Introduction to Options

In this chapter, we will introduce the basic elements of an Option. We will cover things such as what is
meant by an option, what are the two types of options, what is meant by strike price, option price,
expiration date, etc. The objective of this chapter is to familiarize the reader with the basics of options.

In this module, we will talk in detail about one of the most versatile derivative
instrument, Options. Over the course of the next several chapters, we will cover options in
detail, starting right from the basics such as defining what an option is and the types of
options before gradually proceeding to more complex areas such as Option Greeks and
Option strategies. So, without any further delay, let us get started with the exciting world
of options.

Option Definition-An option is a derivative contract that gives the holder of the instrument (i.e. the
buyer) the right, but not an obligation, to buy or sell an underlying asset at a certain fixed price on or before
a pre-determined date.

Let us now break this definition down into pieces:

- A right to the buyer, but not an obligation

- Buying or selling an asset at a fixed price

- Buying or selling an asset on or before a pre-determined date

Two types of Options-Before proceeding further, let us first talk about the two types of
options: Call and Put

A Call option is an option that gives the buyer a right, but not an obligation, to buy an
underlying asset at a certain fixed price on or before a pre-determined date.

A Put option is an option that gives the buyer a right, but not an obligation, to sell an
underlying asset at a certain fixed price on or before a pre-determined date.
What about the option seller? Well, in case of a call option, the seller has an obligation to
deliver the underlying asset to the call buyer, in case the call buyer exercises his right to
buy the asset. Similarly, in case of a put option, the seller has an obligation to buy the
underlying asset from the put buyer, in case the put buyer exercises his right to sell the
asset.

Strike price (exercise price)-The pre-agreed price at which the asset will be exchanged
on or before the pre-determined date is called the strike price or the exercise price.

Risk and reward potential-The buyer of an option has limited risk, while the seller of an
option has unlimited risk. On the other hand, the buyer of an option has a potential for
unlimited reward, while the seller of an option has a potential for limited reward.

Option price (Option premium)

As we have seen, the buyer has a right to exercise the option, and not an obligation. On the
other hand, the seller has an obligation to honour the option, in case the buyer exercises
his or her right to the option. Because the buyer has a privilege over the seller, the buyer
must compensate for it by paying the seller a premium. This premium is nothing but the
option price, which is also known as the option premium. Put it in other words, option
price is the price that the buyer must pay to the seller to acquire the right to the option
contract.

Expiration date

Earlier, when defining what an option is, we talked about the pre-determined date. This is
nothing but the expiration date of an option. The buyer of an option can exercise his right
to the option or close out the option position up to or on the expiration date. In case the
buyer does not exercise his right to the option or close out the position up to or on the
expiration date, the option expires worthless. In such a case when the option expires
worthless, the seller gets to keep the entire premium.

View of an Option buyer/writer

The buyer of a call option view is bullish

The buyer of a put option view is bearish

The seller of a call option view is not bullish or bearish

The seller of a put option view is not bearish or bullish

A simple example-Let us assume that a stock is currently trading at ₹100. Let us assume
that Mr. A believes the stock will rise to ₹110 in a month’s time, while Mr. B feels that the
stock will be at or below ₹100 over the same period. Given their respective views, let us
assume that the two decide to trade a call option on this stock having a strike price of,
say,₹100. In other words, this is the price at which Mr. A (the call option buyer) will have
the right to buy the stock from Mr. B (the call option seller) in a month’s time. To do so
however, Mr. A will have to pay a premium to Mr. B, which is nothing but the option price.
Let us say that the price of this option is ₹5. One month down the line, one of the three
things could occur: the price of the stock could go up, down, or remain essentially the
same.

If the price of the stock has gone up to, say, ₹110, the buyer will exercise his right to buy at
the pre-determined price (the strike price) of ₹100. In other words, the buyer will be able
to buy at a price that is below the prevailing market price of ₹110. Also, as the buyer has
exercised his right to buy at ₹100, the seller will be obliged to sell the stock at ₹100. As
such, the buyer would make a gain of ₹10 (₹110 market price - ₹100 strike price).
Reducing the premium of ₹5 that the buyer has already paid, the buyer’s total gain would
be ₹5. On the other hand, the seller would suffer a loss of ₹10 (₹100 strike price - ₹110
market price). Reducing the premium of ₹5 that the seller has received, the seller’s total
loss would be ₹5.

Meanwhile, if the price of the stock has gone down to, say, ₹95, the buyer will not exercise
his right to buy at the pre-determined price of ₹100 as he can directly buy it from the
market at a lower price of ₹95. Hence, the buyer will let the option expire worthless. As
such, the buyer would lose the entire premium of ₹5, which will be his loss. On the other
hand, as the buyer has not exercised his right to the option, the seller will get to keep the
entire premium of ₹5 with him, which is his profit.

Let us now put everything that we have learned so far in a tabular format:

Call Option Put Option

A call option gives the holder a A put option gives the holder a
right to buy an asset at a certain right to sell an asset at a certain
Definition
price on or before a pre- price on or before a pre-
determined future date determined future date

A call buyer has a right, but not an A put buyer has a right, but not an
Buyer obligation, to buy the asset at a obligation, to sell the asset at a
certain price on or before a pre- certain price on or before a pre-
determined future date determined future date

A call seller has an obligation to A put seller has an obligation to

give delivery of the asset to the take delivery of the asset from the
call buyer at a certain price on or put buyer at a certain price on or
Seller
before a pre-determined future before a pre-determined future
date, in case the call buyer date, in case the put buyer
exercises his right to the option exercises his right to the option

Buyer’s other
Holder or owner
names

Seller’s other
Writer
names

Risk to buyer Limited to the extent of premium paid

Risk to seller Potentially unlimited

Reward to buyer Potentially unlimited

Reward to seller Limited to the extent of premium received

Buyer’s view Bullish Bearish

Seller’s view Bearish Bullish

Call
Option Type
Option Price ₹3.00

Strike Price ₹100.00

Underlying price at initiation ₹95.00

Underlying price in 1-month ₹108.00

Will the Buyer exercise? Yes

By exercising the option, the buyer can buy the underlying at

₹100, when it is available in the market for ₹108, enabling him
Why?
to gain ₹8 (as he is able to buy at a price that is below the
market price)

Profit/loss? Profit of ₹5 after reducing the cost (option price of ₹3)

Option Type Call

Option Price ₹3.00

Strike Price ₹100.00

Underlying price at initiation ₹95.00

Underlying price in 1-month ₹93.00

Will the Buyer exercise? No

As the underlying price in a month’s time is lower than the

strike price of ₹100, the buyer will not exercise his right to
Why?
buy, as he can directly buy the underlying from the market at
₹93

Profit/loss? Loss of ₹3 as the buyer has not exercised his right to buy

Option Type Put

Option Price ₹4.00

Strike Price ₹100.00

Underlying price at initiation ₹103.00

Underlying price in 1-month ₹90.00

Will the Buyer exercise? Yes

By exercising the option, the buyer can sell the underlying at

₹100, when it is available in the market for ₹90, enabling him
Why?
to gain ₹10 (as he is able to sell at a price that is above the
market price)

Profit/loss? Profit of ₹6 after reducing the cost (option price of ₹4)

Option Type Put

Option Price ₹4.00

Strike Price ₹100.00

Underlying price at initiation ₹103.00

Underlying price in 1-month ₹107.00

Will the Buyer exercise? No

As the underlying price in a month’s time is higher than the

strike price of ₹100, the buyer will not exercise his right to
Why?
sell, as he can directly sell the underlying in the market at
₹107

Profit/loss? Loss of ₹4 as the buyer has not exercised his right to sell

KEY TAKEWAYS

Now that we have a strong understanding of the basics of options, it is time to conclude
this topic by discussing about the terminologies that we have learned so far. The concepts
that we have learned in this chapter would form the basic blocks of things that we are
going to discuss in the forthcoming chapters, including Option Greeks and Option
Strategies. Hence, it is crucial to have a strong understanding of these terminologies. We
advise a reader to spend quality time on understanding the terminologies that we have
discussed in this chapter, before moving ahead to the next chapter.

• Call option: A call option gives the buyer the right to buy the underlying asset in the
future for a specific price, called the strike price.
• Put option: A put option gives the buyer the right to sell the underlying asset in the
future for a specific price, called the strike price.
• Long position: A long position implies buying an option, which could be a call or a
put or both.
• Short position: A short position implies selling an option, which could be a call or a
put or both.
• Strike price: Strike price refers to a pre-agreed price at which the underlying asset
will be bought (in case of call option) or sold (in case of put option) on or before the
expiration day. It is a price that is specified at the time of entering into an option
contract. It is also known as the exercise price.
• Underlying price: This refers to the current price of the underlying instrument. At
any point in time, the current or the underlying price of a security could be above
the strike price of that underlying, or below the strike price, or exactly at the strike
price.

Option Price and Option Value

In this chapter, we shall study some crucial concepts that pertain to options. These include the two
elements of option price (intrinsic value and time value) and moneyness of an Option. We will also cover
how to calculate the breakeven point of an option, how to calculate the profit/loss potential of an option
and discuss about the option payoff charts. We will conclude this chapter by talking about the key
terminologies that were covered over the course of this chapter.

Intrinsic value, Time value, and Moneyness of an Option

Now that we have understood the basics of options, it is time to move on to the other
aspects of an option contract.

Elements of an Option price

As we saw earlier, an option price, which is also known as the option premium, is the price
that an option buyer must pay to the option seller to acquire the right to the option. There
are two elements to an option price: intrinsic value and time value. In other words,

Option price = intrinsic value + time value

Let us now understand what each of these elements mean.

Intrinsic value of an Option

Intrinsic value of an option measures the extent to which an option is In-the-Money

(ITM).It can be calculated by finding the difference between the strike price of an
option and the corresponding current price of the underlying. At any point in time,
the intrinsic value of an option could be either positive or zero. It cannot be negative.
A positive intrinsic value occurs when the holder of the option contract stands to
benefit by exercising his right to the option, while a zero intrinsic value occurs when
the holder of the option contract wouldn’t benefit by exercising his right to the
option.
Intrinsic value of a call: A call option will have a positive intrinsic value when its
strike price is below the current market price. On the other hand, a call option will
have no intrinsic value when its strike price is equal to or above the current market
price

Intrinsic value of a call = current price - strike price

If the above value is positive, it means the call option has an intrinsic value. If it is
zero or negative, it means the call option has no intrinsic value.

Intrinsic value of a put: A put option will have a positive intrinsic value when its
strike price is above the current market price. On the other hand, a put option will
have no intrinsic value when its strike price is equal to or below the current market
price.

Intrinsic value of a put = strike price - current price

If the above value is positive, it means the put option has an intrinsic value. If it is
zero or negative, it means the put option has no intrinsic value.

Keep in mind that intrinsic value cannot be negative. As such, if the intrinsic value of a
call or a put turns out to be negative, then it is construed as zero.

Time value of an Option

Time value = option price - intrinsic value

Moneyness of an Option

Now that we have understood what intrinsic value and time value of an option is, it is
time to talk about another crucial section that is called moneyness of an option. At
any point in time, an option could be in any one of the three forms:

In-the-Money (ITM)

At-the-Money (ATM)

Out-of-the-Money (OTM)

Let us split each of the above into two groups: one for a call option and the other for a
put option.
• In-the-Money (ITM) Call option: A call option is said to be ITM when the strike price of that
option is below the corresponding current market price of the underlying. In other words, if
(Market price - Strike price) > 0, a call option is said to be ITM. Notice that an ITM call option will
have a positive intrinsic value.

• At-the-Money (ATM) Call option: A call option is said to be ATM when the strike price of that
option is equal to the corresponding current market price of the underlying. In other words, if
(Market price - Strike price) = 0, a call option is said to be [Link] that an ATM call option will
have no intrinsic value.

• Out-of-the-Money (OTM) Call option: A call option is said to be OTM when the strike price of
that option is above the corresponding current market price of the underlying. In other words, if
(Market price - Strike price) < 0, a call option is said to be OTM. Notice that an OTM call option
will have no intrinsic value.

• In-the-Money (ITM) Put option: A put option is said to be ITM when the strike price of that
option is above the corresponding current market price of the underlying. In other words, if
(Strike price - Market price) > 0, a put option is said to be ITM. Notice that an ITM put option will
have a positive intrinsic value.

• At-the-Money (ATM) Put option: A Put option is said to be ATM when the strike price of that
option is equal to the corresponding current market price of the underlying. In other words, if
(Strike price - Market price) = 0, a put option is said to be [Link] that an ATM put option will
have no intrinsic value.

• Out-of-the-Money (OTM) Put option: A put option is said to be OTM when the strike price of
that option is below the corresponding current market price of the underlying. In other words, if
(Strike price - Market price) < 0, a put option is said to be OTM. Notice that an OTM put option
will have no intrinsic value.

Breakeven point, Profit/Loss on an Option contract

Now, we shall focus on two important concepts: One is how to calculate the breakeven
point of call and put options, and the other is how to calculate the profit/loss on an option
position.

First, let us understand what breakeven point is. Breakeven point, as the name suggests, is
the point of no profit, no loss. It is the point where an option trader is neutral on the profit
front, i.e. he is neither making money nor losing money. Now, let us see how to calculate
breakeven point for calls and puts. First, let us see the equation of calculating breakeven
point, and then we shall explain each of them.

Breakeven point of a long call: Strike price + option premium paid

Breakeven point of a short call: Strike price + option premium received

Breakeven point of a long put: Strike price – option premium paid

Breakeven point of a short put: Strike price – option premium received

Payoff Charts

The chart above is the payoff chart of a long call option.

The chart above is the payoff chart of a short call option..

The chart above is the payoff chart of a long put option.

The chart above is the payoff chart of a short put option.

KEY TAKEWAYS

We shall now conclude by discussing about the terminologies that we have learned in this
chapter. Again, the concepts that we have learned in this chapter are extremely important
and would form the basic blocks of things that we are going to discuss in the forthcoming
chapters. Hence, it is crucial to have a very strong understanding of these terminologies.
We strongly suggest the reader to spend quality time on understanding these
terminologies, before moving ahead to the next chapter.

• Option price: This is the price that an option buyer must pay to an option seller for
acquiring the right to the option contract. It comprises of two components – time
value and intrinsic value. An option price is also known as option premium.

Option price = Intrinsic value + Time value

• In-the-money (ITM) option: A call option is said to be ITM if the current price of
the underlying security is above the strike price, while a put option is said to be ITM
is the current price of the underlying is below the strike price.
• At-the-money (ATM) option: A call/put option is said to be ATM if the current
price of the underlying security is equal to the strike price.
• Out-the-money (OTM) option: A call option is said to be OTM if the current price of
the underlying security is below the strike price, while a put option is said to be OTM
if the current price of the underlying security is above the strike price.
• Intrinsic value of an option: Intrinsic value refers to the amount an option is ITM.
If an option is OTM, its intrinsic value is zero. For a call/put option that is ITM,
intrinsic value is calculated as the absolute value of the difference between the
current price of the underlying and the strike price.
• Time value of an option: Time value is the difference between the option price and
the intrinsic value. If an option is OTM, option price is equal to time value (as
intrinsic value is zero). The greater the time to expiration, the higher will be the time
value, and vice versa.
• Breakeven price: This is the price at which the buyer of an option will be at
breakeven, i.e. neither making a profit nor a loss. For a call option, the breakeven
price is equal to strike price plus the premium paid by the buyer; while for a put
option, the breakeven price is equal to strike price minus the premium paid by the
buyer.
What Is Open Interest?
Open interest is the total number of outstanding derivative contracts, such
as options or futures that have not been settled for an asset. The total open interest does not count,
and total every buy and sell contract. Instead, open interest provides a more accurate picture of
the options trading activity, and whether money flows into the futures and options market are
increasing or decreasing.

EXAMPLE: - A Buys 100 option contract & B sells 100 option contract

So open interest will be – 100

To understand open interest, we must first explore how options and futures contracts are created.
If an options contract exists, it must have had a buyer. For every buyer, there must be a seller since
you cannot buy something that is not available for sale.

The relationship between the buyer and seller creates one contract, and a single contract equates
to 100 shares of the underlying asset. The contract is considered "open" until the counterparty
closes it. Adding up the open contracts, where there are a buyer and seller for each, results in the
open interest.

If a buyer and seller come together and initiate a new position of one contract, then open interest
will increase by one contract. Should a buyer and seller both exit a one contract position on a
trade, then open interest decreases by one contract. However, if a buyer or seller passes off their
current position to a new buyer or seller, then open interest remains unchanged.

KEY TAKEAWAYS
Open interest is the total number of outstanding derivative contracts, such as options or futures
that have not been settled.

Open interest equals the total number of bought or sold contracts, not the total of both added
together.

Open interest is commonly associated with the futures and options markets.

Increasing open interest represents new or additional money coming into the market while
decreasing open interest indicates money flowing out of the market.
Changes to Open Interest
It's important to note that open interest equals the total number of contracts, not the total of each
transaction by every buyer and seller. In other words, open interest is the total of all the buys or all
of the sells, not both.

The open interest number only changes when a new buyer and seller enter the market, creating a
new contract, or when a buyer and seller meet—thereby closing both positions. For example, if
one trader has ten contracts short (sale) and another has ten contracts long (purchase), and these
traders then buy and sell ten contracts to each other, those contracts are now closed and will be
deducted from open interest.

Open interest is commonly associated with the futures and options markets, where the number of
existing contracts changes from day to day. These markets differ from the stock market, where
the outstanding shares of a company's stock remain constant once a stock issuance has been
completed.

The Importance of Open Interest

Open interest is a measure of market activity. Little or no open interest means there are no
opening positions, or nearly all the positions have been closed. High open interest means there are
many contracts still open, which means market participants will be watching that market closely.

Open interest is a measure of the flow of money into a futures or options market. Increasing open
interest represents new or additional money coming into the market while decreasing open
interest indicates money flowing out of the market.

Open Interest and Trend Strength

Open interest is also used as an indicator of trend strength. Since rising open interest represents
additional money and interest coming into a market, it is generally interpreted to be an indication
that the existing market trend is gaining momentum or is likely to continue.

For example, if the trend is rising for the price of the underlying asset such as a stock, increasing
open interest tends to favor a continuation of that trend. The same concept applies to downtrends.
When the stock price is declining, and open interest is increasing, open interest supports
further price declines.
Real World Example of Open Interest
Below is a table of trading activity in the options market for traders, A, B, C, D, and E.
Open interest is calculated following the trading activity for each day.

DATE TRADING ACTIVITY OPEN INTEREST

JAN 1 A buys 1 option & B sells 1 1

option contract
JAN 2 C buys 5 option & D sells 5 6
option contract
JAN 3 A sells his 1 option & D buys his 5
1 option contract
JAN 4 E buys 5 option from C who sells 5
5 option contract

Table showing how transactions affect open interest.

Jan 1: Open interest increases by one since only one contract is created consisting of
a buy and sell.

Jan 2: Five new options contracts are created, so open interest increases to six.

Jan 3: Open interest declines by one because traders A and D square off one contract
to close their positions. As stated earlier, open interest is not the total of both buy
and sell trades.

Jan 4: Open interest remains at five since there are no new contracts created.
Investor E bought five existing contracts from C.
ACTION IN OPEN INTEREST WITH PRICE

➢ Long buildup: An increase in open interest and price.

➢ Short buildup: An increase in open interest with decrease in price.
➢ Long unwinding: A decrease in open interest and price.
➢ Short covering: A decrease in open interest with increase in price.

STATUS CHANGE CHANGE VIEW

OI% PRICE%

Long +10% +2% BULLISH

Buildup

Short +10% -2% BEARISH

Buildup

Long -10% -2% BEARISH

Unwinding

Short -10% +2% BULLISH

Covering