Options are the contracts that give you the right but not the obligation to buy or sell shares or an index at a specified price on or before the expiry date of the contract. So the risk with options is very limited in the sense that you can make unlimited profits if the market goes in your expected direction but limited loss if the market goes against your prediction. Ofcourse this risk limitation comes with a price. You have to pay the premium which is very little amount of the total value of shares in that lot for buying the option contract which is the only amount you will be losing if the market goes against you.
The seller of the option is called the option writer. He does not have any right over the contract but he is obliged to comply with the contract if the market goes against him. That is his loss will be unlimited if the market goes against him and his profit is limited to the premium the buyer pays to buy the option.
Lot Size and Duration of the Options:
Both lot sizes and the duration of the option contracts are similar to that of futures contract. Each option contract will have a certain number of shares as determined by the exchange. Just like futures, three month contracts will be traded simultaneously. They are current month or near month contract, second month or middle month contract and the third or far month contract. All contracts expire on the last Thursday of the corresponding month. On expiry of the near month contract, the second month contract becomes the near month contract, and the far month contract becomes the second month contract and the fresh far month contract will be generated on the working day next to the expiry date.
Every option type will have minimum of five strike prices, two above the spot price and the two below the spot price and the one equivalent to the spot price. In India, Stock options are American options which means it can be exercised at any time of the contract period while the index options are European options which means it can be exercised only on the expiry date of the contract and not before.
The number of Outstanding positions in a contract is called the open interest of that contract. This is an indicator to evaluate the strength of the market at any given point of time. Open interest of any contract would be nil after the expiry date of that contract as all the open positions will be closed on the expiry date.
Types of Options:
Options are of two types depending on whether one wants to buy or sell shares at a specific price in the futures. They are:
1. Call Options (gives you the right to buy shares or index)
2. Put Options (gives you the right to sell shares or index)
Buying a call option gives you the right to buy a certain number of shares or an index at a predetermined price (strike price) on or before the expiry date of that option contract. You need to pay a premium to the option seller/writer. As long as the market does not move above the strike price, the option writer can enjoy the premium. But once the price moves above the strike price, the option writer will be losing the premium partly or the whole or even he has to bear a huge loss if the market moves higher than the break even point (strike price plus the premium amount). This is exactly when the option buyer starts making huge money. And till then he stands the risk of losing premium partly or wholly.
To illustrate with example, let’s say, a call option lot of DLF on strike price Rs 210 is available at a premium of Rs 10/share. One option lot of DLF consists of 2000 shares. So the buyer needs to pay Rs 20,000 (premium Rs 10 *2000 shares per lot) to buy a call option lot of dlf at strike price Rs 210. The buyer will start making money only when the DLF price moves above Rs 220 (strike price 210 + 10 premium). As long as the price stays below or at Rs 210, the buyer stands to lose the premium which also means the seller gains the premium. When the price stays above Rs 210 but below Rs 220, buyer will be recovering his premium partly or wholly while the option seller will be losing premium partly or wholly.
Buying a put option gives you the right to sell a certain number of shares or an index at a predetermined price (strike price) on or before the expiry date of that contract. Just like call option, you need to pay a premium which is very less compared to the total value of the contract. You will start making profit when the price moves below the strike price minus the premium amount. Till then you will be either losing premium partly or wholly depending on the price of the underlying shares. This is exactly opposite to the case of the option seller/writer. He gains when buyer lose and viceversa. But the buyer’s loss is limited to premium while the option writer’s loss is unlimited while his gain is limited to premium.
To illustrate with the example, let’s say , a put option lot of DLF with strike price Rs 210 is available at a premium of Rs 10 per share. Since the lot size is 2000 shares, the buyer has to pay Rs 20,000 to buy a single lot of DLF put option. The buyer will start making money when the price falls below Rs 200 (strike price Rs 210 – Rs 10 premium amount). And it is exactly when the seller starts losing money. And when the price hovers between 200 to 210, both seller and buyer stands to lose the premium wholly or partly. When the price moves above 210, the buyer loses his whole premium and hence the limited loss and the seller gains the premium and hence the limited gain.
Covered Options and Naked Options:
If the seller of an option has the underlying shares to nullify the losses if the market goes against his predictions in the option, then it is called covered option.
If the Seller of an option does not have any underlying shares to nullify the losses if the market goes against his prediction in the option that he sold, then it is called Naked option which means his option does not have any protection against the unlimited losses when the market goes against his prediction.
How to close or square off or offset the option positions?
To square off or offset or closing the open option position, one needs to sell if purchased or buy if sold the option of the same share or index, same quantity, same strike price and the same month contract.