Understanding the Components of an Option Contract

Contracts for equity options are similar to a traders' and investors' toolset.

They support efficient risk management and market movement capitalisation.

The fact that options provide holders the freedom to exercise without any obligations separates them from other financial products.

Options enable traders to speculate on potential price changes or safeguard themselves against stock price declines. They are essential to the stock derivatives market because they give traders a channel for trading.

The terms, circumstances, and features of option contracts are determined by a combination of several components. In-depth discussion of these elements and their importance in creating winning trading strategies will be provided in this article.

Let's examine each of them in more detail.

Underlying Securities

The underlying securities, also known as the underlying asset, are the financial instruments upon which the option contract is based. These assets can vary widely and may include stocks, commodities (such as gold, oil, or wheat), currencies, indexes, or even other derivative instruments.

The underlying asset determines the nature of the option contract and its value. Different assets exhibit varying levels of volatility, liquidity, and sensitivity to market factors, which influence option pricing and trading strategies. For example, options on highly liquid stocks may offer more opportunities for trading compared to options on illiquid stocks.

• Options on stocks: Investors may buy call options on shares of a company to speculate on upward price movements or buy put options to hedge against potential downside risk.
• Options on commodities: Traders may use options on commodities like gold or oil to hedge against price fluctuations or to speculate on future price movements.

In the Indian market, let's consider an example of options on a popular stock, Reliance Industries Limited (RIL). As the underlying asset for options contracts, RIL's stock price movements significantly impact the value and trading dynamics of the options.

• Call Options: An investor may purchase call options on RIL if they anticipate a bullish trend in the stock price. For instance, if RIL is currently trading at ₹2,000 per share, an investor might buy a call option with a strike price of ₹2,100 expiring in one month, expecting the stock price to rise above ₹2,100 by the expiration date.
• Put Options: Conversely, an investor concerned about a potential downturn in RIL's stock price may buy put options. For instance, if RIL is trading at ₹2,000 per share, an investor might purchase a put option with a strike price of ₹1,900 expiring in one month, providing protection in case the stock price falls below ₹1,900.

The relationship between a derivative and its underlying security is fundamental to understanding how derivatives function in the market. In the Indian context, where option contracts are available for a variety of securities, this relationship plays a crucial role in determining the value and performance of derivative securities.

Suppose an investor purchases a call option on TCS stock with a strike price of ₹3,000, expiring in one month. If the price of TCS stock rises above ₹3,000 during the option's validity period, the call option holder stands to gain.

• Scenario 1: TCS Stock Price Rises: If the market price of TCS stock increases to ₹3,200, the call option holder can exercise the option, buying TCS stock at the strike price of ₹3,000 and immediately selling it at the higher market price of ₹3,200, thereby realising a profit.
• Scenario 2: TCS Stock Price Falls: Conversely, if the price of TCS stock declines below ₹3,000, the call option holder may choose not to exercise the option. In this case, the option expires worthless, and the holder loses the premium paid for the option.

A clear understanding of the underlying securities is fundamental to evaluating option contracts and devising strategies that align with investment objectives and risk tolerance.

Contract Size

Next, let's talk about contract size. This is like the "portion control" of options trading. It tells you how much of the underlying asset is covered by a single options contract. Think of it as the amount of "stuff" you're dealing with when you trade options.

In the Indian options market, contract size refers to the specific quantity of the underlying asset covered by a single options contract. This aspect is crucial for traders as it directly influences the scale of exposure and potential returns associated with their options positions.

Now, contract sizes aren't one-size-fits-all. They can vary depending on what you're trading and the rules of the market. For example, if you're trading options on individual stocks, the contract size might be based on a specific number of shares per contract. But if you're trading index options, it might represent a certain value of the underlying index.

Understanding contract size is key because it gives you a sense of how much "impact" your options trade has. Let's say you buy one call option on a stock with a contract size of 100 shares. That means you've got the right to buy 100 shares of that stock at the strike price if you decide to exercise the option.

Now, this also affects the money side of things. When you're planning your trades, you need to consider how much cash you'll need to make them happen. Larger contract sizes mean you might need more money upfront to get into the trade.

So, next time you're looking at options, keep an eye on the contract size. It's like knowing how big a slice of cake you're getting - it helps you plan your meal (or trade) accordingly!

Let's consider another example to further illustrate contract size in the Indian options market, taking Infosys Limited (INFY).

The contract size for options on Infosys Limited is 1,000 shares per contract. Understanding the contract size is crucial because it determines the quantity of shares controlled by a single options contract. Here, each contract represents the right to buy or sell 1,000 shares of Infosys stock, depending on the type of option and the trader's position.

Let's say you're bullish on Infosys stock and decide to buy one call option on INFY with a strike price of ₹1,500, expiring in one month. If the market price of Infosys stock rises above ₹1,500 during the option's validity period, you have the opportunity to exercise the option and buy 1,000 shares of Infosys stock at ₹1,500 per share. This allows you to potentially profit from the price appreciation of Infosys stock.

Understanding contract size is vital because it impacts the capital requirements and potential returns of options trades. Additionally, regulators in the Indian market stipulate certain requirements regarding contract sizes to ensure market integrity and liquidity.

In fact, Indian market regulators mandate that the value of options contracts on individual securities should not be less than ₹5 lakhs at the time of their introduction on any exchange. Moreover, the permitted lot size for futures and options contracts is standardized for a given underlying asset or as stipulated by the exchange.

Expiry Day

In options trading, the expiry day refers to the date on which the option contract expires and becomes void. This component is crucial as it sets the timeline for the option's validity and influences the trading strategy and decision-making process of investors and traders.

Options contracts have a finite lifespan and expire on standard expiry days determined by the Exchange. The expiry day marks the culmination of the options contract, serving as the final trading day for that particular series of options.

In India, options contracts typically expire on the last Thursday of the expiry month or the last Thursday of the expiry week, depending on the specific rules of the Exchange. However, if the last Thursday falls on a trading holiday, the contracts expire on the previous trading day.

On the expiry date, all unexercised options in a particular series become invalid, and traders no longer have the ability to exercise their rights. It's important to note that in the case of options contracts, traders are not obligated to fulfill the contract. Therefore, if the option is not acted upon by the expiry date, it simply expires.

Impact on Trading Strategies:

The expiry day significantly impacts trading strategies. Traders must consider the expiry date when planning their trades and analyzing market trends. Different strategies may be employed depending on whether the option expires in the short term, medium term, or long term.

For example, traders employing short-term strategies may focus on options with near-term expiry dates to capitalize on short-term price movements. On the other hand, investors with longer-term perspectives may prefer options with extended expiry dates to allow more time for their strategies to unfold.

Let's consider an example of options expiry for a hypothetical stock, XYZ Ltd. traded on the National Stock Exchange of India (NSE).

Suppose we're dealing with options contracts expiring in the current month. In India, options typically expire on the last Thursday of the expiry month or the last Thursday of the expiry week.

The current month is January, and the last Thursday falls on January 27th. However, January 27th is a trading holiday. Therefore, according to exchange rules, the options contracts on XYZ Ltd. will expire on the previous trading day, which is January 26th.

On January 26th, all unexercised options contracts on XYZ Ltd. expire. Traders holding these options have until the end of the trading session to decide whether to exercise their rights. If they choose not to exercise the options by the expiry date, the contracts simply expire, and the premium paid to buy the options is forfeited.

For example, if a trader had purchased call options on XYZ Ltd. with a strike price of ₹1,500 and paid a premium of ₹50 per share, and the market price of XYZ Ltd. stock remained below ₹1,500 on the expiry date, the call options would expire worthless. In this case, the trader loses the premium paid to buy the options but is not obligated to pay any additional amount.

Similarly, if a trader had sold put options on XYZ Ltd. with a strike price of ₹1,400 and received a premium of ₹40 per share, and the market price of XYZ Ltd. stock remained above ₹1,400 on the expiry date, the put options would also expire worthless. The trader gets to keep the premium received for selling the options.

The expiry date of futures and options (F & O) contracts often leads to heightened volatility in the stock market. As the expiry date approaches, traders rush to close out their F & O positions, leading to increased trading activity. Depending on the nature of the contracts settled, the market may become bullish or bearish. Arbitrageurs exploit pricing discrepancies between the cash and derivatives markets by buying and selling assets simultaneously. This activity can cause rapid price fluctuations, impacting overall market volatility.

While expiry-related trading effects can be significant, they are typically short-lived. Once the expiry date passes and contracts are settled, the market tends to correct itself.

Exercise/Strike Price

The exercise or strike price of an options contract is the predetermined price at which the underlying asset can be bought or sold if the option is exercised. This component is crucial as it determines the price at which the option holder can execute their rights.

The relationship between the strike price and the current market price of the underlying asset influences the intrinsic value of the option.

This component serves as the anchor price for the options agreement and influences trading decisions and outcomes.

The exchange provides exercise prices for all listed options, offering a range of choices for traders. As the price of the underlying shares moves, new exercise prices are introduced to accommodate market fluctuations. For call options, the strike price represents the buying price of the underlying shares upon exercise. Conversely, for put options, it signifies the selling price of the underlying asset.

Suppose TCS stock is currently trading at ₹3500 per share.

Available options contracts for TCS may include strike prices such as 3400, 3450, 3500, 3550, and 3600, among others. These strike prices offer traders a range of choices based on their market outlook and trading strategies. Traders can refer to the option chain to view the available strike prices and premiums for TCS options contracts. The option chain provides a comprehensive overview of the various strike prices and their corresponding premiums, aiding traders in making informed decisions.

An option chain provides a snapshot of available strike prices and premiums for a particular contract. It lists different strike prices along with their corresponding premiums, allowing traders to make informed decisions.

The strike price represents the future trading price, while the spot price is the current market price. Traders reference the spot price when agreeing on a strike price for an options contract.

In summary, the exercise or strike price is a crucial aspect of options trading, providing traders with a reference point for their trading decisions. By understanding the relationship between strike prices and market dynamics, traders can effectively manage their options positions and navigate the derivatives market.

Premium

The premium is the price paid by the option buyer to the option seller for acquiring the rights conveyed by the options contract. It represents the cost of purchasing the option and is determined by various factors, including the underlying asset's price, volatility, time to expiration, and prevailing market conditions. Several factors influence the premium of an option:

• Intrinsic Value: It is the difference between the current market price of the underlying asset and the strike price.
• Time Value: It reflects the potential for the option to gain value before expiration, influenced by factors such as time to expiration and volatility.
• Volatility: Higher volatility typically leads to higher option premiums to account for increased uncertainty.
• Interest Rates: Changes in interest rates can impact the cost of carrying the underlying asset, affecting option premiums.
• Market Conditions: Supply and demand dynamics in the options market also influence premium levels.

Option premiums are quoted on a per-share basis, with one contract typically representing 100 shares of the underlying asset. To calculate the total premium for an options contract, multiply the quoted premium by the contract size.

For option buyers, the premium represents the maximum potential loss if the option expires worthless. Conversely, for option sellers, the premium received represents the maximum potential profit if the option expires worthless.

Option premiums can fluctuate over time in response to changes in market conditions, underlying asset prices, and other factors. Traders must monitor premium movements to assess the profitability of their options positions.

Various pricing models, such as the Black-Scholes model, are used to estimate option premiums based on inputs such as underlying asset price, strike price, time to expiration, volatility, and interest rates.

The premium is a critical component of options trading, representing the cost of acquiring option rights. By understanding the factors that influence premium levels and monitoring premium movements, traders can make informed decisions and effectively manage their options positions.

Options Settlement

Options settlement refers to the process by which the rights and obligations of options contracts are fulfilled or resolved. It occurs either through physical settlement or cash settlement, depending on the type of option and the preferences of the parties involved.

Physical Settlement: In physical settlement, the option holder exercises their right to buy or sell the underlying asset at the agreed-upon strike price. This results in the actual transfer of the underlying asset from the option seller to the option buyer. Physical settlement is common for options on stocks and other tangible assets.

Cash Settlement: In cash settlement, the option's value is settled in cash instead of the actual delivery of the underlying asset. The cash amount is determined based on the option's intrinsic value at expiration. Cash settlement is often used for options on indices, currencies, and futures contracts.

Suppose Mr. A, an investor, is interested in purchasing a call option contract for Infosys Limited (INFY), a leading technology company listed on the National Stock Exchange of India (NSE). Mr. B, another market participant, is willing to sell the option contract to Mr. A. The call option contract has a strike price of ₹1500 per share and expires on June 30, 2022.

As per the terms of the agreement, Mr. A agrees to pay a premium of ₹20 per share to Mr. B for the option contract. This premium amount reflects the cost incurred by Mr. A to acquire the rights conveyed by the option contract.

Now, on the expiry date, June 30, 2022, Mr. A has two options for settlement: physical settlement or cash settlement. If Mr A decides to exercise the option and the market price of INFY on the expiry date is above ₹1500, Mr. B is obligated to deliver the actual shares of INFY to Mr. A at the agreed-upon strike price of ₹1500 per share.

Alternatively, if a cash settlement is preferred, and the market price of INFY on June 30, 2022, exceeds ₹1500, Mr. B would be required to pay Mr. A the difference between the market price and the strike price, multiplied by the lot size of 1000 shares. This cash settlement provides Mr. A with the flexibility to receive the value of the option contract in cash rather than acquiring the underlying shares.

Under the regulatory oversight of the Securities and Exchange Board of India (SEBI), options trading in the Indian market adheres to specified guidelines for settlement methods, contract specifications, and trading practices. Traders like Mr. A and Mr. B must understand the implications of different settlement options to make informed decisions and effectively manage their options positions in the market.

Conclusion

Knowing the ins and outs of an option contract is key for investors and traders in the equity derivative market. Everything from the underlying securities to the strike prices plays a role in shaping the value and behavior of options. Armed with this knowledge and good risk management skills, traders can seize opportunities and work towards their financial objectives in the ever-changing options market.