlying instrument for a consideration.
It is reported that NSE plans to commence trading in Index options from 4th June , 2001. The NSE has detailed as given below proposed contract specifications for Index options :
A. Underlying Index - S&P CNX Nifty
B. Contract size - Permitted lot size shall be 200 or multiples thereof
C. Price steps - Re.0.05
D. Price Bands - Not applicable
E. Style - European / American
F. Trading cycle - The options contracts will have a maximum of three month trading cycle – the near month ( one), the next month ( two) and the far month ( Three) New contract will be introduced on the next trading day following the expiry of near month contract
G. Expiry day - The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.
H. Settlement basis - Cash settlement on a T + 1 basis
I. Settlement prices - Based on expiration price as may be decided by the Exchange
Now , we will present herewith who the option can be utilised to best of our advantage .
Supposing , in my perception Nifty will move upward over the short term , I am expected to Buy Nifty Call Option.
Illustration : Current Nifty in the cash market is 1450 . I will buy one contract of Nifty near month calls for say Rs.15.00 each. If current strike price is 1480 , i.e. 2.07% out of the money. In the present instance , I will be required to pay premiun of Rs. 2300 ( 11.50 * 200 ) . At this juncture , my break-even level of Nifty option will be 1495.00. Now , suppose at expiration date , Nifty advances by 10%, i.e. 1595 , then
Nifty at expiration level - 1595.00
Less Strike Price - 1480.00
Option value - 115.00
Less Purchase price - 15.00
Profit per nifty - 100.00
Profit on the contract - Rs.20000 (Rs.100* 200)
I would bear in mind that if Nifty is at or below 1480 at expiration date , I as a call holder would be losing the entire premium, i.e. Rs.3000 in this example. If at expiration, Nifty is between 1480 ( the strike price) and 1495.00 (breakeven), then I could exercise the call option and receive the amount by which the index level exceeds the strike price. This will help me to reduce some burden of buying option .
Thus , I will , depending on the market condition and my perception, may sell the call even before expiry.
Supposing , now in my perception Nifty will move downward over the short term , I am expected to Buy Nifty put Option.
Illustration : Current Nifty in the cash market is 1450 . I will buy one contract of Nifty near month puts for Rs.14 each. The strike price is 1420 , i.e. 2.07% out of the money. In the present instance , I will be required to pay premiun of Rs. 2800 ( 14.00 * 200 ) .At this juncture , my break-even level of Nifty option will be 1406.00. Now , suppose at expiration date , Nifty declien by 10%, i.e. 1305 , then
Put Strike Price - 1420
Nifty expiration level - 1305
Option value - 115
Less Purchase price - 14
Profit per nifty - 101
Profit on the contract - Rs.20200 (Rs.101.00* 200)
Constituents list of S&P CNX NIFTY
1. Asea Brown Boveri Ltd. - Electrical Equipment
2. Asian Paints (India) Ltd.- Paints
3. Associated Cement Companies Ltd. - Cement and Cement Products
4. Bajaj Auto Ltd. - Automobiles - 2 and 3 Wheelers
5. Bharat Heavy Electricals Ltd. - Electrical Equipment
6. Britannia Industries Ltd. - Food and Food Processing
7. BSES Ltd. - Power
8. Castrol (India) Ltd. - Lubricants
9. Cipla Ltd. - Pharmaceuticals
10. Cochin Refineries Ltd. - Refineries
11. Colgate-Palmolive (India) Ltd. - Personal Care
12. Dabur India Ltd. - Personal Care
13. Digital Equipment (India) Ltd. - Computers - Software
14. Dr. Reddy's Laboratories Ltd. - Pharmaceuticals
15. Glaxo India Ltd. - Pharmaceuticals
16. Grasim Industries Ltd. - Diversified
17. Gujarat Ambuja Cements Ltd. - Cement And Cement Products
18. HCL Infosystems Ltd. - Computers - Hardware
19. HDFC Bank Ltd. - Banks
20. Hero Honda Motors Ltd. - Automobiles - 2 and 3 Wheelers
21. Hindalco Industries Ltd. - Aluminium
22. Hindustan Lever Ltd. - Diversified
23. Hindustan Petroleum Corporation Ltd. - Refineries
24. Housing Development Finance Corporation Ltd. - Finance - Housing
25. I T C Ltd. - Cigarettes
26. ICICI Ltd. - Financial Institution
27. Indian Hotels Co. Ltd. - Hotels
28. Indian Petrochemicals Corporation Ltd. - Petrochemicals
29. Infosys Technologies Ltd. - Computers - Software
30. Larsen & Toubro Ltd. - Diversified
31. Mahanagar Telephone Nigam Ltd. - Telecommunication - Services
32. Mahindra & Mahindra Ltd. - Automobiles - 4 Wheelers
33. Nestle India Ltd. - Food and Food Processing
34. NIIT Ltd. - Computers - Software
35. Novartis India Ltd. - Pharmaceuticals
36. Oriental Bank of Commerce - Banks
37. Procter & Gamble India Ltd. - Personal Care
38. Ranbaxy Laboratories Ltd. - Pharmaceuticals
39. Reckitt & Colman of India Ltd. - Personal Care
40. Reliance Industries Ltd. - Petrochemicals
41. Reliance Petroleum Ltd. - Refineries
42. Satyam Computer Services Ltd. - Computers - Software
43. Smithkline Beecham Consumer Healthcare Ltd. - Food and Food Processing
44. State Bank of India - Banks
45. Tata Chemicals Ltd. - Diversified
46. Tata Engineering & Locomotive Co. Ltd. - Automobiles - 4 Wheelers
47. Tata Iron & Steel Co. Ltd. - Steel and Steel Products
48. Tata Power Co. Ltd. - Power
49. Tata Tea Ltd. - Tea and Coffee
50. Zee Telefilm Ltd. - Media & Entertaintment