Purchasing a call option
As in the case of a futures contract, if you wish to purchase an option contract, you must register with a broker by entering into Client Broker Agreement and completing all the legal formalities. Remember that you will have to enter into a Client Broker Agreement with each and every broker you intend to trade with. Once registered, you can place an order for an option contract based on your perceptions about the future movements in the market.
Payments/margins involved in buying and selling call options
When you buy an option contract, you pay only the premium for the option and not the full price of the contract. The premium is payable to the broker based on the contract issued to you at the end of the day. Your broker then passes on this premium to the exchange on the next working day. Then exchange pays this premium to the broker of the seller of the option, who in turn passes it on to his client.
Remember, while the buyer of an option has a liability that is limited to the premium that he must pay, the seller has a limited gain but his potential losses are unlimited. Therefore, the seller of an option has to deposit a margin with the exchange, via his broker, as security in case of an adverse movement in the price of the options that he has sold. The margins are levied on the contract value and the amount (in percentage terms) that the seller has to deposit is dictated by the exchange. This amount typically ranges from 15 per cent to as high as 60 per cent in times of extreme volatility. So, the seller of a call option of Reliance at a strike price of 970, who receives a premium of Rs 10 per share would have to deposit a margin of Rs 1,16,400, assuming a margin of 20 per cent (20 per cent of 970 x 600), although the value of his outstanding position is Rs 5,82,000.
Settling a call option
When you sell or purchase an index option, since these are European style options, you can either exit your position before the expiry date, through an offsetting trade in the market, or hold your position open until the option expires. Subsequently, the clearing house settles the trade. In the case of stock options, since these are American style options, you can either sell your long positions or buy back your short positions before the expiry of the contract or exercise your option anytime on or before the expiry date of the contract.
For a buyer of a call option
If you decide to square off your position before the expiry of the contract, you will have to sell the same number of call options that you have purchased, of the same underlying stock and maturity date. If you have purchased 2 options (lot size 500) at a strike price of Rs 100, on XYZ Ltd. which expire at the end of March, you will have to sell the above 2 options (strike price Rs 100, expiry end-March) of XYZ Ltd., in order to square off your position.
When you square off your position by selling your options in the market, as the seller of an option, you will earn a premium. The difference between the premium at which you bought the options and the premium at which you sold them will be your profit or loss.
In case you exercise your option on or before the expiration date, the stock exchange will calculate the profit/loss on your positions. This is basically the difference between closing market price on the day you exercise the option and the strike price. Your account will be credited or debited for the amount of your profit or loss. However, your maximum loss will be restricted to the premium paid.
For the seller of a call option
If you have sold call options and want to square off your position, you will have to buy back the same number of call options that you have written and these must be identical in terms of the underlying scrip and maturity date to the ones that you have sold.
In case the option gets exercised on or before the expiration date, the stock exchange will calculate the profit/loss on your position, based on the difference between the strike price and the closing market price on the day that the option is exercised and you will have to bear the losses, if any. These will be adjusted against the margin that you have provided to the exchange and the balance margin will be credited to your account with the broker.
When you purchase a ‘put option’ it gives you the right to sell the underlying stock or index at a pre-determined price (strike price/exercise price) on or before a specified date in the future (expiry date).
In a number of ways, a ‘put’ is similar to a ‘call’ option. Just as in the case of a caII option:
• A strike price and expiry date are predetermined by the stock exchange.
• The buyer of a put option places a buy order, through his broker, for an option that is available in the market, specifying the strike price and the expiry date and how much he is ready to pay for the option.
• The buyer of the put option must pay a premium, which is passed on to the seller by the exchange.
• The seller must maintain margins with his broker.
• The buyer of a put option can exercise his option to sell the shares on or before the expiry date in the case of stock options and only on the expiry date in case of index options.
• The buyer could also sell off the put option to another buyer before the expiry date and receive a premium.
However, the major difference between a call and a put option is that a put option is used when market conditions and expectations are diametrically opposite to those that call for a call option. Let’s take a look.
Illustration of a put option on an index
Suppose the Nifty is currently 3000 points and you feel bearish about the market and expect the Nifty to fall from its present levels to around 2900 levels within a month. To make the most of your view of the market, you could purchase a 1-month put option with a strike price of 2950. If the premium for this contract is Rs 10 per share, you will have to pay up Rs 1,000 for the Nifty put option (100 units x Rs 10 per unit).
Let’s see what outcomes you and the seller of the option derive from this transaction under various market conditions.
Index levels Above 2950 levels Between 2950 and 2940 levels At 2940 levels Below 2940 levels Payoff for the index put purchaser Put lapses and the purchaser loses the premium Put Purchaser recovers part of his premium but still makes an overall loss Put purchaser breaks even if the option is exercised Put owner makes profits if the option is exercised Payoff for the index put seller The premium is the option writer’s income The option writer loses part of the income that he has received The option writer also breaks even Option writer makes losses -‘…….————-
Illustration of a put option on stocks
Put options on stocks also work the same way as call options on stocks. However, the option buyer is bearish about the price of a stock and hopes to profit from a fall in its price. Getting back to the example of Reliance shares, assume that bad news is expected at the AGM and you believe the price of Reliance will fall from its current level of Rs 950 per share. To make the most of a fall in the price, you could buy a put option on Reliance, at the strike price of Rs 930 at a market determined premium of say Rs 10 per share. You would have to pay Rs 6,000 as premium (600 shares x Rs 10 per share) to purchase one put option on Reliance.
Here’s what you and the seller of the option derive from this transaction under various market conditions.
Payoff for the Reliance Put seller The option writer also breaks even The put seller makes losses that are equivalent to the put purchaser’s profits The option writer loses part of the income that he has received The premium is the option writer’s income
Covered options and Naked options
Now, you may have noticed that while the buyer of the option has limited scope for losses, he could make unlimited profits, if the market moves strongly in his favour. The seller of an option, on the other hand, only stands to benefit from the premium that he receives but could lose considerably, if the market moves against him So, doesthis mean that an option seller must necessarily be an intrepid speculator? Not really. You could sell call options in order to hedge your investments or reduce the cost of your investments. However, the difference is that you must actually hold the underlying shares of the calls that you sell. These are called ‘covered call’ options.
Put purchaser recovers part of his premium but still makes an overall loss Put purchaser breaks even if the option is exercised Put lapses and the purchaser loses the premium No major announcement in AGM. Share price tumbles to say Rs 900 and the put owner exercises his option to make profits , Payoff for the Reliance Put Purchaser Above Rs930 At Rs920 Below 920 levels Between Rs 920 and Rs 930 Price of Reliance J \.
Reducing the price of existing shares
Suppose you actually hold 600 share of Reliance in your demat account. If you do not expect any major movements in the price of Reliance in the cash market and wish to reduce the cost of these shares, you could sell a call option to the extent of the shares that you hold. This becomes a covered call. Here’s how it works. If you do not expect the price of Reliance to go beyond Rs 950 per share, you may sell a Reliance call at a strike price of Rs 950 for a premium of Rs 20. You will receive a total premium of Rs 12,000 (Rs 20 x 600 shares).
If all goes well and the price does not increase above Rs 950, your shares are safe with you and the premium that you receive goes towards reducing the cost of the shares that you hold by Rs 20 each. However, if the price does go above Rs 950, you always have your shares to fall back on. You could sell off your shares to settle off the buyer of the call. It is assumed that you will have chosen a strike price that is above the cost at which your purchased the shares so that in case the option is exercised, you do not make an actual loss, only a notional one. This is because you are not able to benefit from selling your shares at a price that is higher than the strike price, although the market hascrossed that level.
You could also use the covered call strategy to limit the risk of an open position that you have in the futures market, by likening your long futures position to the long cash market position explained in the covered call illustration above.
A covered call could also benefit a speculator who does not want to take undue risks but merely make the most of a bearish expectation from the price of an underlying share or index. Let’s say that you expect the price of Reliance to fall. You could purchase a put option to benefit from this situation, but that would mean that you have to pay a premium. So, instead, you may decide to sell a Reliance call option and receive a premium. If the price of Reliance moves in your favour (i.e., actually falls), the call will not be exercised. But if it rises beyond the strike price, you could use the shares that you hold to settle off the buyer of the call.
Naked calls or puts
When you sell a naked call or put option, you have no underlying assets or open position in the futures market to protect you from an unlimited loss, if the market goes against you. These types of options are sold by speculators who feel very strongly about the direction of an index or the price of a stock. And, if the market does go against them, they may try to salvage the situation by offsetting their option sale by purchasing identical options or they may consider taking up a position in the futures market that will nullify the losses made through selling a naked call or put.
So far, you have come to understand that the price that you pay to purchase an option is called the premium. You also know that it is a small fixed amount and that it is market driven. Now let’s look a little deeper at how this premium IS arrived at in the market and the science beneath it. However, before that, you must familiarize yourself with certain terms, which will facilitate a better understanding of pricing of options.
In-the-money, out-of-the-money and at-the-money
Irrespective of whether you buy a call or a put option, you will find yourself in one of three situations – in-the-money, out-of-the-money or at-the-money. A call option is said to be in the- money, if the price of the stock in the cash market is greater than the strike price, i.e.. you could make money by executing the option. If the strike price is higher than the spot price of the share, the call is said to be out-of-the-money, i.e., you will not make money by exercising the option. However, if the stock price matches the strike price, the call is said to be at-the-money.
In the case of a put option, things are the other way around. When the strike price is greater than the spot price, you are in-the-money, since this is a situation that could be profitable to you. If the strike price is lower than the spot price, you are out-of-the-money (no scope for profit) and when the two are equal, you are at-the-money.
Scenario Spot Price> Strike Price Spot Price < Stri ke Price Spot Price = Strike Price Buy a Call Option In-the-money Out-of-the-money At-the-money Buy a Put Option Out-of-the-money In-the-money At-the-money
Intrinsic and Time value
in case of Put Option ….. •. . . …. … o a • a • ~ 15-0=15 15-0=15 G 30-20=10 .. Intrinsic Value (C-8) Intrinsic Value (8-C) F G (980-970)=10 30-10=20 F (970-950)=20 E E Classification Classification In-the-money In-the-money
Out-of-the money At the money Out-of-the money (950-970)=0 Intrinsic and Time value in case of Call Option .. D 30 D 30 15 970 15 C 970 970 C 970 950 8 950 980 8 980 2 2 A A
Intrinsic value and Time value
An option premium is the sum of two components. These are the ‘intrinsic value’ and the ‘time value’.
Option price = Intrinsic value of the option + Time value of the option.
The intrinsic value is the difference between the cash market spot price and the strike price and is considered to be either positive (if you are in the- money) or zero (if you are either at-the-money or out-of-the-money). Putting it simply, if a contract is in-the-money, it offers some value to a prospective buyer but if it is at the-money or out-of-the-money, the buyer sees no sense in buying it; as a result, it has no value, i.e., its value is zero. There is no question of an option having a negative intrinsic value.
The time value of an option contract is directly dependent on the time left between the current date and the expiry date of the contract, i.e., the time to expiry. The greater the time to expiry, the higher will be the time value in any contract. This is because at the beginning of the contract month, the buyer of the option has more time during which he can exercise or offset an option. In comparison, options that are nearer expiry allow a buyer less leeway to wriggle out of a tricky situation. It is the extra time and therefore lower risk that gives a contract with a longer time to expiry a higher time value.
Combined effect of the intrinsic value and time value
At the beginning of a contract period, an option may fetch a slightly higher price than it will later on, due to the time value. However, as time elapses and the expiry date approaches, the value of an option diminishes, all other factors being constant. Side by side, an option will always fetch an intrinsic value, as long as it remains in-the-money till the expiry date. If it goes out-of-the money or stays at-the-money, the option may not have any intrinsic value but its time value remains and diminishes as the expiry date draws near.
This is best explained with a couple of examples.
A summary of what these models suggest can be concisely presented as in the table below. ……. Potential Losses Potential Returns Spot Rate + + Strike Rate + + Time + + + Volatility + + + Interest Rate + + When You Buy call Limited to the loss Unlimited Profits are Bullish Options of Premium amount When you Buy Put Limited to the loss Unlimited Profits are Bearish Options of Premium amount When you Sell Put Unlimited losses in limited to the are Bullish Options the event of markets Premium Income in a Bearish of a lower going against your market strike price views When you Sell Call Unlimited losses in Limited to the are Bearish Options the event of Premium Income in a Bullish of higher markets going market strike price against your views When to use Call and Put Options and the associated Risks –
Other factors that affect the option premium
While option premiums are largely a function of the strike price, spot price and the time to expiry, there are other major factors that affect the pricing of an option. These are volatility (ups and downs in the price of the underlying stock), interest rate and dividends, if any, between the current date and the expiry date. There are advanced models like the Black and Scholes’ model, which try to determine the price of an option on the basis of a number of variables. These models also enable a trader to track the changes in pricing of options as the parameters and variables used in the model change.