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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 could be traded. This is called strike price.
Contract has a maturity date which is the date till the contract is valid.
The seller (called option writer) 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 Options please don’t give up. 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?
The amount payable by the option buyer to the option writer (seller) for owning the option. The value of
premium is determined by the market by demand and supply. It is also influenced by the price movement of
the underlyer (stock, index etc).
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Options expiry is a date after which the contract is no longer valid.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 an 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
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
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
Example : If NIFTY cut-off price = 5025 Net = 5000 – 5025 + 50 = Rs. 25 per contract(Profit)
If NIFTY cut-off price = 5100 Net = 5000 – 5100 + 50 = Rs. -50 per contract (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. Writer sells to option buyer
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 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 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 fulfil 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 payment. To avoid these kinds 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 is and what
should be the fair price of an option, whether the option is under-valued, 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 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.