FAQs: Futures & Options
WITH the exit of badla from the coming month, the stockmarket
will see the introduction of options and futures in a big way. For
investors who have difficulty in understanding the terminologies
associated with options and futures as well as its modes of working,
here's some lucid explanation.
What are options?
An option
is a contract, which gives the buyer (holder) the right, but not the
obligation, to buy or sell specified quantity of the underlying
assets, at a specific (strike) price on or before a specified time
(expiration date).
The underlying may be commodities like
wheat/ rice/ cotton/ gold/ oil or financial instruments like equity
stocks/ stock index/ bonds etc.
Important
Terminology
Underlying - The specific security / asset on which
an options contract is based.
Option Premium - This is the
price paid by the buyer to the seller to acquire the right to buy or
sell
Strike Price or Exercise Price - The strike or exercise
price of an option is the specified/ pre-determined price of the
underlying asset at which the same can be bought or sold if the
option buyer exercises his right to buy/ sell on or before the
expiration day.
Expiration date - The date on which the
option expires is known as Expiration Date. On Expiration date,
either the option is exercised or it expires
worthless.
Exercise Date - is the date on which the option is
actually exercised. In case of European Options the exercise date is
same as the expiration date while in case of American Options, the
options contract may be exercised any day between the purchase of
the contract and its expiration date (see European/ American
Option)
Open Interest - The total number of options contracts
outstanding in the market at any given point of time.
Option
Holder: is the one who buys an option which can be a call or a put
option. He enjoys the right to buy or sell the underlying asset at a
specified price on or before specified time. His upside potential is
unlimited while losses are limited to the Premium paid by him to the
option writer.
Option seller/ writer: is the one who is
obligated to buy (in case of Put option) or to sell (in case of call
option), the underlying asset in case the buyer of the option
decides to exercise his option. His profits are limited to the
premium received from the buyer while his downside is
unlimited.
Option Class: All listed options of a particular
type (i.e., call or put) on a particular underlying instrument,
e.g., all Sensex Call Options (or) all Sensex Put
Options
Option Series: An option series consists of all the
options of a given class with the same expiration date and strike
price. E.g. BSXCMAY3600 is an options series which includes all
Sensex Call options that are traded with Strike Price of 3600 &
Expiry in May.
(BSX Stands for BSE Sensex (underlying index),
C is for Call Option , May is expiry date and strike Price is
3600)
What is Assignment?
When the holder of an option
exercises his right to buy/ sell, a randomly selected option seller
is assigned the obligation to honor the underlying contract, and
this process is termed as Assignment.
What are European and
American Style of options?
An American style option is the one
which can be exercised by the buyer on or before the expiration
date, i.e. anytime between the day of purchase of the option and the
day of its expiry.
The European kind of option is the one
which can be exercised by the buyer on the expiration day only &
not anytime before that.
What are Call Options?
A call
option gives the holder (buyer/ one who is long call), the right to
buy specified quantity of the underlying asset at the strike price
on or before expiration date.
The seller (one who is short
call) however, has the obligation to sell the underlying asset if
the buyer of the call option decides to exercise his option to
buy.
Example: An investor buys One European call option on
Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If
the market price of Infosys on the day of expiry is more than Rs.
3500, the option will be exercised.
The investor will earn
profits once the share price crosses Rs. 3600 (Strike Price +
Premium i.e. 3500+100).
Suppose stock price is Rs. 3800, the
option will be exercised and the investor will buy 1 share of
Infosys from the seller of the option at Rs 3500 and sell it in the
market at Rs 3800 making a profit of Rs. 200 { (Spot price - Strike
price) - Premium}.
In another scenario, if at the time of
expiry stock price falls below Rs. 3500 say suppose it touches Rs.
3000, the buyer of the call option will choose not to exercise his
option. In this case the investor loses the premium (Rs 100), paid
which shall be the profit earned by the seller of the call
option.
What are Put Options?
A Put option gives the
holder (buyer/ one who is long Put), the right to sell specified
quantity of the underlying asset at the strike price on or before a
expiry date.
The seller of the put option (one who is short
Put) however, has the obligation to buy the underlying asset at the
strike price if the buyer decides to exercise his option to
sell.
Example: An investor buys one European Put option on
Reliance at the strike price of Rs. 300/-, at a premium of Rs. 25/-.
If the market price of Reliance, on the day of expiry is less than
Rs. 300, the option can be exercised as it is 'in the
money'.
The investor's Break even point is Rs. 275/ (Strike
Price - premium paid) i.e., investor will earn profits if the market
falls below 275.
Suppose stock price is Rs. 260, the buyer of
the Put option immediately buys Reliance share in the market @ Rs.
260/- & exercises his option selling the Reliance share at Rs
300 to the option writer thus making a net profit of Rs. 15 {(Strike
price - Spot Price) - Premium paid}.
In another scenario, if
at the time of expiry, market price of Reliance is Rs 320/ - , the
buyer of the Put option will choose not to exercise his option to
sell as he can sell in the market at a higher rate. In this case the
investor loses the premium paid (i.e Rs 25/-), which shall be the
profit earned by the seller of the Put option. (Please see
table)
How are options different from futures?
The
significant differences in Futures and Options are as
under:
Futures are agreements/contracts to buy or sell
specified quantity of the underlying assets at a price agreed upon
by the buyer and seller, on or before a specified time. Both the
buyer and seller are obligated to buy/sell the underlying
asset.
In case of options the buyer enjoys the right and not
the obligation, to buy or sell the underlying asset.
Futures
Contracts have symmetric risk profile for both buyers as well as
sellers, whereas options have asymmetric risk profile.
In
case of Options, for a buyer (or holder of the option), the downside
is limited to the premium (option price) he has paid while the
profits may be unlimited.
For a seller or writer of an
option, however, the downside is unlimited while profits are limited
to the premium he has received from the buyer.
The futures
contracts prices are affected mainly by the prices of the underlying
asset. Prices of options are however, affected by prices of the
underlying asset, time remaining for expiry of the contract and
volatility of the underlying asset.
It costs nothing to enter
into a futures contract whereas there is a cost of entering into an
options contract, termed as Premium.
Explain In the Money, At
the Money and Out of the money Options.
An option is said to
be 'at-the-money', when the option's strike price is equal to the
underlying asset price. This is true for both puts and
calls.
A call option is said to be in-the-money when the
strike price of the option is less than the underlying asset price.
For example, a Sensex call option with strike of 3900 is
'in-the-money', when the spot Sensex is at 4100 as the call option
has value.
The call holder has the right to buy a Sensex at
3900, no matter how much the spot market price has risen. And with
the current price at 4100, a profit can be made by selling Sensex at
this higher price.
On the other hand, a call option is
out-of-the-money when the strike price is greater than the
underlying asset price. Using the earlier example of Sensex call
option, if the Sensex falls to 3700, the call option no longer has
positive exercise value. The call holder will not exercise the
option to buy Sensex at 3900 when the current price is at 3700.
(Please see table)
A put option is in-the-money when the
strike price of the option is greater than the spot price of the
underlying asset. For example, a Sensex put at strike of 4400 is
in-the-money when the Sensex is at 4100. When this is the case, the
put option has value because the put holder can sell the Sensex at
4400, an amount greater than the current Sensex of
4100.
Likewise, a put option is out-of-the-money when the
strike price is less than the spot price of underlying asset. In the
above example, the buyer of Sensex put option won't exercise the
option when the spot is at 4800. The put no longer has positive
exercise value.
Options are said to be deep in-the-money (or
deep out-of-the-money) if the exercise price is at significant
variance with the underlying asset price.
What are Covered
and Naked Calls?
A call option position that is covered by an
opposite position in the underlying instrument (for example shares,
commodities etc), is called a covered call.
Writing covered
calls involves writing call options when the shares that might have
to be delivered (if option holder exercises his right to buy), are
already owned.
E.g. A writer writes a call on Reliance and at
the same time holds shares of Reliance so that if the call is
exercised by the buyer, he can deliver the stock.
Covered
calls are far less risky than naked calls (where there is no
opposite position in the underlying), since the worst that can
happen is that the investor is required to sell shares already owned
at below their market value.
When a physical delivery
uncovered/ naked call is assigned an exercise, the writer will have
to purchase the underlying asset to meet his call obligation and his
loss will be the excess of the purchase price over the exercise
price of the call reduced by the premium received for writing the
call.
What is the Intrinsic Value of an option?
The
intrinsic value of an option is defined as the amount by which an
option is in-the-money, or the immediate exercise value of the
option when the underlying position is marked-to-market.
For
a call option: Intrinsic Value = Spot Price - Strike
Price
For a put option: Intrinsic Value = Strike Price - Spot
Price
The intrinsic value of an option must be a positive
number or 0. It cannot be negative. For a call option, the strike
price must be less than the price of the underlying asset for the
call to have an intrinsic value greater than 0. For a put option,
the strike price must be greater than the underlying asset price for
it to have intrinsic value.
Explain Time Value with reference
to Options.
Time value is the amount option buyers are willing to
pay for the possibility that the option may become profitable prior
to expiration due to favorable change in the price of the
underlying. An option loses its time value as its expiration date
nears. At expiration an option is worth only its intrinsic value.
Time value cannot be negative.
What are the factors that
affect the value of an option (premium)?
There are two types of
factors that affect the value of the option
premium:
Quantifiable Factors:
underlying stock
price,
the strike price of the option,
the volatility
of the underlying stock,
the time to expiration
and;
the risk free interest rate.
Non-Quantifiable
Factors :
Market participants' varying estimates of the
underlying asset's future volatility
Individuals' varying
estimates of future performance of the underlying asset, based on
fundamental or technical analysis
The effect of supply &
demand- both in the options marketplace and in the market for the
underlying asset
The "depth" of the market for that option -
the number of transactions and the contract's trading volume on any
given day.
What are different pricing models for
options?
The theoretical option pricing models are used by option
traders for calculating the fair value of an option on the basis of
the earlier mentioned influencing factors.
An option pricing
model assists the trader in keeping the prices of calls & puts
in proper numerical relationship to each other & helping the
trader make bids & offer quickly. The two most popular option
pricing models are:
Black Scholes Model which assumes that
percentage change in the price of underlying follows a normal
distribution.
Binomial Model which assumes that percentage
change in price of the underlying follows a binomial
distribution.
Who decides on the premium paid on options
& how is it calculated?
Options Premium is not fixed by the
Exchange. The fair value/ theoretical price of an option can be
known with the help of pricing models and then depending on market
conditions the price is determined by competitive bids and offers in
the trading environment.
An option's premium / price is the
sum of Intrinsic value and time value (explained above). If the
price of the underlying stock is held constant, the intrinsic value
portion of an option premium will remain constant as
well.
Therefore, any change in the price of the option will
be entirely due to a change in the option's time value.
The
time value component of the option premium can change in response to
a change in the volatility of the underlying, the time to expiry,
interest rate fluctuations, dividend payments and to the immediate
effect of supply and demand for both the underlying and its
option.
Explain the Option Greeks?
The price of an Option
depends on certain factors like price and volatility of the
underlying, time to expiry etc. The option Greeks are the tools that
measure the sensitivity of the option price to the above mentioned
factors.
They are often used by professional traders for
trading and managing the risk of large positions in options and
stocks. These Option Greeks are:
Delta: is the option Greek
that measures the estimated change in option premium/price for a
change in the price of the underlying.
Gamma: measures the
estimated change in the Delta of an option for a change in the price
of the underlying
Vega : measures estimated change in the
option price for a change in the volatility of the
underlying.
Theta: measures the estimated change in the
option price for a change in the time to option expiry.
Rho:
measures the estimated change in the option price for a change in
the risk free interest rates.
What is an Option
Calculator?
An option calculator is a tool to calculate the price
of an Option on the basis of various influencing factors like the
price of the underlying and its volatility, time to expiry, risk
free interest rate etc.
It also helps the user to understand
how a change in any one of the factors or more, will affect the
option price.
Who are the likely players in the Options
Market?
Developmental institutions, Mutual Funds, FIs, FIIs,
Brokers, Retail Participants are the likely players in the Options
Market.
Why do I invest in Options? What do options offer
me?
Besides offering flexibility to the buyer in form of right to
buy or sell, the major advantage of options is their versatility.
They can be as conservative or as speculative as one's investment
strategy dictates.
Some of the benefits of Options are as
under:
High leverage as by investing small amount of capital (in
form of premium), one can take exposure in the underlying asset of
much greater value.
Pre-known maximum risk for an option
buyer
Large profit potential and limited risk for option
buyer
One can protect his equity portfolio from a decline in
the market by way of buying a protective put wherein one buys puts
against an existing stock position.
This option position can
supply the insurance needed to overcome the uncertainty of the
marketplace. Hence, by paying a relatively small premium (compared
to the market value of the stock), an investor knows that no matter
how far the stock drops, it can be sold at the strike price of the
Put anytime until the Put expires.
E.g. An investor holding 1
share of Infosys at a market price of Rs 3800/-thinks that the stock
is over-valued and decides to buy a Put option' at a strike price of
Rs. 3800/- by paying a premium of Rs 200/-
If the market
price of Infosys comes down to Rs 3000/-, he can still sell it at Rs
3800/- by exercising his put option. Thus, by paying premium of Rs
200,his position is insured in the underlying stock.
How can
I use options?
If you anticipate a certain directional movement
in the price of a stock, the right to buy or sell that stock at a
predetermined price, for a specific duration of time can offer an
attractive investment opportunity.
The decision as to what
type of option to buy is dependent on whether your outlook for the
respective security is positive (bullish) or negative
(bearish).
If your outlook is positive, buying a call option
creates the opportunity to share in the upside potential of a stock
without having to risk more than a fraction of its market value
(premium paid).
Conversely, if you anticipate downward
movement, buying a put option will enable you to protect against
downside risk without limiting profit potential.
Purchasing
options offer you the ability to position yourself accordingly with
your market expectations in a manner such that you can both profit
and protect with limited risk.
Once I have bought an option
and paid the premium for it, how does it get settled?
Option is a
contract which has a market value like any other tradable commodity.
Once an option is bought there are following alternatives that an
option holder has:
You can sell an option of the same series
as the one you had bought and close out /square off your position in
that option at any time on or before the expiration.
You can
exercise the option on the expiration day in case of European Option
or; on or before the expiration day in case of an American option.
In case the option is 'Out of Money' at the time of expiry, it will
expire worthless.
What are the risks involved for an options
buyer?
The risk/ loss of an option buyer is limited to the
premium that he has paid.
What are the risks for an Option
writer?
The risk of an Options Writer is unlimited where his
gains are limited to the Premiums earned. When a physical delivery
uncovered call is exercised upon, the writer will have to purchase
the underlying asset and his loss will be the excess of the purchase
price over the exercise price of the call reduced by the premium
received for writing the call.
The writer of a put option
bears a risk of loss if the value of the underlying asset declines
below the exercise price. The writer of a put bears the risk of a
decline in the price of the underlying asset potentially to
zero.
How can an option writer take care of his
risk?
Option writing is a specialized job which is suitable only
for the knowledgeable investor who understands the risks, has the
financial capacity and has sufficient liquid assets to meet
applicable margin requirements. The risk of being an option writer
may be reduced by the purchase of other options on the same
underlying asset thereby assuming a spread position or by acquiring
other types of hedging positions in the options/ futures and other
correlated markets.
Who can write options in Indian
derivatives market?
In the Indian Derivatives market, Sebi has
not created any particular category of options writers. Any market
participant can write options. However, margin requirements are
stringent for options writers.
What are Stock Index
Options?
The Stock Index Options are options where the underlying
asset is a Stock Index for e.g. Options on S&P 500 Index/
Options on BSE Sensex etc.
Index Options were first
introduced by Chicago Board of Options Exchange in 1983 on its Index
'S&P 100'. As opposed to options on Individual stocks, index
options give an investor the right to buy or sell the value of an
index which represents group of stocks.
What are the uses of
Index Options?
Index options enable investors to gain exposure to
a broad market, with one trading decision and frequently with one
transaction. To obtain the same level of diversification using
individual stocks or individual equity options, numerous decisions
and trades would be necessary.
Since, broad exposure can be
gained with one trade, transaction cost is also reduced by using
Index Options. As a percentage of the underlying value, premiums of
index options are usually lower than those of equity options as
equity options are more volatile than the Index.
Who would
use index options?
Index Options are effective enough to appeal
to a broad spectrum of users, from conservative investors to more
aggressive stock market traders.
Individual investors might
wish to capitalize on market opinions (bullish, bearish or neutral)
by acting on their views of the broad market or one of its many
sectors.
The more sophisticated market professionals might
find the variety of index option contracts excellent tools for
enhancing market timing decisions and adjusting asset mixes for
asset allocation.
To a market professional, managing risks
associated with large equity positions may mean using index options
to either reduce risk or increase market exposure.
What are
Options on individual stocks?
Options contracts where the
underlying asset is an equity stock, are termed as Options on
stocks. They are mostly American style options cash settled or
settled by physical delivery.
Prices are normally quoted in
terms of the premium per share, although each contract is invariably
for a larger number of shares, e.g. 100.
How will
introduction of options in specific stocks benefit an
investor?
Options can offer an investor the flexibility one needs
for countless investment situations. An investor can create hedging
position or an entirely speculative one, through various strategies
that reflect his tolerance for risk.
Investors of equity
stock options will enjoy more leverage than their counterparts who
invest in the underlying stock market itself in form of greater
exposure by paying a small amount as premium.
Investors can
also use options in specific stocks to hedge their holding positions
in the underlying (i.e. long in the stock itself), by buying a
Protective Put. Thus they will insure their portfolio of equity
stocks by paying premium.
ESOPs (Employees' stock options)
have become a popular compensation tool with more and more companies
offering the same to their employees. ESOPs are subject to lock in
periods, which could reduce capital gains in falling markets -
Derivatives can help arrest that loss along with tax
savings.
An ESOPs holder can buy Put Option in the underlying
stock & exercise the same if the market falls below the strike
price & lock in his sale prices
Whether exchange traded
equity options are issued by companies underlying them.
The
equity options traded on exchange are not issued by the companies
underlying them. Companies do not have any say in selection of
underlying equity for options.
Whether the holders of equity
options contracts have all the rights that the owners of equity
shares have.
Holder of the equity options contracts do not have
any of the rights that owners of equity shares have - such as voting
rights and the right to receive bonus, dividend etc. To obtain these
rights a Call option holder must exercise his contract and take
delivery of the underlying equity shares.
What are Leaps
(long term equity anticipation securities)?
Long term equity
anticipation securities (Leaps) are long-dated put and call options
on common stocks or ADRs.
These long-term options provide the
holder the right to purchase, in case of a call, or sell, in case of
a put, a specified number of stock shares at a pre-determined price
up to the expiration date of the option, which can be three years in
the future.
What are exotic Options?
Derivatives with more
complicated payoffs than the standard European or American calls and
puts are referred to as Exotic Options. Some of the examples of
exotic options are as under:
Barrier Options: where the
payoff depends on whether the underlying asset's price reaches a
certain level during a certain period of time.
CAPS traded on
CBOE (traded on the S&P 100 & S&P 500) are examples of
Barrier Options where the pay-out is capped so that it cannot exceed
$30.
A Call CAP is automatically exercised on a day when the
index closes more than $30 above the strike price. A put CAP is
automatically exercised on a day when the index closes more than $30
below the cap level.
Binary Options: are options with
discontinuous payoffs. A simple example would be an option which
pays off if price of an Infosys share ends up above the strike price
of say Rs. 4000 & pays off nothing if it ends up below the
strike.
What are Over-The-Counter
Options?
Over-The-Counter options are those dealt directly
between counter-parties and are completely flexible and customized.
There is some standardization for ease of trading in the busiest
markets, but the precise details of each transaction are freely
negotiable between buyer and seller.
Where can I trade in
Options and Futures contracts.
Like stocks, options and futures
contracts are also traded on any exchange. In Bombay Stock Exchange,
stocks are traded on BSE On Line Trading (BOLT) system and options
and futures are traded on Derivatives Trading and Settlement System
(DTSS).
What is the underlying in case of Options being
introduced by BSE?
The underlying for the index options is the
BSE 30 Sensex, which is the benchmark index of Indian Capital
markets, comprising 30 scrips.
What are the contract
specifications of Sensex Options?
BSE's first index options is
based on BSE 30 Sensex. The Sensex options would be European style
of options i.e. the options would be exercised only on the day of
expiry.
They will be premium style i.e. the buyer of the
option will pay premium to the options writer in cash at the time of
entering into the contract.
The Premium and Options
Settlement Value (difference between Strike and Spot price at the
time of expiry), will be quoted in Sensex points The contract
multiplier for Sensex options is INR 50 which means that monetary
value of the Premium and Settlement value will be calculated by
multiplying the Sensex Points by 50.
For e.g. if Premium
quoted for a Sensex options is 50 Sensex points, its monetary value
would be Rs. 2500 (50*50).
There will be at-least 5 strikes
(2 In the Money, 1 Near the money, 2 Out of the money), available at
any point of time. The expiration day for Sensex option is the last
Thursday of Contract month.
If it is a holiday, the
immediately preceding business day will be the expiration
day.
There will be three contract month series (Near, middle
and far) available for trading at any point of time. The settlement
value will be the closing value of the Sensex on the expiry
day.
The tick size for Sensex option is 0.1 Sensex points
(INR 5). This means the minimum price fluctuation in the value of
the option premium can be 0.1.In Rupee terms this translates to
minimum price fluctuation of Rs 5. ( Tick Size * Multiplier =0.1*
50).
What is SPAN?
Specific Portfolio Analysis of Risk
(SPAN) is a worldwide acknowledged risk management system developed
by Chicago Mercantile Exchange (CME). It is a portfolio-based margin
calculating system adopted by all major Derivatives
Exchanges.
Objective of SPAN
SPAN identifies overall risk
in a complete portfolio of futures and options at the same time
recognizing the unique exposures associated with both inter-month
and inter-commodity risk relationships.
It determines the
largest loss that a portfolio might suffer with in the period
specified by the exchange i.e may be day (or) two. BSE has licensed
SPAN from CME for calculating margin requirements at the Exchange
level. At the same time members can also calculate margin
requirements of their clients by using PC SPAN.
What is
PC-SPAN?
PC-SPAN is an easy to use program for PC's which
calculates SPAN margin requirements at the members' end. How PC SPAN
works:
Each business day the exchange generates risk parameter
file (parameters set by the exchange ) which can be down loaded by
the member.
The position file consisting of members' trades
(own + clients) and the risk parameter file has to be fed into
PC-SPAN for calculation of Margins payable for the trades
executed.
What will be the new margining system in the case
of Options and futures?
A portfolio based margining model (SPAN),
would be adopted which will take an integrated view of the risk
involved in the portfolio of each individual client comprising of
his positions in all the derivatives contract traded on the
Derivatives Segment.
The Initial Margin would be based on
worst-case loss of the portfolio of a client to cover 99 per cent
VaR over two days horizon. The Initial Margin would be netted at
client level and shall be on gross basis at the Trading/Clearing
member level.The Portfolio will be marked to market on a daily
basis.
How will the assignment of options takes place?
On
Exercise of an Option by an Option Holder, the trading software will
assign the exercised option to the option writer on random basis
based on a specified algorithm.
What does an investor need to
do to trade in options?
An investor has to register himself with
a broker who is a member of the BSE Derivatives Segment.
If
he wants to buy an option, he can place the order for buying a
Sensex Call or Put option with the broker. The Premium has to be
paid up-front in cash.
He can either hold on to the contract
till its expiry or square up his position by entering into a reverse
trade.If he closes out his position, he will receive Premium in
cash, the next day.
If the investor holds the position till
expiry day and decides to exercise the contract, he will receive the
difference between Option Settlement price and the Strike price in
cash.If he does not exercise his option, it will expire
worthless.
If an investor wants to write/ sell an option, he
will place an order for selling Sensex Call/ Put option. Initial
margin based on his position will have to be paid up-front (adjusted
from the collateral deposited with his broker) and he will receive
the premium in cash, the next day.
Everyday his position will
be marked to market and variance margin will have to be paid. He can
close out his position by a buying the option by paying requisite
premium. The initial margin which he had paid on the first position
will be refunded.
If he waits till expiry, and the option is
exercised, he will have to pay the difference in the Strike price
and the options settlement price, in cash. If the option is not
exercised, the investor will not have to pay anything.
What
steps will be taken by the exchange to create awareness about
options amongst masses?
The exchange is conducting free of cost
futures and options awareness programs for member brokers and their
clients. This will be conducted across the country to reach
investors at large. |
