A TO Z ON OPTIONS

OPTIONS TRADING

Welcome to the world of option trading. A major advantage of options is their versatility. They can be as conservative or as speculative as your investing strategy dictates. Options enable you to tailor your position to your own set of circumstances. Consider the following benefits of options:
    * You can protect stock holdings from a decline in market price
    * You can increase income against current stock holding 
    * You can prepare to buy a stock at a lower price
    * You can position yourself for a big market move even when you don't know which way prices will move
    * You can benefit from a stock price rise without incurring the cost of buying the stock outright

Basic Concepts

What is an option?
An option is a contract which gives the buyer the right, but not the obligation, to buy or sell shares of the underlying security or index at a specific price for a specified time. Stock option contracts generally are for 100 shares of the underlying stock. There are two types of options: calls and puts.

Call option
A call option gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy.  The buyer of an equity call option has purchased the right to buy 100 shares of the underlying stock at the stated exercise price. Thus, the buyer of one QQQ April 30 call option has the right to purchase 100 shares of QQQ at Rs30 up until April expiration. The buyer may do so by filing an exercise notice through his broker prior to the expiration date of the option. All calls covering QQQ are referred to as an "option class." Each individual option with a distinctive trading month and strike price is an "option series."

Put option

A put option gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell. The buyer of a put option has purchased the right to sell 100 shares of the underlying stock at the contracted exercise price. Thus, the buyer of one QQQ April 25 put has the right to sell 100 shares of QQQ at Rs. 25 any time prior to the expiration date. In order to exercise the option and sell the underlying at the agreed upon exercise price, the buyer must file a proper exercise notice with the OCC through a broker before the date of expiration. All puts covering QQQ stock are referred to as an "option class." Each individual option with a distinctive trading month and strike price is an "option series."

Strike price
The strike, or exercise, price of an option is the specified share price at which the shares of stock can be bought or sold by the buyer if he exercises the right to buy (in the case of a call) or sell (in the case of a put). A strike price is the actual numeric value of the option. For example, a April option may have strike prices of 25, 30 and 35. Strike prices are determined when the underlying reaches a certain numeric value and trades consistently at or above that value. If, for example, XYZ stock was trading at 29, hit a price of 30 and traded consistently at this level, the next highest strike may be added.

Option premium

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.
The option price is constitued of 2 price components, the intrinsic value and the time value. 

(Option price = intrinsic value + time value)

Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

Condition	Call	Put
Strike price < underlying security price	In-the-money    Intrinsic value >0	Out-of-the-money Intrinsic value = 0
Strike price > underlying security price	Out-of-the-money  Intrinsic value = 0	In-the-money Intrinsic value >0
Strike price = underlying security price	At-the-money   Intrinsic value = 0	At-the-money  Intrinsic value = 0

Time value: It is determined by the remaining lifespan of the option, the volatility and the cost of refinancing the underlying asset (interest rates).
Time value = option price - intrinsic value

Examples

Option	Strike	Option Premium	Stock	Intrinsic Value	Time Value
Call	3	Rs.3	Rs.29	Rs.1	Rs.2
Put	50	Rs.4	Rs.52	Rs.2	Rs.2
Call	25	Rs.2	Rs.25	Rs.0	Rs.2
Put	100	Rs.6	Rs.101	Rs.1	Rs.5
Call	15	Rs.1	Rs.16	Rs.0	Rs.1
Put	40	Rs.18	Rs.55	Rs.15	Rs.3

Notice in the above examples that the intrinsic value plus the time value equals the total premium of the option.

Factors determining the option price

There are 6 factors which impact on the price of an option. These factors are:

• Option exercise price
• Current underlying price
• Remaining life of the option
• Volatility
• Interest rates
• Dividend

Factor rises / is higher	Price of call	Price of put
Option exercise price	lower	higher
Current underlying price	higher	lower
Remaining life	higher	higher
Volatility	higher	higher
Interest rates	higher	lower
Dividend	lower	higher

What is an at-the-money option? An in-the-money option? An out-of-the money option?

When the price of the underlying security is equal to the strike price, an option is at-the-money.

A call option is in-the-money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.

A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the money if the strike price is less than the market price of the underlying security.

Examples

Option	Strike	Stock	At-the-money In-the-money Out-of-the-money
Call	35	Rs.29	out-of-the-money
Put	45	Rs. 52	out-of-the-money
Call	25	Rs.25	at-the-money
Put	100	Rs.101	at-the-money
Call	10	Rs.16	in-the-money
Put	40	Rs.25	in-the-money