17.10 Key concepts
What is the pay off for writer of an option?
The writer of the Call Option is generally bearish, while the writer of the Put Option is generally bullish. So here he is exposed to unlimited risk. While his returns are limited. Now the question arises. If Option writing is so risky, why should anybody write Options? There could be several aspects to this strategy. First, you might be sure of your view and hence do not mind generating an income from it. Secondly, unlimited losses might not actually happen in practice. For instance, if you have sold the Satyam 40 Call to Mahesh (you are bearish) and Satyam actually starts moving up. You would tend to be nervous. So, what would you do?
You would buy back the Satyam call. It could have become more expensive (say Rs 45). So, what you sold for Rs.40, you would buy back at Rs.45, making a loss of Rs.5.This is not unlimited in practice. Thirdly, most Option writers are more sophisticated players and would cover their unlimited risks by some other position. For instance, they might sell one call and buy another call (bull or bear spread). They might sell a call and buy a future. They might sell a call and buy the underlying shares. There could be more complex strategies.
Option Writing however requires:
- a higher degree of understanding,
- risk management ability and
- a very active presence in the market regularly.
There are two main types of options:
American options can be exercised at any time between the date of purchase and the expiration date. Most exchange- traded options are of this type.
European options are different from American options in that they can only be exercised at the contract expiration date.
Please note that the name of the option does not imply where the option trades – they are just names. (Europe option is not the one traded in Europe). At expiration, an American option and a European option on the same asset with the same strike price are identical. They may either be exercised or allowed to expire. Before expiration, however, they are different and may have different values, so you must distinguish between the two.
What is exercise in Option
The owner of an option contract may exercise it, indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties, and the contract itself is terminated. When exercising a call, the owner of the option purchases the underlying shares at the strike price from the option seller, while for a put, the owner of the option sells the underlying to the option seller.
Concept of Moneyness.
Moneyness tells option holders whether exercising will lead to a profit. There are many forms of moneyness, including in, out or at the money. Moneyness looks at the value of an option if you were to exercise it right away.
An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately.
A call option on the index is said to be in-the money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).
An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
The strike price is defined as the price at which the holder of an options can buy (in the case of a call option) or sell (in the case of a put option) the underlying security when the option is exercised. Hence, strike price is also known as exercise price. Investor has the option to buy either call option or put option at different price levels (strike prices). For example if ABC share is traded at Rs. 50 available strike prices can be 40, 45,50, 55,60 65 etc.
Strike prices for in case of a Call option
- In the money : when the strike prices less than stock prices – Rs 40 and Rs 45.
- At the Money : when the strike price equivalent to the stock price – Rs 50.
- Out-of-the-Money: when the strike price greater than stock price – Rs 55 and Rs 60.
Strike prices in case of a Put option
- Out-of-the-Money : when the strike prices less than stock prices – Rs 40 and Rs 45.
- At the Money : when the strike price equivalent to the stock price Rs 50.
- In the money: when the strike price greater than stock price – Rs 55 and Rs 60.
The price paid to acquire the option. Also known simply as option price. Not to be confused with the strike price. Market price, volatility and time remaining are the primary forces determining the premium. The option premium is simply the price of the option. Please do not confuse this with the exercise price of the option, which is the price at which the underlying asset will be bought/sold if the option is exercised. There are two components to the options premium and they are intrinsic value and time value.
Intrinsic Value and Time Value
Intrinsic value of an option: Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of the- money (OTM), its intrinsic value is zero.
Time value of an option: In addition to the intrinsic value, the seller charges a ‘time value’ from the buyers of the option. This is because the more time there is for the contract to expire, the greater the chance that the exercise of the contract will become more profitable for the buyer.
This is a risk for the seller and he seeks compensation for it by demanding a ‘time value’. The time value of an option can be obtained by taking the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out-of-the-money (OTM) or At-the-money (ATM) has only time value and no intrinsic value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else being equal. At expiration, an option has no time value.