Stock Options Basics

Options Definitions

Call option.  A call buyer pays a premium to the option writer, which gives the option buyer the right, within a specified period, to buy 100 shares of stock (or one futures contract) at a specified price (known as the strike price), no matter how high the stock price may rise. For example, say a trader buys a call option with a strike price of 50. The stock then rises to 100. By virtue of holding a call option with a strike price of 50, the trader can exercise the option and buy 100 shares of stock at a price of 50 a share.

Put Option . A put buyer pays a premium to the option writer, which gives the option buyer the right, within a specified period, to sell 100 shares of stock (or one futures contract) at a specific price, no matter how low the stock price may fall. For example, say a trader buys a put option
with a strike price of 50. The stock then falls to 10. Because the trader holds a put option with a strike price of 50, the trader can exercise the option and sell 100 shares of stock at 50.

Underlying. In the world of options, the word underlying refers to the security on which a given option is based. For example, IBM is the underlying security for all IBM options. In futures markets, Soybean futures are the underlying for all Soybean options.

Option buyer- Long Call.A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.

Option writer- Short Call.A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium.
The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium.

Put Buyer-Long Put   A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for
buying the option.

Put Writer-Short Put  A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be
below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot
price of the underlying is more than the strike price, the buyer lets his option un-exercised and
the writer gets to keep the premium.

Option Trading . In the Futures and Options segment, trading in S&P CNX Nifty Index, CNX IT index, Bank Nifty Index, Nifty Midcap 50 index and single stocks are available. Trading in Mini Nifty Futures & Options and Long term Options on S&P CNX Nifty are also available.

Strike price or exercise price. The strike price is the price at which an option can be exercised, that is, the price per share that the buyer of a call option must pay to buy the stock if the buyer chooses to exercise his or her option. Option exchanges designate the available strike prices for each listed security. Strike prices for options on futures are set by the exchange and vary from commodity to commodity.

Expiration date. The date after which an option is void and ceases to exist is its expiration date. For NSE stock options, the expiration date is the last Thursday of the expiration month. In other words, June options expire on the Last Thursday in June, July options expire on the Last Thursday in July, and so on. For futures options, the expiration months and expiration dates can vary and are set by the exchange on which a given series of options is traded.

Expiration cycle.S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.

Theoretical price or fair value. The price at which a given option is considered fairly valued based on a combination of variables used in a standard option pricing model is called the option’s fair value.

In-the-money option. A call option is in the money if its strike price is less than the current market price of the underlying. A put option is in the money if its strike price is higher than the current market price of the underlying.
A call option with a strike price of 50 is considered in the money as long as the price of the stock is greater than 50. A put option with a strike price of 50 is considered in the money as long as the price of the stock is less than 50.

Out-of-the-money option. An option that currently has no intrinsic value is an out-of-the-money option. A call option is out of the money if its exercise price is higher than the current market price of the underlying. A put option is out of the-money if its exercise price is lower than the current price of the underlying.

A call option with a strike price of 50 is considered out of the money as long as the price of the stock is less than 50. A put option with a strike price of 50 is considered out of the money as long as the price of the stock is greater than 50.

At-the-money option. For any security, the option whose strike price is currently closest to the actual price of the underlying security is generally referred to as the at-themoney strike. Please note that, technically speaking, the at-the-money option is usually slightly in or out of the money. For example, if a stock is trading at a price of 96, the 95 call and the 95 put options are considered the atthe- money strikes, even though the call option is 1 point in the money and the put is 1 point out of the money.

Intrinsic value. The amount by which an option is in the money is its intrinsic value. An out-of-the-money option has no intrinsic value. If a call option has a strike price of 50 and the underlying stock is trading at 55, the 50 call option has 5 points of intrinsic value. If a put option has a strike price of 50 and the underlying stock is trading at 45, the 50 put option has 5 points of intrinsic value.

Extrinsic value (or time premium). The price of an option less its intrinsic value is its extrinsic value. The entire premium of an out-of-the-money option consists of extrinsic value, or time premium. Time premium is essentially the amount an option buyer pays to the option seller (above and beyond the intrinsic value of the option) to induce the seller to enter into the trade. All
options lose the entire time premium at expiration, a phenomenon referred to as time decay

Long. A long position results from the purchase of an option contract.

Short. A short position results from the short sale of an option contract, also known as writing a contract.

Buy premium or long premium. A buy premium results when you enter into a position where you are paying more money for the option you buy than you take in for any option you may write.

Sell premium or short premium. A sell premium results from entering into a position where you are taking in more money for the option you buy than you pay out for any option you may write.

Naked option. Buying an option of a single strike price is considered a naked long option. Writing an option of a single strike price is considered a naked short position. The buyer of the IBM 95 call is holding a long naked option. The writer of the IBM 95 call is holding a short naked option.

Spread. A spread position involves buying or writing options of different strike prices or different expiration months. A trader who buys the IBM 95 call and simultaneously writes the IBM 100 call has entered into a spread position.

Historic volatility. A value calculated based on the price fluctuations of the underlying security is the stock’s historic volatility. This value represents an estimate of how far the underlying security is likely to fluctuate in price over the ensuing 12-month period. A stock with a historic volatility of 20% would be expected to fluctuate plus or minus 20% from its current price over the ensuing 12 months.

Implied option volatility. The implied option volatility is the value that must be plugged into an option pricing model to cause the model to arrive at the current market price as an output, given the other known variables. It may also be referred to as option volatility and implied volatility.

Overvalued option. An option is considered overvalued if market price is greater than the theoretical price generated for that option by an option pricing model.

Undervalued option. An option is considered undervalued if its market price is less than the theoretical price generated for that option by an option pricing model.

Expensive option. An option can be considered expensive if implied volatility is high relative to the historic range of implied volatility for options on the underlying security.

Inexpensive option. An option can be considered inexpensive or cheap if its implied volatility is low relative to the historic range of implied volatility for options on the underlying security.

F & O Contract Specifications at NSE