OPTION CONCEPTS

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The investor would find it useful to know certain important terms used with regard to transactions in options. These terms are listed below:

Strike price,
In-the-money,
Out-of-the-money,
At-the-money,
Covered Call, and
Covered Put

At this stage, we would like to reiterate, that the visitors who have not dealt in stocks and share, or investors who have dealt in stocks and shares but have not indulged in the leverage provided by options as a speculative instrument would be well advised to meet a qualified investment advisor to understand the nuances of this instrument.

It is always better to be on the side of caution and have a healthy margin of safety available to us at all times in our financial transactions.

Strike price: The strike price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval would be of 20. Let's say that the index is currently at 1410, then the strike prices available would be 1370, 1390, 1410, 1430 and 1450. The strike price is also called the exercise price. This strike price is fixed for the entire duration of the option, the profit or loss from the contract would depend on the price movement of the underlying stock or index in the Cash market.

In-the-money: A Call option is said to be "in-the-money", if the strike price is les than the market price of the underlying (whether stock or index). A Put option is "in-the-money", when the strike price is greater than the market price of the underlying.

Let's say Raj purchases 1 SATCOM AUG 190 Call at a premium of INR 10.00. Here, the option is "in-the-money" till the market price of SATCOM is ruling above the strike price of INR 190.00. Which is the price at which Raj would like to buy 100 shares of SATCOM anytime before the end of August.

Similarly, if Raj has purchased a Put option at the same strike price; then the option would be "in-the-money" if the market price of SATCOM was lower than INR 190.00 per share.

Out-of-the-money: A Call option is said to be "out-of-the-money" if the strike price of the contract is greater than the market price of the underlying stock. Similarly, a Put option is "out-of-the-money" if the strike price is les than the market price of the underlying stock.

To explain this further, let's say Raj purchases 1 INFTEC AUG 3500 Call at a premium of INR 150.00. The option is "out-of-the-money", if the market price of INFTEC is ruling below the strike price of INR 3,500.00. Which is the same price at which Raj would like to buy 100 shares of INFTEC anytime before the end of August.

Similarly, if Raj has purchased a Put option at the same strike price; then the option would be "out-of-the-money", if the market price of INFTEC was above INR 3,500.00 per share.

At-the-money: The option with a strike price equal to that of the market price of the underlying stock is considered to be "at-the-money" or near-the-money.

Let's say Raj purchases 1 ACC AUG 150 Call or Put at a premium of INR 10.00. In this case, if the market price of ACC is ruling at INR 150.00, which is equal to the strike price, then the option is said to be "at-the-money".

To explain this further, let's say the Index is at 1410, then the strike prices available would be 1370, 1390, 1410, 1430 and 1450. The strike price for a Call option that are greater than the underlying Index are said to be "out-of-the-money" for strike prices 1430 and 1450 considering that the underlying in the cash market is at 1410. Similarly, "in-the-money" strike prices would be 1370 and 1390 which are lower than the underlying of 1410. And of course, the strike price 1410 would be "at-the-money".

At these prices an investor can take a positive or negative view on the market; that is both Call and Put options would be available. Therefore, for a single series 10 options (that is 5 Calls and 5 Puts) would be available; and considering that there are 3 series, a total of 30 options would be available to take a position.

Covered Call options: Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this would cover his loss in the options position, in case there is a sharp increase in the price of the stock. Further, he is able to reduce his average cost of acquisition in the cash market (which would be the cost of acquisition less the option premium received).

To illustrate this, let's say Raj believes that HUL has hit rock bottom at a price level of INR 182.00 and that it would move up in a narrow range. He can take a long position in HUL shares and at the same time write a Call option with a strike price of INR 185.00 and collect a premium of INR 5.00 per share. This would bring down the effective cost of HUL shares to him to INR 177.00 (that is INR 182.00 less INR 5.00). If the price stays below INR 185.00 till expiry, then the Call option would not be exercised and Raj the writer of the Call option would keep the INR 5.00 per share he had collected as premium. If on the other hand the price goes above INR 185.00 and the option is exercised, then Raj would deliver the shares acquired in the cash market.

Covered Put options: Similarly, the writer of a Put option can create a covered position by selling the underlying security (that is, if it is already owned). The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the stock, as the underlying asset has already been sold. However, if the there is a sharp decline in the price of the underlying asset, the option would be exercised and the investor would be left only with the premium amount. The loss in the option exercised would be equal to the gain in the short position of the underlying asset.

For a better understanding of options, we would suggest that the investor read about role of options and futures; what are options?; types of options and option styles, class and series. We would strongly recommend that the investor first study these investment instruments; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him.

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