Basics of options :
- Options vs. Futures/Forwards:
Options allow unlimited profit with limited loss, unlike futures which have unlimited profit/loss potential. - Definition:
An option gives the holder the right but not obligation to buy/sell an underlying asset at a set price on or before a set date, for a premium. - Parties Involved:
- Buyer (Holder): Pays premium, has a right but no obligation.
- Seller (Writer): Receives premium, carries an obligation if buyer exercises the option.
- Types of Options:
- Call Option: Right to buy the asset.
- Put Option: Right to sell the asset.
- Option Styles:
- American Option: Can be exercised any time before expiry.
- European Option: Can be exercised only on expiry (used in India).
- Key Terms:
- Option Premium: Price paid by buyer to seller.
- Spot Price: Current market price of the asset.
- Strike Price: Price at which the asset can be bought/sold via option.
- Open Interest: Total outstanding option contracts.
- Exercise and Assignment:
In India, only exercised on expiry; assignment means allocating exercised options to sellers. - Position Types:
- Opening Purchase/Sale: Initiates a long/short position.
- Closing Purchase/Sale: Closes an existing short/long position.
- Index vs. Stock Options:
- Index Options: Based on market indices (e.g. Nifty, Sensex).
- Stock Options: Based on individual stocks (e.g. ONGC, NTPC).
- Closing Transactions:
Must involve the same option series (same strike price and expiry) to offset positions.
Contract specifications of exchange-traded options :
- Contract Size: Number of underlying asset units in a contract, varying by stock/index. Example: Nifty options have a lot size of 50.
- Contract Trading Cycle:
- Stock options: 3-month cycle (near, next, far month).
- Index options: Weekly and monthly cycles, plus 3 quarterly (Mar, Jun, Sep, Dec) and 8 half-yearly expiries.
- Expiration Date:
- Nifty: Last Thursday of expiry month.
- Bank Nifty: Last Wednesday.
- As per SEBI (Oct 2024), from Nov 20, 2024 — exchanges can offer weekly expiries on only one benchmark index.
- Tick Size: Minimum price movement allowed.
- Index options: ₹0.05.
- Stock futures: Varies by price and exchange (e.g., NSE: ₹0.01 for <₹250 stocks).
- Final Settlement Price: Based on the closing price of the underlying stock/index on the contract’s last trading day; no daily settlement for options.
- Trading Hours: 9:15 a.m. to 3:30 p.m., Monday to Friday.
- BSE Sensex Option Specifics:
- Lot size: 10
- Contract cycle: 7 weekly, 3 monthly, 3 quarterly, 8 semi-annual
- Expiry: Friday (weekly/monthly/quarterly)
- European style; cash-settled on expiry day’s closing price.
Moneyness of an option :
- Options are categorized as:
- In-the-Money (ITM)
- At-the-Money (ATM)
- Out-of-the-Money (OTM)
- In-the-Money (ITM):
- Positive cash flow if exercised immediately.
- Call option: Spot price > Strike price
- Put option: Spot price < Strike price
- At-the-Money (ATM):
- Zero cash flow if exercised immediately.
- Strike price = Spot price, or closest available strike.
- Out-of-the-Money (OTM):
- Negative cash flow if exercised immediately.
- Call option: Spot price < Strike price
- Put option: Spot price > Strike price
Intrinsic value and time value of an option :
- Option premium consists of two parts: intrinsic value and time value.
- Intrinsic value is the in-the-money amount an option holder would gain if exercised immediately.
- Only in-the-money options have intrinsic value; at-the-money and out-of-the-money options have zero intrinsic value.
- Intrinsic value cannot be negative, as an option holder isn’t obligated to exercise at a loss.
- Call option intrinsic value = Spot Price (S) – Exercise Price (X); minimum zero.
- Put option intrinsic value = Exercise Price (X) – Spot Price (S); minimum zero.
- Example: Nifty Put with strike 18400 and spot 18315.10 has intrinsic value ₹84.90.
- Time value is the difference between an option’s premium and its intrinsic value.
- At-the-money and out-of-the-money options have only time value.
- Example: Call option premium ₹124.50 has full time value as its intrinsic value is zero.
Payoff Charts for Options :
- Long Option (Buyer):
- Holds the right (not obligation) to buy/sell underlying asset.
- Maximum loss is limited to premium paid.
- Profit depends on underlying price movement at expiry.
- Short Option (Seller):
- Has an obligation, not a right.
- Maximum gain is the premium received.
- Potential losses can be unlimited.
- Long Call:
- Profit when index rises above strike + premium (BEP).
- Loss limited to premium paid.
- No margin required.
- Potential for unlimited profit.
- Short Call:
- Profit limited to premium received.
- Losses increase as index rises above BEP.
- Margin required due to unlimited risk.
- Long Put:
- Profit when index falls below strike – premium (BEP).
- Loss limited to premium paid.
- No margin required.
- Maximum profit if index falls to zero.
- Short Put:
- Profit limited to premium received.
- Losses increase as index falls below BEP.
- Margin required due to potential heavy losses.
- Risk & Return Summary:
- Long Position: Limited risk (premium), unlimited return.
- Short Position: Unlimited risk, limited return (premium).
Distinction between futures and options contracts :
- Asymmetric vs. Symmetric Risk: Options have asymmetric risk exposure, where gains and losses differ significantly. For example, the loss for a call option buyer is limited to the premium paid, but gains can be unlimited if the stock price rises. Futures have symmetric risk exposure with equal potential for gains or losses.
- Leverage: Options provide leverage, meaning small premiums can lead to large percentage gains. However, if the market doesn’t move as anticipated, losses can be magnified, and the entire premium paid could be lost.
- Key Differences between Futures and Options:
- Obligations: Futures contracts bind both parties to buy or sell the asset. In options, the buyer has the right but not the obligation, while the seller has the obligation if the buyer exercises the option.
- Margins: Futures buyers and sellers must pay initial margins, while options buyers pay a premium, and sellers deposit initial margin.
- Gains and Losses: Futures allow unlimited gains or losses for both parties. Options buyers can only lose the premium paid, while sellers face unlimited losses but gain only the premium.
- Margins (MTM): Both futures parties are subject to daily margins, while only options sellers are subject to daily margins.
Basics of Option Pricing and Option Greeks :
- Option Pricing Fundamentals:
- Option premiums are determined by various market factors, not set by stock exchanges or SEBI.
- The price of an option consists of intrinsic value and time value.
- Five main factors affect option prices: spot price, strike price, volatility, time to expiration, and interest rates.
- Factors Affecting Option Prices:
- Spot Price: A rise in the underlying asset’s price increases call option value and decreases put option value, and vice versa.
- Strike Price: A higher strike price decreases the call option’s value and increases the put option’s value.
- Volatility: Higher volatility increases option premiums for both calls and puts due to greater potential for movement in the underlying asset.
- Time to Expiration: Longer time to expiration increases option premiums, but time decay causes the option’s time value to decrease as expiration approaches.
- Interest Rates: High interest rates increase call option values and decrease put option values.
- Option Greeks:
- Delta (δ): Measures the sensitivity of an option’s price to changes in the underlying asset’s price. Positive for call options and negative for put options.
- Gamma (γ): Measures the rate of change of delta as the underlying asset’s price changes, indicating the acceleration of price changes.
- Theta (θ): Measures the sensitivity to time decay. As expiration nears, options lose value due to decreasing time value.
- Vega (ν): Measures sensitivity to changes in volatility. Higher volatility increases the option price.
- Rho (ρ): Measures sensitivity to changes in interest rates. Higher interest rates increase the value of call options and decrease put options.
Option Pricing Models :
- Option Pricing Models: These are methods used to determine the value of options.
- Binomial Pricing Model: Developed by William Sharpe in 1978, it represents price evolution using a binomial tree, where prices can either go up or down at fixed rates. It’s accurate but complex and time-consuming.
- Black & Scholes Model: Introduced in 1973 by Fisher Black and Myron Scholes, this model is simpler and faster. It calculates the call option price using five factors: stock price, strike price, volatility, time to expiration, and risk-free interest rate. The formula for call and put options is provided along with the relevant variables.
Implied volatility of an option :
- Volatility affects option prices but is invisible; historical volatility is measured via past price changes.
- Traders focus on expected volatility during an option’s remaining life, not just historical volatility.
- Implied volatility (IV) is derived by inputting market data into the Black-Scholes model in reverse to match the market option price.
- IV differs from historical volatility as it reflects market expectations.
- Option traders use IV to decide whether to buy or sell — typically selling options when IV is high and buying when IV is low.
- High IV before major events (like a court verdict) leads to higher option premiums.
- Option writers use high premiums as a safety margin against the asymmetric nature of option payoffs.
- If adverse or favourable outcomes are already priced into options via higher premiums, writers may avoid significant losses.
Analysis of options from the perspectives of buyer and seller :
- Option Premium Components:
- Option premium = Intrinsic Value + Time Value.
- Deep ITM options have higher intrinsic value and premiums; ATM and OTM options have only time value and lower premiums.
- ATM Option Uncertainty:
- ATM options are most sensitive to price changes due to the potential to quickly move ITM or OTM.
- Their premium depends on time to expiry and volatility.
- Call Option Buyer Analysis:
- Example with index at 17562, call premiums rise as strike prices decrease.
- Profitability depends on index closing above breakeven points.
- ROI is calculated as (Profit / Premium Paid).
- Higher ROI possible in OTM options if price moves favorably.
- Call Option Seller Analysis:
- Neutral to bearish view; maximum gain = premium received.
- Losses increase if the index closes above the breakeven.
- Higher premiums received for ITM options, but riskier.
- Put Option Buyer Analysis:
- Bearish strategy; higher strike (ITM) puts have higher premiums.
- ROI improves for deep OTM puts if the index falls sharply.
- Put Option Seller Analysis:
- Neutral to bullish outlook; gains capped at premiums received.
- High risk in selling ITM puts despite higher premiums.
- Safer but lower return in selling deep OTM puts.
- Conclusion:
- Traders can choose from futures and options of various strikes and expiries.
- Strategy selection depends on market outlook and risk appetite.