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The basic structure of call options was explained in the previous chapter. The purpose of the previous chapter was capture some essential concepts about 'Call Option' such as -
The next chapter, i.e. We will be looking at the Call Option (Part 2) in greater detail. Before we move on, let's first decode some basic options jargons. These jargons will help us learn and make it easier to understand the next discussion about the options.
We will be looking at a few of these jargons.
Remember, we only have looked at the structure of a call option. I encourage you to only understand the call option's jargons.
Strike price
The strike price is the price at which both the buyer and seller agree to enter into an option agreement. In the previous chapter, the anchor price for the "Ajay-Venu" example was Rs.500,000/–, which is also their 'Strike Price. We also examined a stock example in which the anchor price was Rs.75/–, which is also their strike price. The strike price is the price at which stock can be purchased on expiry for all 'Call" options.
for example- If A is willing to buy HCL's call option of Rs.370(being strike price)then it implies that A is ready to pay premium today to 'purchase the rights of (buying HCL at Rs.370 on expiry'.so he will buy HCL at Rs.370,only if HCL is trading above Rs 370.
Below a snapshot is given from NSE"s website where different strike prices and the associated premium is given-
(IMAGE 1)
The table you see is an "Option Chain", which lists all strike prices for a contract and the premium. The option chain also contains additional trading information like Open Interest, volume, bid/ask quantity, etc. For now, I suggest that you ignore the rest and focus only on the highlighted information.
Basis Price
As one knows that from an underlying asset ,a derivative contract gets its value . The spot market price at which an underlying asset trades is called the underlying price. In the ITC case, ITC traded at Rs.336.90/= in the spot market. This is the underlying market price. To benefit from a call option, the price must rise for the buyer.
Exercise of an option contract
The act of exercising an option contract means that you claim your right to purchase the options contract after the expiry. When you hear the phrase "exercise an option contract" used in context of a Call Option, it means that one is claiming the right and price to purchase the stock. He or she would only do it if the stock trades above the strike. Important: You can only exercise your option on the expiry date and not before.
Assume that one has 15 days left to expire and buys the ITC 340 call option. ITC is currently trading at 330 on the spot market. Assume that the stock price rises to 360 the day after the option buyer buys the 340 call option. In such a scenario, an option buyer cannot request a settlement (he can't exercise) against the call options he has. Settlement will take place on expiry date, based upon the price of the asset in the spot market on that day.
Option Expiry
Options contracts also have expiry, just like futures contracts. Both equity futures contracts and option contracts expire the last Thursday in every month. Option contracts have the same concept as futures contracts. They can be categorized by current month, middle month, or far month. Take a look at this snapshot -
(image 2
Here's a quick snapshot of the option to purchase Ashok Leyland Ltd for a strike price Rs.70 at Rs.3.10/+. There are two expiry options available: 26 March 2015 and 30 April 2015. (mid-month), 28 th Mai 2015. (far month). The premium can change as the expiry date changes. We will discuss it in detail once we have the chance. Option Premium
We have already discussed premium in a couple of instances. I think you now know a few facts about the 'Option Premium. Premium is the amount that the option buyer must pay to the option seller/writer. The premium is paid by the option buyer to purchase the right to buy or sell the asset at strike price after expiry.
You have probably understood this part. Now we will look at 'Premiums from a different perspective. It is also important to mention that all of option theory rests on 'Option Premium. Option premiums are a crucial part of trading options. As we move through the module, you'll see that discussions will be heavily centered on the option premium.
Let's go back to the 'Ajay Venu' example that we discussed in the previous chapter. Take a look at the circumstances in which Venu accepted Rs.100,000.00 from Ajay.
Let's now consider each of these points separately and see what impact they would have on our option premium.
News The news about the deal between Ajay & Venu was only speculation. Venu was therefore happy to pay Rs.100,000. Let's just assume that the news was not speculative, and that there was bias. Perhaps a local politician suggested in the recent press conference they might consider building a highway in this area. This information makes it clear that the news is not a rumor. There is now a chance that the highway will indeed be built, although there is still some speculation.
You can use this for considering a bigger picture. Do you think Venu would accept Rs.100,000.00 as a premium? He may not be able to accept the premium because he knows that there is a good chance of the highway coming up, and therefore land prices will rise. He may still be open to taking the chance, provided that the premium is more appealing. He might consider an agreement more attractive if the premium was Rs.175,000/= instead of Rs.100,000.
Let's now put this in stockmarket perspective. Let's say Infosys trades at Rs.2200/day today. The 2300 call option has a one month expiry and is priced at Rs.20/. As Venu (option writer), would you accept Rs.20 per share as a premium to enter into an agreement?
As a seller/writer, you give the buyer the option to buy Infosys option for Rs. Two months down the road, you will be 2300.
Let's say that Infosys shares are expected to rise by 0% for the next month. You might consider accepting the premium of Rs.20/.
What if a corporate event, such as quarterly results, causes the stock price to rise? Is the option seller willing to accept Rs.20/ as the premium? It may not be worthwhile to take on the risk of Rs.20/-.
What if, despite the corporate event, someone offers Rs.75/- premium instead of Rs.20/? It may be worth the risk at Rs.75/-
We will keep this discussion in our minds. Let's now focus on the 2 and points. Time
Ajay clearly knew that 6 months was enough time to allow the dust to settle and for the truth to be revealed about the highway project. What if there were only 10 days? The time is now shorter and there is not enough time to make the event happen. Ajay is not likely to be happy to pay Rs.100,000./- premium to Venu in such circumstances. Ajay is not motivated to pay such a premium to Venu, so I don't believe so. He might offer a lower premium, like Rs.20,000/-.
However, I am trying to emphasize the fact that premium is not a fixed rate. It can be affected by many factors. There are a few factors that can increase or decrease the premium. In real markets, all of these factors affect the premium simultaneously. The premium is affected by 5 factors, similar to news and times. These are the "Option Greeks". Although we are not ready to fully grasp Greeks yet, we will in the next stage of this module.
Let me now remind you of and appreciate these points in relation to option premium.
These points are important and I can assure you that you are on the right track if you have understood them.
Settlement
Take a look at this Call option agreement -
(image 3
This is a call option to purchase JP Associates at Rs.25/–, as highlighted in green. The expiry date is 26 th February 2015. The premium is Rs.1.35/– (highlighted in red) and the market lot, 8000 shares.
Let's say there are two traders: 'Trader A’ and 'Trader B. Trader A would like to purchase this agreement (option buyer), and Trader B would like to sell (write). Here's how cash flow looks if the contract is for 8000 shares.
The premium is Rs.1.35/share. Trader A must pay the entire amount.
= 8000 * 1.35
As a premium payment to Trader B, Rs.10 800/-
Now that Trader B has the Premium form Trader, he is bound to sell Trader 8000 shares of JP Associates to Trader A on 26 thMarch 2015, if Trader A chooses to exercise his agreement. This does not mean that Trader A should have 8000 shares of JP Associates with him on 26 th March. Options are cash settled India. This means that Trader A can exercise his right to have 8000 shares with him on 26 March. Trader B must pay only the cash differential to Trader.
This is why 26 th February JP Associates is currently trading at Rs.32/. This means that the option buyer (Trader B) will be able to purchase 8000 shares of JP Associates at 25/$. This means that he will be able to purchase JP Associates at 25/$, even though the shares are trading at Rs.32/$ in the open market.
This is the normal cash flow.
You can also look at it this way: The option buyer makes a profit of Rs.7/share (32-25 per share). The option buyer receives 8000 shares but the cash equivalent. This means that Trader A would get the cash equivalent of what he would make.
= 7*8000
From Trader B.
The option buyer initially spent Rs.10 800/- to purchase this right. His real profits would therefore be -
= 56,000-10,800
= Rs.45,000./-
This is a staggering return of 41.99% if you consider it in percentage terms (without annualizing).
Options are a highly attractive trading instrument because they offer a large asymmetric return. Options are hugely popular among traders because of this.