Understanding Options

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What is an Option ?

It is a contract that enables a RIGHT (which is not an obligation) to be given by the option seller to the option buyer to BUY/SELL a certain quantity of an asset in at a price agreed upon today. Example: Suppose you have bought an option of 500 shares of ABC Company at a strike price of 100. This option gives you a right to buy 500 shares at INR 100 before contract expiry. The seller is under an obligation to sell 500 shares to you at INR 100 whenever asked for. The option seller is thus under an obligation to execute the contract. Option seller is also called as “Writer” while option buyer is also called as “Holder”.

Types of Options:

  • CALL: This option gives the buyer the right to BUY. You generally buy a CALL option when you have a bullish view on the stock. This is same as going LONG in futures.
  • PUT: This option gives the buyer the right to SELL. You generally buy a PUT option when you have a bearish view on the stock. This is same as going SHORT in futures.
  • American: All options that can be exercised (Explained ahead) on or before the contract expiry are called American options. All stock options in India are American.
  • European: All options that can be exercise only on contract expiry are called European options. In India, options on the index i.e Sensex and NIFTY are European styled options.

Terminologies used in options:

Strike price: It is the price at which the buyer has been given the right to buy/sell. It is the transaction price which is decided by the exchange.
Expiry day: A pre-defined period when the option will expire. This predefined period is last Thursday of every month for Indian stock markets. You can settle the contract even before this period. If you don’t explicitly settle the contract, the exchange does it implicitly for you on this predefined period.

Premium: It is the price which the buyer pays to the seller to BUY a CALL/PUT Option
Exercising an option: (Explained in case study)
Exercise day: It is the day when the option is exercised.
Spot: It is the price of the stock (underlying asset) in the cash market.

ATM/ITM/OTM:

At the money (ATM), In the money (ITM) and Out of the money (OTM) are the three terms which are used to describe the relationship between the options strike price and the price of the underlying asset (stock).
ATM: This is a scenario when the options strike price is exactly the same as the price of the stock in the cash market. Example: if a stock ABC in cash market is trading at 200 then ABC 200 call and put option are at the money. This is the break-even point i.e no profit no loss zone for our position.
ITM: This is a scenario when for a call option; the strike price is below the stock price and for a put option the strike price is above the stock price in the cash market. This is a profit zone for our position if the option is exercised.
OTM: This is a scenario when for a call option; the strike price is above the stock price and for a put option the strike price is below the stock price in the cash market. This is a loss making zone for our position if the option is exercised.These options are cheaper than compared to ITM and ATM options. They provide huge returns if the view proves right. For Example: suppose a ABC stock is trading at INR 300, then a call with strike price 290 (ITM) could be priced at 1.50, while the call with a strike price 310 (OTM) could be priced at 40 Paise. If the stock rallies to INR 320, the INR 290 call would be around 3.00, while the 310 call would be priced around 1.00. In this case the return on investment is higher on INR 310 call than on the INR 290 call.
Note: It is recommended to always opt for a ITM option.

Types of Contracts:

In options trading, there are 3 contracts that are open at any point in time

1. ‘Current month’ which is the 1st month contract.
2. ‘Next month’ which is the 2nd month contract.
3. ‘Far month’ which is the 3rd month contract.

Case Study 1: Buying a CALL Option (Limited Risk Unlimited Profits)

Case: Mr. Rakesh wants to BUY Call option of ABC company.
View: Bullish
Premium to be paid: INR 10
Strike Price: 100
Lot Size: One lot (1000 shares) of ABC
Contract Month: February 2013.
Total Investment made for one lot: (premium * lot size) = 10 * 1000 = INR 10000.

Analysis:

So now technically to make money the stock (spot) needs to move above 110 because our break even is 100 (Strike Price) + 10 (Premium) = 110. Any price movement of the spot above 110 would yield us profit.
Risks (Limited): If at all till the expiry the spot stays below 110, then the option would make a loss and the maximum loss would always be equal to the total premium paid i.e 10000.
Rewards (Unlimited): If the spot rallies above 110, say 130 the premium goes up to say 25.

So profits = (Current Premium – Buying Premium) * lot size
= (25-10) * 1000
= 15000
The rewards would go on increasing as the spot keeps rallying higher.

Exercising an option:

Since an option is a right given by the seller to the buyer, the buyer has the right to exercise that right. In the above case we sold the option and the profit was 15000. Now if you exercise your option then your net profit would be
= (Current stock price – Strike Price) – (Premium Paid) * Lot Size
= [(130 – 100) – (10)] * 1000
= 20000
Note: Exercising an option has been discontinued by SEBI and is no more a valid concept now.

Case Study 2: Selling a CALL Option (Unlimited Risk Limited Profits):

In the above case study 1, the CALL option seller would have received the premium of 10000 from the option buyer initially. This is the maximum money that he could make. If the spot rallies like it rallied above then the losses of the option seller are unlimited now. If the option is exercised, the losses are tremendous.

Case Study 3: Buying a PUT Option (Limited Risk Unlimited Profits):

Case: Mr. Rakesh wants to Buy PUT option of ABC company.
View: Bearish
Premium to be paid: INR 10
Strike Price: 100
Lot Size: One lot (1000 shares) of ABC
Contract Month: February 2013.
Total Investment made for one lot: (premium * lot size) = 10 * 1000 = INR 10000.

Analysis:

So now technically to make money the stock (spot) needs to move below 90 because our break even point is 100 (Strike Price) – 10 (Premium) = 90. Any price movement of the spot below 90 would yield us profit.
Risks (Limited): If at all till the expiry the spot stays above 90, then the option would make a loss and the maximum loss would always be equal to the total premium paid i.e 10000.
Rewards (Unlimited): If the spot breaks below 90, say 70 the premium goes up to say 25.

So profits = (Current Premium – Buying Premium) * lot size
= (25-10) * 1000
= 15000
The rewards would go on increasing at the spot keeps falling.

Now if you exercise your option then your net profit would be
= (Strike Price – Current stock price) – (Premium Paid) * Lot Size
= [(100 – 70) – (10)] * 1000
= 20000

Case Study 4: Selling a PUT Option (Unlimited Risk Limited Profits):

In the above case study 3 the PUT option seller would have received the premium of 10000 from the option buyer initially. This is the maximum money that he could make. If the spot falls below the break-even point as it did above, then the losses of the option seller are unlimited now. If the option is exercised, the losses are tremendous.

Important points to note:

• Since this is a high risk segment, follow experts. Please do not be creative!
• Never ever sell a PUT or a CALL as the risks are unlimited here.
• Options are mere shadow images of the stock price in the cash market. As the stock price moves in the cash market, the option price also moves. Hence stop loss for options should always be followed in the cash segment only. If stop loss is triggered in cash segment, exit your option position also.
• Options have liquidity problems. If you see profits and can square-off your position, go ahead!
• When a stock is moving up it takes time to run. But when it is falling, it falls very fast. Do not miss opportunities to SHORT.