We were familiar with the fundamental call option structure from the previous chapter. The goal of the previous chapter was to summarise a few crucial “Call Option” ideas, including:

1. When you anticipate that the underlying price will rise, it makes sense to purchase a call option.
2. The buyer of the call option loses money if the underlying price declines or remains unchanged.
3. The premium (agreement fees) that the buyer of the call option pays to the seller/writer of the call option is equal to the amount of money that the buyer would lose.

We will try to comprehend the call option in greater detail in the following chapter, called Call Option (Part 2). However, let’s first explain a few common option jargons before moving on. Talking about these terminologies now will not only improve our understanding, but it will also make the discussion of the possibilities that will follow simpler to understand.

We shall examine the following jargon:

1. Strike Cost
2. Fundamental Price
3. A contract for an option is
4. Choice Expires
5. Choice Premium
6. Optional Agreement

Please keep in mind that as we have only examined the call option’s fundamental structure, I would advise you to solely comprehend these terms in relation to call options.

Strike Cost

Think of the striking price as the anchor price at which the buyer and seller (of the option) concur to engage in a contract. For instance, the anchor price in the “Ajay – Venu” example from the previous chapter was Rs. 500,000, which also served as the “Strike Price” for their agreement. We also looked at a stock example where the strike price and anchor prices were both 75 rupees. The strike price for all “Call” options denotes the price at which the stock may be  on the expiration day.

For instance, if the buyer is willing to pay a premium today to purchase the right to “buy ITC at Rs. 350 on expiration,” they are eager to buy ITC Limited’s call option with a strike price of Rs. 350. It goes without saying that he will only purchase ITC at a price above Rs. 350.

In reality, below is a screenshot of the NSE website where I have included various ITC strike prices and the corresponding premium.

An “Option Chain” is the table you see above, and it basically summarises all the various strike prices that are  for a contract along with the premium for the same. In addition to this data, the option chain contains a wealth of additional trade data, including Open Interest, volume, bid-ask quantity, etc. I advise you to ignore everything else for the time being and focus just on the material that has been highlighted.

1. The underlying’s spot price is in the maroon highlight. As we can see, ITC was trading at Rs. 336.9 per share at the time of this picture.
2. All of the different strike prices that are are highlighted in blue. Strike rates range from Rs. 260 (with Rs. 10 intervals) up to Rs. 480, as can be.

3. Keep in mind that each striking price stands alone. By paying the necessary premium, one can enter into an options agreement at a particular strike price.

4. For instance, a 340 call option can be by paying a premium of Rs. 4.75. (highlighted in red)

1. This gives the buyer the option to purchase ITC shares for Rs. 340 at expiration. Of course, you now see the situation in which purchasing ITC at 340 on expiration day would be advantageous.

Fundamental Price

As is common knowledge, the value of a derivative contract is derived from the underlying asset. The price at which the underlying asset trades on the spot market is known as the underlying price. For instance, ITC was trading at Rs.336.90/- in the spot market when we examined that case. The underlying price is as follows. In order for the buyer of a call option to profit, the underlying price must rise.

A contract for an option is exercised

Claim your right to purchase the options contract at expiration by exercising your option contract. When someone says, “exercise the option contract,” they simply mean that they are asserting their right to purchase the stock at the specified strike price. It is obvious that he or she would only act in this manner if the stock is trading over the strike. A key detail to keep in mind is that you can only exercise the option on the day it expires, not at any other time.

Therefore, let’s imagine that someone purchases an ITC 340 Call option with 15 days remaining when ITC is trading at 330 in the spot market. Assume further that the stock price rises to 360 the following day after he purchases the 340 call option. In such a case, the call option holder cannot exercise his call option and cannot ask for a settlement. Only on the day of the expiry will settlement take place, and it will be  on the price the asset is trading for on that day in the spot market.

Choice Expires

The same as a futures contract, an options contract has an expiration date. In reality, the last Thursday of every month is the expiration date for both equity futures and options contracts. Options contracts have the same current month, mid-month, and far-month ideas as futures contracts.

The call option to purchase Ashok Leyland Ltd. at a strike price of Rs. 70 is shown in this snapshot at a price of Rs. 3.10/-. As you can see, there are three expiration dates: March 26, 2015, April 30, 2015, and May 28, 2015. (far month). Of course, as and when the expiry changes, the option premium also does. We will discuss it further when the moment is right. But at this point, I just want you to keep in mind two things about expiry: just with futures, there are three possible expiry options, and the premium varies depending on which option you choose.

Choice Premium

Since we’ve already talked about the premium on a few occasions, I assume you now understand a few things regarding the “Options Premium.” The premium is the sum of money that the option buyer must pay to the option seller or writer. The option buyer purchases the right to exercise his wish to buy (or sell, in the case of put options) the asset at the strike price upon expiration in exchange for the payment of a premium.

We must be going in the correct direction if you have understood this portion up to this point. We’ll now go on to comprehend a fresh viewpoint on “premiums.” Additionally, I suppose it is crucial to point out at this point that the “Options Premium” is what the entire concept of option theory depends on. When trading options, option premiums are a very important factor. You’ll notice as we go through this lesson that the choice premium will eventually take up a lot of the talks.

Let’s go back to the “Ajay-Venu” scenario from the previous chapter. Think about the conditions in which Venu agreed to accept Ajay’s premium of Rs.

1. News coverage – There was only speculative coverage of the highway project, and it was unclear whether it would actually proceed.

1. Consider that in the last chapter, we examined 3 potential outcomes, of which 2 were in Venu’s favor. Venu, therefore, stands to gain more from the arrangement while not having an inherent statistical advantage, given that highway news is hypothetical.

2. Time – There were six months to determine if the initiative would be successful or not.

1. This argument works in Ajay’s favor. There is a greater chance that the event will favor Ajay because there is more time before it expires. Take this as an example: If you were to run 10 kilometers, would you be more likely to finish it in 20 minutes or 70 minutes? Of course, the likelihood of success increases with the length of time.

Now let’s take a look at both of these issues separately and determine how they might affect the options premium.

Due to the completely hypothetical nature of the news at the time of the contract between Ajay and Venu, the latter was happy to accept the premium of Rs. 100,000. Let’s just pretend for a second that the news was  and not hypothetical. Perhaps a local legislator made a suggestion during the most recent news conference that a motorway might be  for that location. The news is no longer a rumor after learning this information. Suddenly, though there is still some speculation, there is a chance that the motorway might actually appear.

Consider this in context: Do you believe Venu will accept Rs. 100,000 as a premium? He is aware that there is a good likelihood the motorway would be built, in which case land prices would rise. But given that there is still a chance component, he might be willing to take the risk if the premium is more alluring. The deal might be more appealing to him if the premium was Rs. 175,000 instead of Rs. 100,000.

Let’s now consider this in the context of the stock market. Assume that Infosys is currently trading at Rs. 2200. The cost of the 2300 Call option with a one-month expiration is Rs. 20. Consider yourself in Venu’s (the option writer’s) position: Would you sign a contract accepting Rs. 20 per share as premium?

You provide the buyer the right to purchase an Infosys option at Rs. 2300 one month from now if you enter into this options agreement as a writer or seller.

Assume that no foreseen corporate activity will cause the share price of Infosys to increase throughout the course of the ensuing month. Given this, you might agree to accept the Rs. 20 premium.

What happens, though, if a corporate event (such as quarterly reports) tends to boost the stock price? Will the option seller continue to accept Rs. 20 as the agreement’s premium? It is obvious that taking the risk of Rs. 20 may not be worthwhile.

Having stated that, what if someone is willing to pay Rs. 75 as premium rather than Rs. 20 notwithstanding the planned corporate event? At Rs. 75, I suppose it could be worthwhile to take a chance.

Let’s keep this conversation in the back of our minds as we move on to the second item, which is time.

Ajay knew for sure that six months would be enough time for the dust to settle and the whole story about the motorway project to come to light. What if there were just 10 days in the future, as opposed to 6 months? There is simply not enough time for the event to take place now that time has passed. Do you believe Ajay will be content to give Venu an Rs. 100,000 premium in this situation (where time is not on Ajay’s side)? I don’t think so because Ajay wouldn’t be motivated to provide Venu with such a high premium.

Perhaps he would settle for a lower premium, like Rs. 20,000.

Anyway, the point I want to convey here is that premium is never a set rate, keeping both news and time in context. It is susceptible to a number of things. In actual markets, all of these factors function simultaneously and have an impact on the premium. Some factors tend to raise the premium while others tend to lower it. In detail, there are 5 factors that tend to influence the premium (akin to news and time). They are referred to as “Option Greeks.” We won’t grasp the Greeks until much later in this module since it’s too early for us to understand them now.

I want you to keep in mind and be grateful for the following things in relation to the option for the time being premium –

1. The Option Theory depends on the idea of premium.
2. A premium is never a fixed rate; instead, it depends on a variety of other factors.
3. Premiums in actual marketplaces fluctuate practically minute by minute.

I can promise you that you are on the right track if you have acquired and comprehended these concepts thus far.

Settlement of Options

This is a call option to purchase JP Associates at Rs. 25 as indicated in the green accent. The deadline is March 26, 2015. The market lot is made up of 8000 shares, and the premium is Rs.1.35/- (highlighted in red).

Assume that “Trader A” and “Trader B” are the only two traders. Both Trader A and Trader B are interested in purchasing this contract (the option buyer).

Given that the contract is for 8000 shares, the cash flow would be as follows:

Trader A must pay the whole amount of Rs.1.35 per share, which is the premium.

= 8000 * 1.35

= A premium payment of Rs. 10,800 to Trader B.

Now, if Trader A decides to exercise his agreement, Trader B is bound to sell Trader A 8000 shares of JP Associates on March 26, 2015, as a result of Trader B receiving this Premium from Trader A. This does not, however, imply that Trader B should be carrying 8000 shares on March 26. Indian options are cash settled, therefore if trader A decides to exercise his right on March 26, trader B is only required to pay the cash difference to Trader A.

Take into account that JP Associates is trading at Rs. 32/- on March 26 in order to better grasp this. As a result, Trader A, the option buyer, will exercise his option to purchase 8000 shares of JP Associates at a price of 25/-. In other words, he receives the opportunity to purchase JP Associates at a discount from its open market price of Rs. 32.

Typically, the cash flow should look like this:

• Trader A exercises his option to purchase 8000 shares from Trader B on the 26th.
• The transaction will take place at a predetermined price of Rs. 25. (strike price)
• Trader A gives Trader B (8000 * 25) rupees.
• Trader B releases 8000 shares to Trader A for Rs. 25 in exchange for this payment.

• Trader A quickly sells these shares on the open market for Rs. 32 each, earning Rs. 256,000.

• In this trade, Trader A earns a profit of Rs. 56,000 (256,000 – 200000).

The option buyer is generating a profit of Rs. 7 per share (32-25) per share, to put it another way. Instead of sending the option buyer 8000 shares since the option is cash-settled, the option seller instead gives him the cash equivalent of the profit he would have made. Therefore, Trader A would get

= 7*8000

= 56,000 rupees from Trader B.

Considering that the option buyer had initially invested Rs. 10,800 in acquiring this privilege, his actual profits would be:

= 56,000 – 10,800

= Rs.45,200/-

This actually yields a staggering return of 419 percent when expressed in terms of percentage return (without annualizing).

Options are a desirable trading instrument due to the substantial asymmetric return that may be achieved. This is only one of the many factors that traders find options to be so appealing.