Options — What is it?
Options are basically a derivative instrument where you can make a good amount of money, with low investments, if your analysis is right, else you lose the same amount of investment.
But this doesn’t answer what’s the option actually. Let me explain it in detail below with some examples.
Let’s assume you are friends with the horse mafia and know about the upcoming horse race in town where two very good horses A and B are also there with other moderately good horses (C to J) and you would like to gamble on one of them. Through that mafia, you also have the intel that B’s leg is badly hurt which was the fastest amongst the two.
- Which one will you bet on? — Obviously on A … right not B and neither any from C to J.
- Would you prefer to put a higher bet than the rest folks (given that you know A will be the winner)? — again obviously if others are going upto 5x on gambling, you might bid the highest one, let’s say 100x on 🐎 A.
- Assuming that you bet quite high on B before knowing its condition. What will you do? — definitely get rid of those bets or maybe hedge it via betting on A.
Now your horse A wins, why? — Coz B’s injury made B lose on his momentum thorough out the race.
From this horse example, we get to know that momentum is necessary to place higher bets. Along with that, we also learn that staying on the losing bet is stupidity.
This is very much applicable when trading in options. Before using this info for trading, let me talk about the types of options available in the Indian stock market.
In this link — https://www1.nseindia.com/content/fo/fo_underlyinglist.htm — you will get the entire list of indices and stocks which you can trade in futures and options. Please note that not all indices and/or stocks have much volume, so, it's advisable to trade the ones with good volumes.
Futures and options have two things in common — lot sizes and expiry dates.
Lot size means that they come in a fixed quantity. Like currently Banknifty lot size = 25, you can't buy just 20 out of it, just because your astrologer says it is your lucky number.
The expiry date means that the contract expires on this particular date. As futures and options are contracts, every contract has an expiry date. At any given point in time, in the Indian market, we have three series of contracts available.
1/ current month
2/ next month
3/ far month
All of them will have an expiry on the last Thursday of that month if it's a holiday then the previous trading day will be the expiry date, beyond which next month's series will become the current month and the new far month series will come into existence.
In the case of index options like NIFTY and BANKNIFTY, they do have the concept of weekly expiries as well. The contract ceases to stay valid after expiry.
What will happen if I don't exit my options trade and let this go through expiry? — Market will close your option trade. However, there is a concept of physical settlement which we will talk about at the last.
TYPES OF OPTIONS
There are two types of options available — call options and put options.
Indian market follows the European system of expiry which means that the expiry of options happens only on the pre-decided date. Hence, call options are denominated as CE (European call) and put options as PE (European put).
From the buyer’s perspective
Call options — buy when you expect the prices to go up
Put options — buy when you expect the prices to go down
From the seller’s perspective
Call options — sell when you expect the price not to go up, which means the price is flat or going down
Put options — sell when you expect the price not to go down, which means the price is flat or going down
Well, now you must be thinking why the flat price is considered in sell case and not buy case. This also means that the probability of buyer winning is just 1/3rd. This has something to do about options greek. Now, what’s that? — Calm down, will talk about that later.
Now coming back to the horse race example, let's say there were 5 punters who were taking bets for horse A, each of them were taking different bets, one is taking at $100, others are taking around $105, $110, etc. which is normally the scenario in every betting. The point is there are many prices available for the same horse in the same race.
In the same way, when it comes to options there will be many such prices will be available for which you can buy/sell options, which is called Strike Price.
Let me explain this with an example now:
TCS — CMP around 3600
Google out TCS option chain — open the NSE link to understand the below part better.
You will see in the strike price column, prices are varying at the frequency of 20rs. which means that at every 20rs price interval, you will be able to place the bet.
In the TCS option, there are around 72 strike prices (SP) available to choose from. SP range available currently is from 2980 to 4420. You can choose to trade in any of the strike prices call or put options.
Woahhhhh, that's too much. How do I select any particular SP to trade?- Well there's a concept of moneyness in the option and option greeks. Let's talk about moneyness now and option greek, a few moments later.
Moneyness of options
As mentioned above TCS is currently around 3600 and date today is 12th March 2022.
For call option
Let us assume you have bought 3600 CE of March expiry, your friend is already having 3500 CE and I have bought 3700 CE of the same expiry and TCS share prices start going up from here. Your betting price will also start going higher as you are winning the race. If TCS grows by say 60rs, your bet will accordingly increase at a faster pace than mine as I have taken the lower bet than yours, and your friend’s bet is making the most money.
This is called moneyness. The higher the price goes up from strike price, the higher is the profitability of call options.
We took the 3 SP scenarios above, in options parlance, there are terms for that.
1/ In the money (ITM) — SP somewhat lower than the stock price — 3500 CE in the above example
2/ At the money (ATM) — SP nearest to the price — 3600 CE
3/ Out of the money (OTM)— SP somewhat above the price — 3700 CE
If you google about them, you will find deep ITM and deep OTM as well but let’s not go there.
For put option
TCS is around 3600, your friend bought 3700 PE, you bought 3600 PE and I bought 3500 PE, because we all got the intel that TCS is going to fall and can even nosedive from here.
As put is opposite of call option, here ITM will be 3700 PE and OTM will be 3500 PE, while ATM remains the same at 3600 PE.
NSE option chain shows all ITM option details in slight orange background.
As ITM options will be making more money for you, they are the costliest amongst ATM and OTM. And OTM is the cheapest one.
So far, I used the word bet which you are betting. In options parlance, its called PREMIUM.
Premium is made up of TIME VALUE and INTRINSIC VALUE.
PREMIUM = TIME VALUE + INTRINSIC VALUE
Time Value = Random value (option greek actually which we will talk about later, yes the article is going big, but focus on learning here). Farther the expiry, higher is this value and vice versa.
Intrinsic Value = Basically some moneyness variable calculated by some formulas which we ain’t gonna talk about, but for ease of estimating premium, we will talk a bit about it.
For call option-
TCS 3500 CE is currently at 161Rs. while the stock price is 3600. So, the minimum of zero or (Stock price minus Strike price) is your Intrinsic value and the rest will be Time Value. IV = 100 and TV = 61.
While 3600 CE is currently at 96Rs., here IV = 0 and TV = 96. And 3700 CE is currently at 52Rs., here IV = 0 and TV = 52.
Usually, TV decreases for higher SP CE, by this logic, 3600 CE is currently overpriced.
For put option-
TCS 3700 PE is currently at 130Rs. while the stock price is 3600. So, the minimum of zero or (Strike price minus Stock price) is your Intrinsic value and the rest will be Time Value. IV = 100 and TV = 30.
While 3600 CE is currently at 78Rs., here IV = 0 and TV = 78. And 3500 CE is currently at 42Rs., here IV = 0 and TV = 42.
Usually, TV decreases for lower SP PE, by this logic, 3600 PE is currently overpriced.
Note -When there is a big event ongoing, like war/elections etc, premiums are usually very high. ATM options of banknifty are actually trading at double price than the normal days.
Buying option is cheaper than selling options. For buying, you have to pay premium * lot size, which means limited risk. For selling, you have to pay, some extra margin as well. On average, if you want to sell option positionally, it takes roughly 1.5–2lacs. Why so? Well stock prices can fluctuate wildly and hence Premium may increase drastically, to maintain this unlimited risk of sellers, margins are on the higher side.
But but but, don’t forget that seller’s winning probability is on twice that buyers which we discussed above.
OPTION GREEKS
Unless and until you want to write a book about them, let us not waste much time here and cover it up in brief. There are five major options greeks to be considered.
DELTA-
Rate of change of premium according to the movement in stock price. The higher the delta, the more beneficial is the option. By this logic, deep ITM is more beneficial.
Let's say TCS goes up by 100rs from 3600, then 3500 CE might increase by 100rs but 3600CE may increase only by 90rs while 3700CE might increase just by 30rs.
GAMMA-
Rate of change of delta according to the movement in stock price. This is the major reason why option buyer doesn't win in the flat movement of stock/index.
Yeah Yeah Yeah !!! Too many complications… I warned above only.
VEGA -
Rate of change of premium in accordance with the volatility of the stock. As the volatility increases, premiums are very unstable. This affects the ATM option the most. On any non-trending day, this can be seen in Banknifty ATM options.
THETA -
Time value measurement. As the expiry approaches, theta keeps on declining due to which premium erosion keeps happening gradually. This is the major reason why option sellers win.
Due to this theta, you will see that most ATM options are very cheap in the last week of the series.
RHO -
This greek measures interest rate. As interest rate increases, premium increases and vice versa. Interest rate change doesn't happen every other day, hence this greek doesn't affect premium much.
Physical settlement of options
If you forget to close your option trade by expiry and the SP is among the 3 ITM (for TCS which is at 3600, then its 3 ITM will be 3580, 3560, 3540 for CE, and on the put side it will be 3620, 3640 and 3660) are forced to undergo physical settlement.
Let's assume today is 31st march, this monthly expiry date, and TCS closes at 3600 and I have 3560 CE bought at 40. I didn’t close the trade because I was in huge profit (and was extremely busy with work as well).
So by this concept of physical settlement, I will have to pay 3560*150=5.34lacs to that SP option seller and that seller will credit the 150 shares of TCS to me at 3560 each.
Note: Physical Delivery doesn’t take place in index options. And is mandatory for stock options. To prevent from this, usually your broker will not let you carry that option on the last day of the series.
Due to this process, usually in the last week, there are fewer option sellers available in the market.
Now, you must have heard that option price went up by 2x, 5x, 10x, etc. This happens because of the momentum. If you are good at analyzing charts, you can easily trade options if the momentum is expected.
For starters, don’t put up money right away in options, see the charts and see how premiums are moving, make the journal and mention where you would have entered based on stock price, at what premium, exit at what price. Keep a check on your accuracy, if that’s very good, then only jump into options trading.
One last thing, you must have heard that XYZ stock is in the ban, it means that you will not be able to make fresh positions in option till it gets unbanned. But you can continue to hold the existing buy/sell position and you can exit them if you choose to.
This is one of my old blogs where I talked about options at a high level along with various strategies involving options. https://theharshvardhanbiswas.medium.com/options-a-derivative-product-6876369f0cf8
