INTRODUCTION TO OPTIONS

Basics of Options

Definition: An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset on or before a stated date/day, at a predetermined price.
Details: The buyer of an option pays a price known as the option premium to the seller, and has the right but no obligation to buy or sell the underlying asset.

Key Concepts

Call Option: An option that gives the buyer/holder the right to buy the underlying asset.
Put Option: An option that gives the buyer/holder the right to sell the underlying asset.
Option Terminology:
- Instrument Type: The type of option, such as Option Index.
- Underlying Asset: The asset that the option is based on, such as Nifty 50.
- Expiry Date: The date on which the option expires.
- Option Type: The type of option, such as Call European or Put European.
- Strike Price: The price at which the underlying asset can be bought or sold.
- Open Price, High Price, Low Price, and Close Price: The prices at which the option is traded.
- Traded Volume: The number of contracts traded.
- Open Interest: The total number of option contracts outstanding for an underlying asset.
- Underlying Value: The current value of the underlying asset.

Option Types

Index Option: An option with a stock index as the underlying asset.
Stock Option: An option with an individual stock as the underlying asset.
American Option: An option that can be exercised at any time on or before the expiry date.
European Option: An option that can only be exercised on the expiry date.

Option Premium and Exercise

Option Premium: The price paid by the option buyer to the option seller.
Spot Price (S): The current price of the underlying asset.
Strike Price (X): The price at which the underlying asset can be bought or sold.
Exercise of Options: The process of buying or selling the underlying asset at the strike price.

Opening and Closing Positions

Opening Purchase (Long on Option): A transaction that creates or increases a long position in a given series of options.
Opening Sale (Short on Option): A transaction that creates or increases a short position in a given series of options.
Closing Purchase: A transaction that reduces or eliminates a short position in a given series of options.
Closing Sale: A transaction that reduces or eliminates a long position in a given series of options.

Contract Specifications of Exchange-Traded Options

Contract Size: The number of units of the underlying asset in a contract, which varies for different stocks and indices. For example, the contract size of Nifty option contracts is 50.
Contract Trading Cycle: The period over which the option contract is traded. Index options have a wider range of expiration dates, including weekly, monthly, quarterly, and semi-annually maturing contracts.
Expiration Date: The last trading date/day of the contract, which is the last Tuesday of the expiry month for Nifty and Bank Nifty option contracts.
Tick Size: The minimum move allowed in price quotations, which is 0.05 paisa for index contracts and varies for stock future contracts based on the exchange and stock price.
Final Settlement Price: The closing price of the relevant index or stock in the cash segment of the exchange on the last trading day of the contract, used for European-style options.
Trading Hours: Equity options contracts can be traded during normal market hours, from 9:15 am to 3:30 pm, Monday to Friday.

Key Contract Specifications for Index Options

Index Options on NSE and BSE: Available for trading with weekly and monthly maturities, with 4 serial weekly cycles and 3 quarterly expiries.
Expiration Dates: Vary by index and exchange, with some expiring on the last Tuesday of the month and others on Thursdays.
Tick Size: 0.05 paisa for index contracts.

Key Contract Specifications for Stock Options

Contract Size: Varies by stock, with the contract size for Nifty option contracts being 50.
Contract Trading Cycle: Follows a three-month trading cycle, with options available for the near month, next month, and far month.
Tick Size: Varies by exchange and stock price, with examples including 0.01 paisa for stocks trading below ₹250 on the NSE and 0.05 paisa for stocks trading above ₹250.

Exchange-Specific Contract Specifications

BSE Sensex Options: Have a contract size of 20, tick size of 0.05, and expire on the last Thursday of the contract month.
NSE Nifty Options: Have a contract size of 50, tick size of 0.05, and expire on the last Tuesday of the contract month.

Moneyness of an Option

In-the-Money (ITM) Option: An option that would give the holder a positive cash flow if exercised immediately.
- A call option is ITM when the spot price is higher than the strike price.
- A put option is ITM when the spot price is lower than the strike price.
At-the-Money (ATM) Option: An option that would lead to zero cash flow if exercised immediately.
- For both call and put options, the strike price is equal to the spot price.
- In practice, an ATM option has a strike price closest to the spot price due to the discrete nature of strike prices.
Out-of-the-Money (OTM) Option: An option that would give the holder a negative cash flow if exercised immediately.
- A call option is OTM when the spot price is lower than the strike price.
- A put option is OTM when the spot price is higher than the strike price.

Intrinsic Value and Time Value of an Option

Intrinsic Value: The amount by which an option is in-the-money, i.e., the amount an option buyer will realize if he exercises the option instantly.
Characteristics of Intrinsic Value:
- Only in-the-money options have intrinsic value.
- At-the-money and out-of-the-money options have zero intrinsic value.
- Intrinsic value can never be negative.
Calculation of Intrinsic Value:
- For a call option: S - X (excess of spot price over exercise price), with a minimum value of zero.
- For a put option: X - S (excess of exercise price over spot price), with a minimum value of zero.

Time Value

Definition: The difference between the premium and intrinsic value of an option.
Key Points:
- ATM and OTM options have only time value, as their intrinsic value is zero.
- Time value represents the potential for the option to become in-the-money before expiration.
Calculation of Time Value:
- Time value = Option premium - Intrinsic value (if any).
- For example, if an option has a premium of Rs.177.60 and an intrinsic value of Rs.84.90, the time value would be Rs.92.70.

Payoff Charts for Options

Long Option: A buyer of an option is said to be “long the option”. The buyer has the right, but not the obligation, to buy or sell the underlying asset.
Short Option: A seller of an option is said to be “short the option”. The seller has an obligation, but not the right, to buy or sell the underlying asset.

Key Concepts

Long Call:
- Definition: A call option gives the buyer the right, but not the obligation, to buy the underlying at the strike price.
- Details: The buyer's potential loss is limited to the premium amount paid, and profit depends on the level of the underlying asset price at the time of exercise/expiry.
Short Call:
- Definition: The seller of a call option has an obligation to sell the underlying at the strike price if the option is exercised.
- Details: The seller's maximum profit is the premium received, and potential loss is theoretically unlimited.
Long Put:
- Definition: A put option gives the buyer the right, but not the obligation, to sell the underlying at the strike price.
- Details: The buyer's potential loss is limited to the premium amount paid, and profit depends on the level of the underlying asset price at the time of exercise/expiry.
Short Put:
- Definition: The seller of a put option has an obligation to buy the underlying at the strike price if the option is exercised.
- Details: The seller's maximum profit is the premium received, and potential loss is theoretically unlimited.

Risk and Return Profile

Long Option: Limited risk (premium paid) and unlimited profit potential.
Short Option: Unlimited downside risk, but limited upside potential (to the extent of premium received).

Break-Even Point (BEP)

Long Call: BEP = Strike Price + Premium (X + P)
Short Call: BEP = Strike Price + Premium (X + P)
Long Put: BEP = Strike Price - Premium (X - P)
Short Put: BEP = Strike Price - Premium (X - P)

Margin Payment

Option Buyer: No margin payment required, as the buyer's potential loss is limited to the premium paid.
Option Seller: Margin payment required, as the seller has an obligation and potential losses can be huge.

Distinction between futures and options contracts

Definition: Futures and options contracts are both used for trading, hedging, and arbitrage, but they have distinct differences in terms of rights and obligations of the counterparties.
Key Differences:
- Obligations: In futures contracts, both the buyer and seller have the obligation to buy or sell the underlying asset. In option contracts, the option buyer has the right to buy or sell the underlying asset without any obligation to do so, while the option seller has the obligation to buy or sell the underlying asset if the option buyer exercises their option.
- Margin Requirements: In futures contracts, both the buyer and seller are required to pay initial margin as decided by exchanges. In option contracts, the option buyer pays a price known as option premium to the option seller, while the option seller needs to deposit initial margin with exchanges at the time of selling an option.
- Potential Gains and Losses: In futures contracts, both the buyer and seller can make unlimited gains or losses. In option contracts, the option buyer can make potentially unlimited gains, but their loss is limited to the premium already paid, while the option seller can face unlimited losses, but their gain is limited to the premium already received.
- Mark-to-Market (MTM) Margins: In futures contracts, both the buyer and seller are subject to payment/receipt of MTM margins on a daily basis. In option contracts, only the option seller is subject to MTM margins on a daily basis.
Leverage: Options offer leverage, as the buyer pays a relatively small premium for market exposure in relation to the contract value, allowing for large percentage gains from small, favorable percentage moves in the underlying equity. However, leverage also has downside implications, as it can magnify the trader's percentage loss if the underlying price does not move as anticipated.

Basics of Option Pricing and Option Greeks

Understanding Vega

Definition: Vega measures the change in an option's price for every 1% change in the implied volatility of the underlying asset.
Details: For example, if the vega of an option is 0.80, its price will change by 0.80% for every 1% change in the implied volatility of the underlying asset. Vega is positive for both long call and long put options, meaning an increase in volatility increases the expected reward from these positions.

Understanding Rho

Definition: Rho (ρ) measures the change in an option's price given a one percentage point change in the risk-free interest rate.
Details: Rho calculates the change in an option’s price per unit increase in the cost of funding the underlying. It is calculated as the change in an option premium divided by the change in the cost of funding the underlying. Rho helps in understanding how changes in interest rates can impact option pricing.

Option Pricing Models

Definition: Option pricing models are mathematical models used to estimate the value of a call or put option.
Details: These models help traders determine the theoretical value of an option based on various factors.

Key Models

Binomial Pricing Model: Developed by William Sharpe in 1978, this model represents the price evolution of the option's underlying asset as a binomial tree of all possible prices at equally-spaced time steps.
Key Characteristics:
- Iterative and accurate
- Complex and time-consuming to implement
- Assumes price can only move up and down at fixed rates with respective simulated probabilities

Black & Scholes Model

Definition: A popular and relatively simple model for calculating option prices, published by Fisher Black and Myron Scholes in 1973.
Key Determinants:
- Stock Price
- Strike Price
- Volatility
- Time to Expiration
- Short-term (Risk-free) Interest Rate
Call Option Price Formula: C = SN(d1) - Xe-rt N(d2)
Put Option Price Formula: P = Xe-rt N(-d2) - SN(-d1)
Variables:
- S = Stock Price
- X = Strike Price
- t = Time Remaining until Expiration (in years)
- r = Current Continuously Compounded Risk-free Interest Rate
- v = Annual Volatility of Stock Price (standard deviation of short-term returns over one year)
- In = Natural Logarithm
- N(x) = Standard Normal Cumulative Distribution Function
- e = Exponential Function

Implied Volatility of an Option

Definition: Implied volatility is the expected volatility of an underlying asset over the remaining life of an option, calculated by running the Black-Scholes model in reverse order using the current option price.
Details: It is different from historical volatility, which is calculated from the historical price movements of the asset. Implied volatility is used by option traders to determine whether it is the right price to buy or sell an option.

Key Concepts

Historical Volatility: The measure of volatility calculated from the historical price changes of an underlying asset over a period of time.
Expected Volatility: The anticipated volatility of an underlying asset over a specific period, often used in option pricing.
Black-Scholes Model: A mathematical model used to calculate the theoretical price of an option, which can be run in reverse to calculate implied volatility.

Trading Strategies

High Implied Volatility: Option traders tend to sell options when implied volatility is high, as it indicates high option prices.
Low Implied Volatility: Traders tend to buy options when implied volatility is low, as it indicates low option prices.
Option Writing: Option writers tend to extract higher premiums from option buyers when implied volatility is high, serving as a margin of safety.

Analysis of Options from the Perspectives of Buyer and Seller

Option Premium: The price paid by the buyer to the seller for the option contract, consisting of intrinsic value and time value.
Intrinsic Value: The amount by which the option is in-the-money, calculated as the difference between the strike price and the current market price of the underlying asset.
Time Value: The amount added to the intrinsic value to reflect the possibility that the option may become more valuable before expiration.

Key Considerations for Option Buyers

In-the-Money (ITM) Options: Have a higher intrinsic value and therefore a higher premium.
At-the-Money (ATM) Options: Have no intrinsic value, only time value, and are cheaper than ITM options.
Out-of-the-Money (OTM) Options: Have no intrinsic value, only time value, and are cheaper than ITM and ATM options.
Return on Investment (ROI): Calculated as net profit as a percentage of premium paid by the option buyer.

Analysis of Call Option Trading

Call Option Buyer: Buys a call option to speculate on a price increase of the underlying asset.
Call Option Seller: Sells a call option to speculate on a price decrease or stability of the underlying asset.
Break-Even Point (BEP): The price at which the buyer breaks even on the option purchase.

Analysis of Put Option Trading

Put Option Buyer: Buys a put option to speculate on a price decrease of the underlying asset.
Put Option Seller: Sells a put option to speculate on a price increase or stability of the underlying asset.
Risk Appetite: The seller of a put option incurs higher risk when selling deep ITM put options, but receives a higher premium.

Summary

Option Trading Strategies: Depend on market analysis and risk appetite, and can involve various combinations of futures and options with different expiries and strikes.