In the Money, Out of the Money and At the Money Options

In the Money, Out of the Money and At the Money Options:

A call option is said to be in the money , if the spot price of the stock or index is greater than the strike price.  i.e., you can make money if you exercise or square off the option in the current scenario. The call option is said to be out of the money if the spot price of the stock or index is lesser than its strike price. i.e you cannot make money if you exercise or square off the option at the current situation. The call option is said to be at the money, if the spot price and the strike price of the stock or index is the same.

The above scenario is exactly the opposite in Put option where it is said to be in the money if the spot price is lesser than the strike price, out of the money if the spot price is greater than the strike price and at the money if the spot price and strike price of the stock or index is the same.

Options Pricing:

We already know that to purchase an option we need to pay a premium which is only a small amount of the actual lot value we purchase. Let’s see how this premium price is derived. All options pricing are the sum of the Intrinsic value and the time value of that option though other factors are involved as well but they do not contribute significant change as that of intrinsic value and time value.

I.e., Options price = Intrinsic Value of that option + Time Value of that option

For eg, if the time value is 10 and the intrinsic value is 20, then the option price is 30. But it will not be exactly 30 as other minor factors like volatility, interest rates and dividends also contribute to the option pricing.

Intrinsic Value:

Intrinsic value is the difference between the spot price and the strike price of the option and is considered either positive or zero but never be negative as there is no point in buying the option if it is out of the money. So the option has intrinsic value only if it is in the money and the intrinsic value of the at the money option and out of the money option is always zero. For example if the spot price of the call option is 350 while the strike price is 340, then the intrinsic value of the call option is 350-340 = 10. Like wise, if the strike price is 340 and the spot price is 330, the intrinsic value is 0 and not -10 as it can never be negative.

Time Value:

Time value of the contract depends on the time interval between the current date and the expiry date. The longer the time interval, the larger the time value and vice versa. This is because, the possibility of the stock or index to move a large distance and hence make the large profit to the position holder is large when the time gap is more compared to the situation when time gap is lesser. This is why the options are priced very high during the initiation of contracts compared to the dates nearer to the date of expiry. 

Options

Options:

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)

Call Options:

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.

Put Options:

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:

Covered 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.

Naked Options

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.

Trading in Futures

Trading in Futures

Trading in futures is similar to trading in stocks except that you do not take delivery of the stocks. In cash market, you can only hold stocks in the long position for a longer period, whereas in the futures market, you can also hold short positions open for many number of days depending on the contract duration.

You do not have to pay the actual value of the lots while buying futures. Instead you will have to deposit only a percentage of the value of the open position which is called margin money which covers the initial and the exposure margin. This margin amount for each stock futures and index futures is prescribed by the exchange depending on the volatility of the stock or index. In addition to maintaining margin, one has to maintain mark-to-market margins (MTM) which covers the daily difference between the cost of the contract and the closing price of the contract for the day.

Settlement of Futures

In Indian stock market, buying stock futures does not result in delivery of shares. So the futures contract has to be settled on or before the date of expiry of the contract by squaring off the position (i.e., taking position opposite to the existing open position of a futures contract). Based on the profit or loss made by the movement of futures prices, the account of the position holder will either be credited or debited. You can square off your position at any point before the expiry date to book profit or loss. Or you can leave your position open till expiry date on which your profit or loss will be calculated based on the closing price on the expiry date and then your account will be credited or debited accordingly.

Trading Strategies in Futures

Let’s see how speculators, arbitrageurs and hedges take advantage of the futures market.

Speculators

Speculators speculate the market direction and thereby buy or sell futures according to their predictions. Since they have to invest only a percentage of the open position, they take advantage of this to hold a huge position and reap huge profit with lesser investment. The downside of this is they will suffer huge loss if their speculation goes wrong.

Arbitrageurs

Arbitrageurs look out for the large difference in spot and futures price and buy the stock in cash market at the spot price and sell the corresponding futures at the current higher price and wait till the expiry date when both spot prices and futures price converge to book the riskless profit by selling the physical shares and buying back the futures.

Hedgers

If the investor expects the downfall in the market, he can protect his open position in the cash market by selling the futures equal to the value of their open position in the cash market. The downside of this is he will not make profit if the market moves up.

Derivatives Trading

Derivatives:

Derivatives are financial contracts that derive their value from an underlying assets like stocks, stock indices, commodities or currencies. All these underlying assets change in value from time to time. So derivatives are basically introduced to transfer these risks from risk averse investor to the risk appetite investor. Two specific derivatives that form a major role in any stock exchange are

1.       Futures

2.       Options

Three kinds of traders play a major role in derivatives segment. They are Hedgers, Speculators and Arbitrageurs.

Hedgers:

Hedgers are those who hedge the risk of falling or increasing of price of the share that they are willing to sell or purchase in the cash market at some point in the future by taking opposite position in the derivatives segment.

Speculators:

Speculators are those who expect the market to fall when others expect them to raise in future. So speculator enters into agreement with the one who wants to protect his shares that he wants to sell at a future time from fall in prices. So speculator agrees to buy the shares at a pre determined price from the hedger. But if the price moves up, obviously the hedger will not sell it to the speculator, since he can make more money by selling it directly in the market. So Speculator will be given a compensation of some amount instead for entering into this contract.

Arbitrageurs:

Arbitrageurs are those who make use of the difference in prices prevailing between the cash market and the derivatives segment and thus make a riskless profit. For example if a share is traded at Rs 100 in cash segment and Rs 105 in futures segment, he will buy the same at Rs 100 in cash segment and sell the same share at Rs 105 in the futures market. On the Contract expiry day, the prices of the share in cash segment and derivatives segment will converge when he can take the pre-determined profit without any risk.