A call option is the right, but not an obligation to buy something at a fixed price – the strike price at anytime within the specified time period.
In this definition, the “something” is the underlying which the investor has the right to buy or sell. The underlying is usually either an exchange traded stock or a commodity. Note that an option gives the buyer the right to buy or sell the underlying contract at a predetermined price. The specific price at which the underlying can be bought or sold is referred to as the strike price or exercise price of the option.
Options only have a limited life-span. In the above definition of an option the buyer of an option can exercise the right within a specified time period. The exercise period of the option specifies when the option expires and can no longer be traded. The exact date in which the option expires is set by the exchanges and differs from one exchange to another. Different month options are entirely different instruments, so a June option is a separate and distinct contract from a July option.
Investors buy call options if they think that the price of the underlying will go up and buy put options if they think the price of the underlying will go down.
The price paid for acquiring the right to buy is called the call option premium. Assume that Microsoft shares are traded on the Exchange at $38.75 on 25th Feb X1. Assuming that the next expiry period is 15th Mar X1, the call option premium having an exercise price of $40 may be priced at $1.25. This means that the buyer of the option can exercise the right to buy the shares at a price of $40 at any time on or before 15th Mar X1. Hence if the price of Microsoft increases beyond $40 then he will stand to gain to the extent the price is over and above the premium paid by him amounting to $1.25 per share. However if the price of Microsoft stays below $40 and even if it drops down substantially to say $30 per share, the buyer of the option would stand to lose only the option premium paid by him already.
Whether the investor has the right to buy or to sell depends on which type of option the investor buys. The purchaser of a call option has the right to buy the underlying asset. The purchaser of a put option has the right to sell the underlying asset. Note that puts and calls are mutually exclusive. A call option does not offset a put option and vice versa.
Example: In the National Stock Exchange, India, the quotes are available for the current month, near month and far month. For example, when investors trade in early May, they get quotes for May, June and July. The settlement period is the last Thursday of the relevant month. So, if an investor buys 1 lot of May-X1 – Rs.600 strike price, call option of ABB at a premium of Rs.6, it means that the investor can exercise the option before the settlement date for May-X1 viz., the last Thursday in May-X1.
A put option is the right, but not an obligation to sell something at a fixed price – the strike price at any time within the specified time period.
The price paid for acquiring the right to sell is called the put option premium. Assume that Microsoft shares are traded on the Exchange at $38.75 on 25th Feb X1. Assuming that the next expiry period is 15th Mar X1, the put option premium having an exercise price of $38 may be priced at $1.00. This means that the buyer of the option can exercise the right to sell the shares at a price of $38 at any time on or before 15th Mar X1. Hence if the price of Microsoft goes below $38 then the investor will stand to gain to the extent the price goes down over and above the premium paid amounting to $1.00 per share. However if the price of Microsoft surges above $38 and even if it rises up substantially to say $50 per share, the buyer of the option would stand to lose only the option premium paid by him already.
When the investor buys a put, then the investor has the right to sell the underlying. Note that the investor is dealing with different instruments here. The investor is buying a put instrument that gives the right to sell a different and distinct instrument which is the underlying asset.
The strike price, also known as the exercise price, is the price at which the underlying stock would be bought or sold by the purchaser of the option. The strike price is fixed during the life time of the option contract and does not undergo any change, even though the market price of the underlying stock would keep fluctuating. When a long call is exercised the seller of the call is obliged to sell the underlying stock to the buyer of the call option at the strike price.
Strike price increments for listed options are standardized by the exchange concerned. The strike price increments are decided based on the value of the underlying stock. The following is the strike price increments of two stock exchanges – US and National Stock Exchange, India.
Strike price Interval rule CBOE (U.S)
On the CBOE, the strike price interval is set at 2 1/2 points when the strike price is between $5 and $25, 5 points when the strike price is between $25 and $200, and 10 points when the strike price is over $200. Strikes are adjusted for splits, re-capitalization, and any other relevant corporate action.
Strike Price Interval Rule for NSE (India)
The Exchange provides a minimum of seven strike prices for every option type (i.e., Calls & Puts) during the trading month. At any time, there are three contracts in-the-money (ITM), three contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval rule is as follows:
|Price of Underlying
||Strike Price interval (Rs.)
|Less than or equal to Rs. 50
|> Rs.50 to less than or equal to Rs. 250
|> Rs.250 to less than or equal to Rs. 500
|> Rs.500 to less than or equal to Rs. 1000
|> Rs.1000 to less than or equal to Rs. 2500
The expiration date is fixed by the stock exchange on which the options are listed. This is the date on which the right to exercise an option contract ceases to exist. In the US markets it is the third Friday of every month. The following is the expiration dates of certain stock exchanges around the world.
|Expiration dates of selected stock exchanges
||Last Trading Date/Expiry
||Third Friday of the Month
||Third Thursday of the Month
||Third Wednesday of the Month
||Third Friday of the Month
||Business day preceding second Friday of the month
|Equity & Index Options
||Last Thursday of the Mont
Expiration cycle determines the different option expiry periods that are available for trading at any point of time. In the US markets, for any given stock, four outstanding expiration months are available for an underlying stock at any point of time. Out of the four, the first two are referred to as near-term months, which would be the two consecutive calendar months following, and the remaining two months would be far-term months which will vary based on the expiration cycle for that given underlying stock.
There are three expiration cycles as follows:
- January Cycle: January-April-July-October
- February Cycle: February-May-August-November
- March Cycle: March-June-September-December
This again depends upon the stock exchange in which the underlying is listed and varies from stock exchange to stock exchange. The system followed in the US is expected to provide an orderly and liquid market, as existence of several expirations with multitude of strike prices would make the volumes thin thereby affecting liquidity.
The value of derivative instrument is derived from the characteristics and value of a related stock and this is known as the underlying asset. The underlying can be any stock, commodity, bullion or Index. The underlying asset is the specific asset based on which the derivative contract is bought or sold.
For e.g., when ABB 600 call is exercised the underlying asset viz., the shares of ABB is bought. When ABB 600 put is exercised, the stock of ABB is sold. Note that the derivative contracts can be bought or sold without actually buying or selling the underlying.
The status of an option changes on a daily basis depending upon the market rate of the underlying. To find out the status of the option, the market rate of the underlying is compared with the strike price of the option contract. Accordingly, an Option will fall into any one of the status viz., ITM, ATM, OTM as mentioned below:
In-The-Money – ITM
For a call option, when the underlying stock is trading for more than the option’s strike price, then the call option is said to be In-The-Money (ITM). A put option is In-The-Money when the underlying stock is trading for less than the option’s strike price.
At-The Money – ATM
When the underlying stock is trading at the same level as the option strike price, then the option is said to be At-The-Money (ATM).
Out-of-The Money – OTM
For a call option, when the underlying stock is trading for less than the option’s strike price, then the call option is said to be Out-of-The-Money (OTM). A put option is In-The-Money when the underlying stock is trading for more than the option’s strike price.
Futures and options traders use the terms long and short similar to the regular equity markets. A long position means that the investor has bought the derivative instrument – futures or options. A short position means that the investor has sold the instrument. So selling short in futures is when the investor sells a contract, without owning one in attempt to profit on a favorable price movement downwards. The seller of a futures contract may own the underlying share to lock the sale price, especially when the market is favorable to the seller.
Can investors sell something that is not already owned by them? This is possible in derivatives market as this is basically an agreement to buy or sell something in the future. Since the investor’s obligation to sell the underlying asset does not occur until a date in the future, the investor can first agree to sell on paper. As long as the investor can buy back the contract before the future date, the investor can fulfill the obligation and realize the difference in favorable price movement. Because derivative instruments deal in the future, the investor can sell first without owning anything and buy back later.
One of the biggest advantages of the derivatives market is that it enables the investor to go short more easily than in spot market. In the spot market it may not be possible to effectively sell short without a substantial price drop especially if the volume sold is large. The regulatory authorities do impose several restrictions that seriously impair one’s ability to sell short in the spot market that are not applied to the derivative market. Selling short is one of the effective methods of hedging for an investor whose overall position is long. Derivatives market enables the investor to assume risk as per the investor’s risk appetite.
Another advantage of derivatives trading is that it is easy to capitalize on a price decline. The investor can sell short just as easily as going long. Derivative markets operate on margin trading and compared to the spot market this gives an advantage of leveraging. However if not handled with due care, leverage can also be one of the major disadvantages of the derivatives market.