Options is a very popular derivative instrument. Most of the turnover at the National Stock Exchange or NSE happens in the Options market. We will discuss trading the Options in detail in this module. But first, let’s discuss the basics.

Remember the derivative segment consists of Futures and Options. You must now be familiar with futures trading.

All instruments traded in the Futures segment in the derivative market would also have facility to trade in the options segment too.

For example, let us take the same example of SSK limited that is traded at the NSE cash segment and NSE derivative segment. At any time, the SSK can be traded in the cash segment and in the three Future contracts (Near, Next and Far).

Also, there would be multiple Options contracts of SSK that will be traded at the same time.

There are basically two types of options namely the call and put for any instrument listed in the derivatives segment.

Call Option is popularly called as CE and Put Option as PE.

The lot size for Options is same as that of Futures for each instrument. The expiry for Options contract is the same as Futures. NSE and BSE has introduced weekly options contracts as well, we will discuss about them later.

When you think that an instrument is bullish, you can buy shares of the instrument in the cash segment, or you can go long in the future contract. But there is another avenue which is trading in the options segment.

In this case, if you are bullish, you can buy the Call Option of the instrument. Unlike the futures contract, you need not pay hefty margin while buying the options. You will just have to pay the premium relevant for the instrument.

Let’s understand it via example.  

For example, SSK is trading at 100 in the Future segment. The lot size is 500. Let’s say current month is June and the last Thursday of the month is on 27^th June.  If you are bullish on SSK, you can buy the Call Option of SSK of 100 strike price. We’ll discuss more about strike price later. Let’s say the premium is ₹2. 

You will have to pay the premium amount (the Lot size x premium amount) to buy the call option.

In above example, you need to pay 1000/- (500 x 2) to buy Call option of SSK for June month at 100 strike-price.

The premium of the call option will rise if the price of SSK moves up. The premium will fall if the price of SSK falls.

So, if you think SSK will rise, you can buy Call Option of SSK with an investment of just 1000/-. But there is a caveat here. The price of SSK should go up before the expiry of the contract. You will make profit from the call option purchase only if the price of SSK rise before the expiry date of 27^th June.

Let’s say SSK goes to 110 before 27^th June and your premium increased to ₹8 from ₹2. You earned 6 points profit in this trade. You can choose to book profit and need not wait for the expiry.

You may notice that the profit made in the options trade is lesser than the cash segment or the future price, but your investment was also less in the options trade. Hence, return on investment would be better in options trading.

This sounds great right? This was just to give you an example of how options trading works. The initial capital outlay is less hence this segment is very popular but trading the options market successfully is not that easy. You need to learn several aspects of the Options market.

You need to understand:

• How premium (option price or option value) behaves,
• What is strike price,
• What happens on expiry.

We will discuss more about premium later, for now you need to know that you can also see it on you trading terminal for each strike price.

Strike price

We discussed strike price 100 for SSK. There will be various strike prices for which options contract will be traded for any instrument. For example, the strike price at 5-point difference may be available for SSK. So, there will be a Call option for strike price for every 5-points increment. That is, the strike price would be 90, 95, 100, 105, 110 and so on. This difference between strike price is decided by the exchange for each instrument.

There will be multiple strike prices trading at a time for all instruments and each strike price will have a call and a put option trading at that time.

Below is screenshot example from Opstra platform.

You need to select Expiry (Contract), Strike price and Type (Call or Put) before buying or selling the option.

American and European

You might have noticed that Call Option is written as CE and not as CO. Put Option is written as PE and not as PO.

There are two types of Options, American and European.

The basic difference is that the American Options gives the right to the holder to exercise options on any date before the expiry. The European options give right to the holder to exercise options only on expiry date. The Options in India are European options, hence the Call options are written as CE and Put options are written as PE.

Like Futures, the Options in India are exercised only on the expiry day. Exercise and squaring off are different things. You can square off your position (sell if you have bought, buy if you have sold) on any day during market time even before the expiry.

The Options will expire on the expiry day, and they will be exercised on the expiry price on that day. In simple words, they will be automatically squared off based on the expiry price.

What happens on expiry

We will discuss more about expiry later because there are some aspects related to settlement. Let’s focus on the basic concepts for now.

Let’s continue with the earlier example relating to SSK.  You bought 27^th June Call Option of SSK of 100 strike prices at the premium price of ₹2. 

In the above example, if you don’t exit the call option before 27^th June, your options contract will be settled at the expiry price. Let’s say expiry price of SSK underlying on that day is 105. 

Final premium price of 100 strike price Call Option will be ₹5 (Expiry price of underlying – Strike price).

You will earn a profit of 3 points. (Expiry price (5) – purchase price (2)).

Had the expiry price been 108, the premium would have been 8 points. Had the expiry price at 104, premium would have been 4 points. If expiry price was 102, premium would have been 2 points, in which case, you would not make any money as the expiry price would be 102 and your purchase price was ₹2.

So, 102 becomes your breakeven point in the above case. So, you will make money only if underlying price expires above 102. In other words, you will make money in long call option only if the premium closes above our investment price.

If expiry was at 101, premium would be ₹1 and you will suffer a loss of 1 point.

If expiry was at 100, premium would be 0. (Expiry price – Strike price).

What if expiry is 98. Premium would be 0. Premium doesn’t go negative. This is an important feature.

Even if SSK falls suddenly and it goes to ₹70, the premium on expiry would still be zero.

That means, the maximum risk for holding the long call option is the premium price you pay. If the price doesn’t move as per your view, the maximum loss is the premium you paid for purchasing the Option.

Moneyness

It was mentioned earlier that there are multiple strike prices of any instrument in the options market.

There are three types of the strike prices based on the moneyness of the option. These are called as  ITM, ATM and OTM strikes.

Let’s assume that SSK is trading at 100 and the difference between strike prices is 5-points.

• The strike-price 100 is known as ATM or At-the-Money strike price.
• The strike prices below ATM i.e 95 and below are known as ITM or In-the-Money strike prices.
• The strike prices above ATM i.e 105 and above are known as OTM or Out of-the-Money strike prices.

Above example is for Call options. Each strike price would be trading at different premium prices. Every option buyer would hope that his option contract expires in-the-money. So, the premium price doesn’t become zero.

Hence, the premium price depends on the chance of price expiring in-the-money. ITM options would be more expensive since they have better chances of expiring in the money. OTM options will be comparatively cheap since they will have less chances of expiring in the money.

See below image.

The premium for ITM Call options would be high because price is already trading above the strike price. The chances of expiry above that price are high.

The premium for ATM Call Options will be moderate because price is trading at that price.

The premium for OTM options will be less because price is trading below it and chances are less that price will trade above it. The chances are more that the Option premium price will be zero on the expiry day.

In above example, chances appear to be less that SSK will go to 110 before expiry. If it does and you will end up making good money if you had bought a Call option of any strike price below 110. If the price does not close above 110, your investment will be eroded based on the strike price for which call option was purchased.

The call option for each strike price will increase and decrease based on the movement in the price of underlying instrument which is SSK in this case. If price increases, the ATM options turn into ITM options and OTM option becomes ATM options. The options premium price will change accordingly.

OTM options are interesting instruments. If the price moves in sync with your expectations, you end up making money. If it doesn’t, the maximum loss is the premium you paid and investment is also relatively less compared to the cash or futures segment.

Sounds like a lottery, isn’t it? ????

But usually, the probability of winning a prize in lottery tickets is very less. It is no different in buying OTM options.

Trading them as lottery would be a bad business idea. People use these instruments very effectively by designing and trading Options strategies. We will discuss those strategies in detail. Before that, we need to understand Put option.

We discussed that you buy a Call Option when have a bullish view on an instrument. What if you are bearish on any instrument? How do we capitalise this using options trading?

Obviously, you can’t sell shares in the cash segment unless you own it. You can of course short sell Future contract. You have another facility which is to buy Put option of the instrument.

All other aspects of Put options are the same as Call Options except one change. The premium price of Put option will increase if the price of the underlying falls. Buying put options obviously needs lesser investment compared to the margin required for shorting future contracts.

For each strike price, there will be a call option as well as put option that would be traded. The ITM, ATM and OTM criteria will be the reverse.

Have a look at the image below.

If the price is trading at 100, the strike price 105 and above are In-the-Money (ITM) Put strike prices. The strike price at 95 or below are Out of-the-money (OTM) Put strike prices. The strike price of 100 is the At-the-money Put strike price.

If you have a bearish view, you can buy the Put option. If the price falls before expiry, you make money.

The calculation at expiry is the reverse of what we discussed for call options. It would be: Strike price – Expiry price of the underlying.

If the expiry price is 95, the premium of 100 strike price would be ₹5. (Strike price – Expiry price).

If expiry price is 90, premium would be ₹10.

If expiry price is 100, premium would be zero.

If expiry price is 103, premium would be zero. Remember, the premium doesn’t go negative, be it calls or puts.

So, for each strike price, there are Call and Put Options trading at different premiums. The Option premium increase and decrease based on the movement in the price of the underlying instrument. The other key aspect influencing options premium price is the time remaining until the expiry of the contract.

We will discuss more about it.

Before reading further, please fill this table, that calculates price of Calls and Puts on the expiry day.

Below are right calculations. If your answers were wrong, please read the above explanation again.

If answers were right, you have understood the basics of this subject well.

Will you be able to understand if I say, all ATM and OTM Options expire worthless on the expiry day? Their premiums will be zero. Take a moment, look at a few examples, and apply the formula. You will get it. Hence, an Option buyer will always wish that his strike price becomes ITM on the expiry day.

Now, you know that:

• There are two types of Options: Call and Put. Call options are bullish and Put options are bearish.
• There are multiple strike prices (moneyness).
• Buying option requires less investment
• Difference between strike price and expiry price is the final premium
• Except ITM options, all other options expire at zero on the expiry day. 

Before you read further - Please select one instrument, put at least one ITM, ATM and OTM strike prices of Call and Put on your trading terminal along with Future and Cash price of the same instrument. Please observe the movement in price and premiums. Don’t trade, you need to learn more about Options.

If you are new to Options, practice this today before you move further:

• Buying Call option is bullish
• Buying Put option is bearish
• Selling Call option is bearish
• Selling Put Option is bullish

Imagine the strike prices of a particular instrument and practice this:

Call Option

• Higher strike prices are OTM
• Near strike price is ATM
• Lower strike prices are ITM

Put Option

• Lower strike prices are OTM
• Near strike price is ATM
• Higher strike prices are ITM

ITM Options

ITM options or deep ITM options have got better chances of expiring in the money. There is more of intrinsic value in them. For this reason, they behave almost like underlying. From this perspective, buying an ITM call option is almost like buying a future contract. Buying ITM put option is almost like selling a future contract.