fbpx

GUIDEBOOKS

Options

Discover our easy-to-understand guidebooks on options trading. They break down the basics of options and how they are priced, making complex ideas simple. Perfect for beginners and those looking to sharpen their options trading skills, these guides offer clear insights into the world of options markets.

Intrinsic Value

Intrinsic Value, in options trading, refers to the difference between an option’s current market price and its strike, or exercise price. This difference is only calculated if the option is “in the money”, meaning it would be profitable to exercise the option at its current value. 

For example, let’s consider a call option (the right to buy) for a stock with a strike price of ₹20. If the market price of the stock is currently ₹25, the intrinsic value of the option would be ₹5 (₹25 – ₹20 = ₹5) because you could exercise the option to buy the stock for ₹20, then immediately sell it for ₹25, netting a profit of ₹5 per share.

On the other hand, if the market price of the stock is below the strike price, the option is considered “out of the money” and its intrinsic value would be ₹0, since it would not be profitable to exercise.

It’s key to note that intrinsic value does not consider the time value of money or the risk associated with the underlying asset. Furthermore, not all options have intrinsic value. Out-of-the-money options, for instance, only have time value. Ultimately, understanding intrinsic value is crucial for making informed investment decisions in options trading.

Call Option

A Call Option is a financial contract in options trading that gives the holder (buyer) the right, but not the obligation, to purchase an underlying security at a predetermined price, referred to as the strike price, before or at a specified date, known as the expiration date

For instance, let’s say you buy a call option to purchase shares of a particular company at ₹50 per share anytime within the next 3 months. If, within this period, the share price rises to ₹60, you can exercise your call option and buy the shares at the agreed price of ₹50, making an immediate profit of ₹10 per share. 

It’s important to remember that purchasing a call option involves a premium, which is the cost of buying the option. This premium is paid upfront when the contract is written and is non-refundable. Basically, a call option is a bet that the price of the underlying asset will increase, giving the holder an opportunity to buy at a lower price.

Option Writer

An Option Writer, also known as an Option Seller, is a person or entity that creates a new options contract and then sells it in the option market. They write a contract, stipulating specific conditions like a certain price (strike price) and time (expiry date), and then offer it for sale. 

The Option Writer gets paid a premium by the buyer for granting them the right, but not the obligation, to buy (in case of a call option) or sell (in case of a put option) an underlying asset at the strike price within the specified time period. The writer assumes the obligation to buy or sell the asset if the buyer chooses to exercise the option. 

Becoming an Option Writer can potentially offer high rewards, but it’s also high risk. This is because if market conditions become unfavourable and the buyer executes the option, the writer is obligated to fulfil the contract, which might result in a significant financial loss. Therefore, option writing is generally only recommended for experienced investors who fully understand the risks involved.

Contract Size

In options trading, the term ‘contract size’ refers to the total number of underlying assets represented by a single options contract. The typical standardized contract size for one equity options contract is 100 shares of the underlying stock. For example, if a trader purchases a call option, this gives them the right (not the obligation) to buy 100 shares of the underlying stock at the agreed strike price, up until the contract’s expiration date.

However, contract size isn’t the same for all types of options contracts. In index options, for example, instead of representing a certain number of shares, the contract size is determined by a multiplier that is applied to the price of the index. 

It is crucial for traders to be aware of the contract size in options trading. It not only helps to calculate the actual cost of the options trade (premium multiplied by the contract size) but also determines exposure to the underlying asset and affects the potential profit or loss. Therefore, this information plays a crucial part in strategic trading decisions.

Expiration Date

In options trading, an Expiration Date refers to the last date that an options contract is valid. On this date, the contract will expire and cease to exist. The holder of the contract has the right to exercise the option at any point before its expiration date. However, if the option is not exercised before this date, it becomes worthless and the holder no longer has any of the rights inherent in that contract.

In simple terms, if you have an option, you can use it to buy or sell the underlying asset at a pre-agreed price, but only until the expiration date. After that, your rights to this particular deal are over, whether you have made a profit or not. The expiration date is one of the key terms involved in an options contract, and it’s part of what defines its value.

Remember, all options are wasting assets, which means that their value decreases over time as they get closer to the expiration date. This continuous decrease in their value is called time decay or theta. Understanding how options’ expiration dates work is crucial to your success as an options trader.

Time Decay

Time Decay, also known as Theta, is a pivotal concept in options trading. It refers to the rate at which the value of an option decreases as time passes, approaching its expiration date. This concept essentially implies that the longer you hold an option, the more its extrinsic value diminishes, all other factors remaining constant.

Time decay is not linear – it accelerates as the option’s expiration date approaches. This means an option loses value at an increasing rate the closer it gets to expiry. For example, a three-month option is going to lose value much more slowly than a one-month option.

The rationale behind time decay is that as the expiration date nears, the probability of the option being in-the-money (profitable) decreases. Therefore, time decay can be considered as the option’s cost of possession. This is why option sellers (writers) benefit from time decay while buyers often see it as a disadvantage. Understanding the impact of time decay on the value of options is a key aspect of successful options trading.

Time Value

In options trading, Time Value or Theta is a crucial concept that denotes the rate at which an option’s price decays or decreases as time progresses towards its expiration date. It measures the sensitivity of an option’s price in relation to time.

Options lose value as they get closer to their expiration date – a process known as time decay. Theta represents this time decay, and is usually expressed as a negative number indicating how much the option will lose in value per day, assuming all other factors remain the same.

For example, an option with a Theta of -0.05 would lose five paise in value daily. As an option gets closer to expiration, its Theta usually increases because the option starts losing value more rapidly. Consequently, Theta is considered a risk for option buyers and an advantage for sellers.

Knowing the Theta of an option not only provides an estimate of the risk associated with time decay, but can also help investors make more informed decisions. Understanding this crucial term is essential for developing a holistic understanding of the options market.

Liquidity and Volume

Liquidity and volume are two fundamental concepts in options trading that beginners must understand. 

Liquidity refers to the ability of an asset to be bought or sold quickly without significantly impacting its price. In terms of options trading, high liquidity is desirable because it allows for transactions to occur smoothly and without unnecessary delays.

If an options contract is highly liquid, it means there’s a large pool of buyers and sellers, which makes for smoother transactions. Liquidity in options is determined by the number of contracts that are open and trading. 

High liquidity also usually equates to tighter bid-ask spreads, meaning traders can buy and sell at better prices.

Volume is related to liquidity, but it’s not the same thing. Volume refers to the number of contracts of a certain option that are being bought or sold within a given period of time. 

This information is often used by traders to gauge the interest or activity level in a particular option. 

High volume often indicates high interest in an option, either because of new information, imminent earnings announcements, or events that could significantly impact the underlying stock price. 

Option Holder

An option holder is an investor who owns an options contract. This person has the right, but not the obligation, to buy or sell an underlying asset at a specific price (known as the strike price) on or before a certain date (the expiration date). 

There are two types of option holders: call option holders and put option holders. 

A call option holder has the right to buy the underlying asset, while a put option holder has the right to sell the underlying asset. 

Important to note, holding an option does not equate to ownership of the actual asset; it merely confers the right to buy or sell that asset. 

The main motivation for an investor to be an option holder is to profit from expected price changes of the underlying asset without having to invest as much capital upfront as they would need to buy or sell the actual asset outright.

Margin

Margin in options trading refers to the amount of money that an investor must deposit and maintain in their account to cover potential losses from their investments. It serves as a form of collateral to ensure financial obligations are met if an investment does not perform as expected. Investors should be aware that the margin requirements for options trading are typically higher than for other types of investments due to the higher level of risk involved.

The actual margin required varies depending on the type of options contract, underlying asset, and other factors. For example, the margin requirement for writing uncovered call options is usually higher than for purchasing call options because the potential losses are unlimited. 

If an investor’s account value falls below the margin requirement, a margin call may be issued by the brokerage firm, requiring the investor to deposit additional funds into their account. Failing to meet a margin call can result in forced liquidation of the investor’s positions at unfavourable prices. Therefore, understanding margin requirements is vital for managing risk in options trading.

Leverage

Leverage, in the context of options trading, refers to an investor’s ability to trade larger amounts of stocks using a smaller amount of capital. It’s like using a lever to lift more weight than your physical strength allows – hence the term ‘leverage’. It allows you to benefit from a financial gain or loss in stocks without actually owning them. 

In practice, an investor can buy an option contract (which is equivalent to 100 shares of a stock), using significantly less money than it would cost to buy the shares outright. The greater potential for profit comes with a greater risk of losses, as the movement in the price can greatly influence profitability. 

The ratio of the amount of money an investor can potentially make to the initial amount they invest is the leverage ratio. A higher leverage ratio means a larger potential return, but likewise, higher risk. 

So, while leverage provides the potential for substantial gains, it also exposes traders to significant risks, especially if the market doesn’t move in the direction expected by the investor. For this reason, it’s recommended to use leverage thoughtfully and judiciously in investment scenarios.

In the Money

In the Money (ITM) is a term used in options trading that refers to an option that has the potential to result in profit if it were to be exercised immediately. 

For a call option (the option to buy a security at a specific price), it is ‘in the money’ if the current market price of the security is higher than the option’s strike price. This means that the trader could buy the security at a lower price than what it’s currently worth on the market. 

For a put option (the option to sell a security at a predetermined price), it is ‘in the money’ if the current market price of the security is lower than the option’s strike price. In this case, the trader could sell the security for a higher price than it’s currently worth on the market. 

The term ‘in the money’ therefore refers to a profitable situation in options trading. 

However, it does not guarantee profit as there are other costs involved like commissions and the price paid for the option.

Option Symbols

In the Indian market, option symbols, also known as option chain symbols or option tickers, follow a specific format that encapsulates various details about the option contract. These details typically include the underlying stock or index, the expiration date, the type of option (call or put), and the strike price. Here’s how to understand these symbols:

  • Underlying Asset: The beginning of the symbol usually represents the underlying stock or index. For example, “INFY” for Infosys or “NIFTY” for the NIFTY 50 index.
  • Expiration Date: The next part of the symbol indicates the expiration date of the option contract. This is typically given in a YYMMDD format. For example, an option expiring on May 27, 2023, would show “230527”.
  • Option Type: This is represented by a single letter – “C” for Call options and “P” for Put options.
  • Strike Price: Finally, the symbol ends with the strike price. This is the price at which the option can be exercised. The format may vary depending on the asset and the exchange, but it’s usually a straightforward numerical representation.

For example, an Infosys call option expiring on May 27, 2023, with a strike price of 1500 might be represented as “INFY230527C1500”.

It’s important to note that the exact format can vary slightly depending on the exchange and the data provider. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the two main exchanges in India where options are traded. It’s always advisable to check the specific guidelines provided by the exchange or your trading platform to ensure an accurate understanding of the option symbols. 

Understanding these symbols is crucial as they provide quick and essential information about the option contracts, aiding in making informed trading decisions.

Moneyness

Moneyness is a vital term in options trading that helps option traders understand the relationship between the price of an underlying asset, like a stock, and the strike price of an option. It characterizes an option’s financial worth or the potential to make money if it were exercised today. There are three possible states of Moneyness – In the Money (ITM), Out of the Money (OTM) and At the Money (ATM).

If an option is considered In the Money (ITM), it means the option would be profitable if it were to be exercised immediately. On the contrary, an Out of the Money (OTM) option suggests that exercising the option immediately would not yield any profit. An option is considered At the Money (ATM) when the price of the underlying asset equals the strike price of the option.

However, it’s important to note that Moneyness does not guarantee profit at the time of the option’s expiry, as this will depend on the asset’s price at that time. It is a key concept for traders regarding the option’s current benefit and future potential.

Options Tables and Chains

Options Tables and Chains are tools used by investors to navigate through various options contracts available for a specific underlying asset. They present crucial data in a concise, organized manner, allowing investors to view and compare different options contracts at a glance.

An Options Table typically displays the key components of an options contract such as the strike price, the bid price, the ask price, volume, and the contract’s expiration date. It can also show the “Last Trade” which indicates the price at which the last transaction occurred.

Options Chains take the options table a bit further by listing all available option contracts – both calls and puts – for an underlying asset in ascending order of their strike prices. It’s typically presented in a grid format with calls on one side and puts on the other. The chain arrangement makes it easy to view and compare potential trading strategies.

Both the Options Tables and Chains are essential for options traders as they form an integral part of their strategy formulation and decision-making process. They allow traders to analyze market conditions, potential profitability, and risk levels of different contracts which can help in making informed trading decisions.

Put Option

A Put Option is a type of Options contract that gives the holder (buyer) the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a certain time frame. The set price of the asset in the contract is known as the ‘strike price’. If the holder decides to sell the asset, the seller of the put option (also known as the writer) is obligated to buy the asset at that strike price. 

Investors typically buy a Put Option when they anticipate that the price of the underlying asset is going to decrease in the future. This type of contract is used as a way to hedge against potential losses in the value of assets they already own, or to speculate on a downturn in the market. 

For example, if an investor owns stock in a company and is concerned that the price may drop significantly, they may purchase a Put Option. If the stock price does indeed fall, they can exercise their Put Option to sell the stock at the higher strike price, reducing their losses. So, essentially, a Put Option can provide some financial protection against declining market prices.

Out of the Money

Out of the Money (OTM) is a term used in options trading to describe a situation when an option’s strike price is different from the current market price of the underlying asset. 

Specifically, a call option is said to be OTM if the strike price is higher than the current market price of the underlying asset. 

Conversely, a put option is considered OTM if the strike price is lower than the market price of the underlying asset. In other words, the option wouldn’t have any intrinsic value if it was executed immediately. 

Traders often purchase OTM options in anticipation of a significant price movement. 

However, these options carry a higher risk because the price needs to move significantly for the option to become profitable.

Strike Price

The strike price, in the context of options trading, refers to the predetermined price at which the holder of an option can buy or sell the underlying asset. In other words, it is the price at which you, as an option contract holder, can exercise your right to trade the specified asset before the expiry of the option.

There are two main types of options, call options and put options. If you hold a call option, the strike price is the price at which you can purchase the underlying asset. On the other hand, if you hold a put option, the strike price is the price at which you can sell the underlying asset. 

To illustrate, let’s say you hold a call option for a stock at a strike price of ₹50. This means you have the right to buy that particular stock for ₹50 per share, regardless of the current market price. If the stock price increases to ₹60, you have the potential to make a profit by exercising your option to buy the stock at the lower strike price.

Understanding the strike price is essential as it is one of the key factors that determine the value of an option, along with the time until expiry and the volatility of the underlying asset.

Premium

In options trading, the term “Premium” refers to the price an investor pays to buy an option contract. It is essentially the cost of obtaining the rights that come with an option. 

The premium is determined by several factors including the price differential between the strike price (the price at which the underlying asset can be bought or sold) and the market price, the time until the option’s expiration date, and the volatility of the underlying asset. 

If you purchase an option, the premium is the maximum amount you are risking. For sellers of options, the premium serves as income. However, the potential losses for the seller could exceed the premium collected. 

It’s important to understand that an options premium is not a fixed amount and it can fluctuate based on a number of factors. Therefore, investors need to monitor the market closely and be aware of any potential impacts on the premium they paid or received.

At the Money

“At the Money” (ATM) is a term used in options trading to describe a situation in which an option’s strike price is identical to the market price of the underlying asset.

For example, if you own a call option (the right to buy) for a stock with a strike price of ₹50, and that stock is currently trading at ₹50 per share in the market, then that option is said to be “at the money.”

Essentially, the “at the money” term is an indication of the relationship between the market price of an underlying asset and the strike price of an option. If you were to execute or exercise an “at the money” option, you would neither make a profit nor incur a loss at that very moment, excluding the costs of the transaction itself.

In terms of an option’s value, “at the money” options consist of entirely “time value” as they contain no intrinsic value. Their total price is largely determined by how much time is left until the option’s expiration date, as well as the volatility of the underlying asset.

Keep in mind that as market conditions fluctuate, an option can move in and out of money, meaning it can switch from being “at the money” to being either “in the money” or “out of the money”, depending on how the price of the underlying asset changes.

Jump to ...