Options, like futures, are financial products whose prices are derived from underlying shares or indices from the spot market.
In options, the buyer is known as ‘options holder’ and the short-seller (who sells a security without owning it) is known as ‘options writer’. Any investor can choose to be any of these.
A buyer enjoys the right to buy or sell underlying shares in specified market lots at a predetermined price, which he may or may not square-off on or before the expiry date. He is not committed to fulfil the terms of the contract unlike in futures contract and let the contract lapse if he is losing. The buyer has to pay only a premium amount to initiate position. However, an option writer is obligated to the terms of the contract, hence, his liability is unlimited.
The market value of an option consists of intrinsic value and time value. Intrinsic value is the difference between the spot price and the selected strike price. If the spot price exceeds the strike price, then the option holder is in a favourable condition, called ‘in-the-money’ for the buyer; if both the prices are almost at the same level then it is ‘at-the money’; and it is called ‘out-of-the-money’ if the spot price lags strike price (unfavourable).
Time value is determined by the time left to till the expiry of the contract. The value of options decreases as the expiry date nears, because they cannot be rolled over. On expiry, an options contract is measured only by its intrinsic value.
There are two kinds of options—Call and Put. Call options is initiated when one buys sensing bullish trend in a stock or index, and squaring off the same when market moves up to earn profit. Whereas, option writer sells anticipating market to fall and retain the premium amount received, should the buyer let his transaction to lapse. Similarly, in Put options, buyer transacts when he expect down trend. Here, the short-seller resorts to sell expecting market to go up.
Again, on the basis of validity, there are two types of options—American and European. American options can be exercised on or before expiry date, whereas European options can be exercised on the expiry date only. In India, stock options are traded in American type and index options are traded in European type.
Example: Spot Price: 60
Strike Price selected: 60 (for current month)
Market lot: 2000 shares
Contract value: Rs.1,20,000
Premium price to be paid to buy Call/Put: Rs.5
Investment: 5x2000 = Rs.10000
If the spot price rises to 70, premium may rise to Rs.12
Trader can square off the transaction and earn profit of Rs.14000 (i.e.12x2000 = 24000-10000)
If the spot price falls to Rs.45, premium may fall to Rs.1
Trader can either square off the transaction to get back Rs.2,000 (1x2000)
Or if it goes well below the investment he can let the transaction lapse. Here, the premium paid by the buyer will be credited to option writer’s account. Option writer has to block a percentage of transaction value and premium amount. In case-II, writer will receive all those money with profit adjusted with premium credited (Writer gains). Or else he will receive remaining amount after deducting the difference cost, like in Case-I (Writer loses).