KNOWLEDGE CENTER

Learning Derivatives - Session III

UNDERSTANDING OPTION CONTRACTS

Option contracts permit non-linear payoffs and hence are extremely useful products for hedging purposes. Trading in index options started in India on 4th June 2001 while that in stock options began on 2nd July 2001.

The previous two sessions on Knowledge Center: Learning Derivatives explained the concepts of Future & Option contracts. This session elaborates further on Option contracts. An option contract is a contract which gives one party the right to buy or sell the underlying asset on a future date at a pre-determined price (called the strike price). The option which gives the right to BUY is called the CALL option while the option which gives the right to SELL is called the PUT option. Call Options Let us take an example of ITC, whose lot size is say 1000 and the current market price is Rs 248. Suppose Mr X buys 1 lot of ITC July 250 Call option at Rs 5 (meaning that he has the right to buy 1000 shares of ITC on 26th July 2012 at a price of Rs 250). On the other hand, Mr Y sells 1 lot of ITC July 250 Call option at Rs 5 (meaning that he is obliged to sell 1000 shares of ITC on the expiry date at a price of Rs 250 if the closing price on expiry is above Rs 250). 1. Payoff for buyer of call option (Mr X): By buying the call option, Mr X is paying a premium of Rs 5 per share (total premium = Rs 5000/-) in order to receive the right to buy 1000 shares of ITC at a pre-determined price of Rs 250. If on the expiry date, the price of ITC is Rs 260, he would exercise his option and buy at Rs 250, thereby gaining Rs 10 per share on expiry date. His net profit would be Rs 5 per share after deducting the premium paid. If the price on expiry is Rs 270, he would make a net profit of Rs 15 (Rs 20 - Rs 5) per share and so on. However, if the price on expiry date is below Rs 250, he will not exercise his option as it is useless to buy something at a price higher than what it is quoting in the market. Hence, his payoff on expiry date would be zero and his net loss would be limited to the extent of the amount of premium paid.

There has been phenomenal growth in the traded value of option contracts on NSE and the total notional value for the year 2011-2012 stood at Rs 2,36,97,063 crores. The compounded annual average growth rate in the same has been as high as 92.6% since the year 2007-2008 !!
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Vinit Pagaria

Email: vpagaria@microsec.in

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2. Payoff for seller of call option (Mr Y): Y sold 1 lot of ITC July 250 Call option and received premium at Rs 5 per share. He, however is obliged to sell 1000 shares of ITC on the expiry date at Rs 250 even if the actual price of ITC on that day is much higher than that. If ITC closes at Rs 230, his payoff on expiry date would be zero as the buyer of the option will not exercise his option to buy at Rs 250. Hence, Ys net profit would be limited to the extent of premium received (Rs 5,000/-). However, if ITC rises and closes at Rs 270, his payoff on expiry date would be a loss of Rs 20 per share (Rs 270 - Rs 250) and his net loss would be Rs 15 per share (Rs 20 - Rs 5). His net loss would be Rs 15,000/- (Rs 15 x 1000).
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Option contracts are of two types - European options and American options. European options can be exercised by the buyer of the option only on the expiry date of the contract whereas an American option can be exercised on any day till the expiry. Both index and stock options traded on NSE are now of European style. The code CE stands for Call European while the code PE stands for Put European

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An important thing to note here is that all the transactions in stock and index futures are currently cash settled in India and hence no actual buying/selling of the underlying has to be done on expiry. Hence, Mr Y would receive Rs 5,000/- (premium) on the date he sells the call option and would have to pay Rs 20,000/- on the expiry date. Important concepts relating to Call options: 1. The buyer of the option pays the premium upfront and the seller of the option receives the premium upfront. 2. The maximum loss of the buyer of the option is limited to the amount of premium paid while the maximum loss that can be incurred by the seller of the call option is unlimited. Higher the rise in the price of the underlying, bigger would be the loss for the seller of the option. The profit of the seller of the call option is however limited to the extent of premium received. 3. The buyer of the call option needs an increase in the price of the underlying in order to make profits. The seller of the call option would however profit if the price of the underlying does not rise above the strike price on expiry. If the price remains at the level of the strike price, the buyer of the option will lose the entire premium while the seller would gain the entire premium amount. 4. A call option is said to be in-the-money if the market price of the underlying is higher than the strike price. It is said to be out-of-the-money if the market is lower than the strike price and it is termed at-the-money if the market price is equal to the strike price.

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Put Options Let us take an example of ITC, whose lot size is say 1000 and the current market price is Rs 250. Suppose Mr S buys 1 lot of ITC July 240 Put option at Rs 2 (meaning that he has the right to sell 1000 shares of ITC on 26th July 2012 at a price of Rs 240). On the other hand, Mr T sells 1 lot of ITC July 240 Put option at Rs 2 (meaning that he is obliged to buy 1000 shares of ITC on the expiry date at a price of Rs 240 if the closing price on expiry is below Rs 240). 3. Payoff for buyer of put option (Mr S): By buying the put option, Mr S is paying a premium of Rs 2 per share (total premium = Rs 2000/-) in order to receive the right to sell 1000 shares of ITC at a pre-determined price of Rs 240. If on the expiry date, the price of ITC is Rs 230, he would exercise his option and sell at Rs 240, thereby gaining Rs 10 per share on expiry date. His net profit would be Rs 8 per share after deducting the premium paid. If the price on expiry is Rs 220, he would make a net profit of Rs 18 (Rs 20 - Rs 2) per share and so on. However, if the price on expiry date is above Rs 240, he will not exercise his option as it is useless to sell something at a price lower than what it is quoting in the market. Hence, his payoff on expiry date would be zero and his net loss would be limited to the extent of the amount of premium paid.

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4. Payoff for seller of put option (Mr T): Y sold 1 lot of ITC July 240 Put option and received premium at Rs 2 per share. He, however is obliged to buy 1000 shares of ITC on the expiry date at Rs 240 even if the actual price of ITC on that day is much lower than that. If ITC closes at Rs 250, his payoff on expiry date would be zero as the buyer of the option will not exercise his option to sell at Rs 240. Hence, Ts net profit would be limited to the extent of premium received (Rs 2,000/-). However, if ITC falls and closes at Rs 234, his payoff on expiry date would be a loss of Rs 6 per share (Rs 240 Rs 234) and his net loss would be Rs 4 per share (Rs 6 - Rs 2). His net loss would be Rs 4,000/- (Rs 4 x 1000).

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S&P CNX Nifty options contracts have 3 consecutive monthly contracts, 3 quarterly months of the cycle March/June/ September/December and 8 following semi-annual months of the cycle June/December available for trading. Thus, at any point in time, there are option contracts with at least 5 year tenure available.

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Just like future contracts and call options, put options are also currently cash settled in India and hence no actual buying/selling of the underlying has to be done on expiry. Hence, Mr T would receive Rs 2,000/- (premium) on the date he sells the put option and would have to pay Rs 6,000/- on the expiry date. Important concepts relating to Put options: 1. The buyer of the option pays the premium upfront and the seller of the option receives the premium upfront. 2. The maximum loss of the buyer of the option is limited to the amount of premium paid while the maximum loss that can be incurred by the seller of the put option is unlimited. Greater the fall in the price of the underlying, bigger would be the loss for the seller of the put option. The profit of the seller of the put option is however limited to the extent of premium received. 3. The buyer of the put option needs a fall in the price of the underlying in order to make profits. The seller of the put option would however profit if the price of the underlying does not fall below the strike price on expiry. If the price remains at the level of the strike price, the buyer of the option will lose the entire premium while the seller would gain the entire premium amount. 4. A put option is said to be in-the-money if the market price of the underlying is lower than the strike price. It is said to be out-of-the-money if the market is higher than the strike price and it is termed at-the-money if the market price is equal to the strike price. Distinction between Call and Put option: 1. A call option is for the right to BUY while a put option is for the right to SELL. 2. The break-even price for a call option is the strike price plus the premium while the break-even price for a put option is the strike price minus the premium. In the previous examples, Mr X & Mr Y both would not make any profit or loss if the closing price on expiry is Rs 255 (250 + 5). The break-even price for Mr S & Mr T would be Rs 238 (240 - 2).

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Pricing of Option contracts Accurate pricing of option contracts is a much complex issue in comparison to pricing of future contracts (which depend on risk-free interest rate, dividends and time to expiry). However, there are six factors that determine the amount of premium at which an option contract trades. Remember that the price of an option contract is the market determined premium at which the trade takes place. The following are the factors that determine the premium of an option contract: The premium of an option contract has two components - Intrinsic value and Time Value. Intrinsic value is the value of the option if it is exercised immediately. The remaining amount of the premium is the time value of the option. 1. Spot Price: Higher the spot price of the underlying, higher would be the price of a call option, all other things remaining constant. Similarly, lower the spot price, lower would be the price of a call option. In our example (Mr X & Mr Y), if the current market price was 255 instead of 248, the premium would have been higher than Rs 5 (all other factors remaining constant). In the case of a put option, lower the spot price, higher would be the premium. In our example of Mr S & Mr T, had the spot price been Rs 238 instead of Rs 242, the premium would have been higher than Rs 2. 2. Strike Price: Higher the strike price of a call option, lower would be the premium and vice-versa. If the premium of ITC July 250 Call option is Rs 5, the premium of ITC July 260 call option would be lower than Rs 5. In the case of put option, higher strike price would command a higher premium. If the premium on ITC July 240 Put option is Rs 2, the premium on ITC July 250 Put option would definitely be higher than Rs 2 (assuming all other factors remaining the same). 3. Time to Maturity: Higher the time to maturity, higher would be the premium on both call and put options. This is because the buyer of the option gets the right to buy or sell the underlying for a greater duration of time. Hence, the premium on ITC August 250 Call option would be higher than Rs 5 and the premium on ITC August 240 Put option would be higher than Rs 2. In the case of a call option, the intrinsic value would be the current spot price of the underlying less the strike price of the call option. In the case of a put option, the intrinsic value is the strike price less the current spot price of the underlying. The intrinsic value can never be negative and hence in case of out-of-the-money options, the entire premium is the time value and the intrinsic value is zero. 4. Dividends: Dividends impact the price of option contracts because dividends reduce the spot price on the day the stock goes ex. However, the derivative contract holders are not entitled to any dividends and hence the F&O market adjusts the prices of the contracts to adjust for dividends that are already declared or that could be declared in the underlying asset. Consequently, the price of a Call option would be lower if there is dividend in the underlying asset. The price of a Put option would be higher if there is dividend in the underlying asset. In our example, if there was dividend of Rs 4 on ITC and the ex-date was 18th July 2012, the premium on the July 250 Call option would have been lower than Rs 5 and that of the July 240 Put option would have been higher than Rs 2. 5. Risk Free rate: An increase in interest rates drive up call premiums and cause put premiums to decrease. However, the impact of change in risk free rate on option prices is relatively less significant. 6. Volatility: Volatility is one of the most important factors in determining the option premiums. Also, all the other factors are generally determinable but how volatile the prices of underlying asset might remain in future is not easily determinable. One thing is certain though - Higher the volatility, higher would be the premiums of both the call and put options. Volatility is of two types - Historical volatility and Implied volatility. Historical or realized volatility is calculated by determining the average deviation from the average price of the underlying asset. On the other hand, implied volatility is the perceived volatility that is derived from the actual market premiums of the option contracts.

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Position Limits Client level position limit The gross open position of a client across all derivative contracts on an underlying should not exceed 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest (in terms of number of shares), whichever is higher. Market wide position limit The market wide limit of open position (in terms of the number of underlying shares) on futures and option contracts on a particular underlying stock is 20% of the number of shares held by non-promoters in the relevant underlying security. When the market wide open interest for any scrip exceeds 95% of the market wide position limit for that scrip, the scrip goes in ban period. This means that no fresh positions can be initiated in the derivatives segment for that underlying. Market participants can square off their existing positions which results in reduced market wide open interest. The scrip remains in the ban period till the market wide open interest is higher than 80% of the market wide position limit. Normal trading in the scrip is resumed after the open outstanding position comes down to 80% or below of the market wide position limit.

The specifications of option contracts are adjusted for corporate actions like bonus, rights issue, stock split and consolidation but are generally not adjusted for dividends. Consequently, the call prices fall while the put prices rise as a result of dividends. However, in case of extra-ordinary dividends (above 10% of market value of the underlying), the strike price of the option contracts is adjusted. Hence, such dividends do not impact the option prices.

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