Friday, February 11, 2011

Options Trading In India - Part I

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 Nifty Call Options (or) all Nifty 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. NIFTY FEB.24 5600CE is an options series which includes all NIFTY Call options that are traded with Strike Price of 5600 & Expiry on Feb 24.

NIFTY - Nifty Index , CE - Call European Feb 24 - Expiry Date 5600 - Strike Price

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.

Read      Part II      Part III        Part IV       Part V

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