Option premium in relation to the Current Market Price (CMP) is always higher, at the beginning of the new month (after previous month’s option expiry on the last Thursday). Again in relation to the CMP, option premium of Next Month Option (August here) is higher than the current or Near Month Option (July here). Still higher would be the Far Month Option Premium (September here). As we approach the expiry date, the premium in relation to CMP starts falling until a day or two before expiry, the premium would be almost zero. This difference is because the buyer of the option for farther off periods stands a greater chance of making profits if given more time to hold the option. The seller therefore deserves to get a higher premium. This intrinsic quality of any option to fall in value with time in relation to the CMP is called the TIME DECAY.
For example, let us imagine at Nifty value of 4500 (CMP), the 4500 Call option at the beginning of the current month (July) was trading at Rs 50/-. A day before expiry, if Nifty is still at 4500, the Call premium would be close to Rs 4/- or Rs 5/-. If Nifty closes at 4500, the value of the call premium would be zero. If Nifty closes at 4510, the call will close at Rs 10/-which is again zero premium in relation to CMP.
The significance of Time Decay
Most retail investors are buyers of options. What one should realize is that due to the inevitable time decay, a buyer has the dice loaded against him, right from the time he enters into the contract. He has to depend on the volatility of the scrip to book his profits along the down-hill journey of the option premium. He, of course, has the advantage that his loss is limited and he has to pay no deposit apart from the actual amount of transaction.
The option writer on the other hand, has the dice loaded in his favor from the time he sells the option (as a primary seller, without having bought the option first). The time decay works to his advantage on a daily basis. As long as the scrip remains stagnant, the premium continues to fall, adding to his gains. He pays the price by the mandatory deposit into the stock exchange and also by accepting the possibility of unlimited loss (but writers usually exit with a small profits and do not hold on to their positions too long to avoid undue risks).
By definition, open interest (OI) means the total number of open contracts on a security or index (NIFTY) , that is, the number of future or options contracts that have not been exercised or expired. Hence, we can say that the open interest position at the end of each day represents the net increase or decrease in the number of contracts for that day.
For example, If A and B buy two Reliance options each today, the open interest at the end of the day is FOUR. On day 2, if A sells one of his options to C (who is a fresh buyer), at the end of the day 2, the OI will remain FOUR (since one buy by C has been compensated by one sale by B). But consider the situation where, A and B have retained their options and C has bought a newly written option (by an initial seller or the so called writer of options).The OI at the end of day 2 will be FIVE. In other words, increase in OI is a reflection of new contracts coming into the market. What then would be the significance of OI variations vis-à-vis market trend ?
If market is on an uptrend and OI is rising :Bullish signal for the index/stock derivative (more calls being written).
If market is on an downtrend and OI is rising :Bearish signal for the index/stock derivative (more puts being written).
If market is on an uptrend and OI is falling :Bearish signal signifying a decreased interest for buying fresh calls. This may precede a trend reversal.
If market is on a downtrend and OI is falling :Bullish signal signifying a squaring off of existing positions in anticipation of a trend reversal.
If the market movement is sideways and OI is rising :This suggests that a trend in either direction is likely soon.
If the market movement is sideways and OI is falling :This suggests that the trend less movement will continue.
Thus open interest is just one of the indicators among many that help us to take a call on the likely direction of the market. It has to be considered along with other technical indicators before taking any decision.
One of the most potent tools in the inventory of option traders are free Calls. How do we get them ? Quite simple in fact. Please note the following example (reference Reliance, any strike level, lot size 150) :
Premium Lots Price Action
40 50 3,00,000 Buy
50 40 3,00,000 Sell
So, the above transaction earns you as many as TEN FREE lots of Reliance Calls in just one day ! If you get an opportunity, you can repeat the operative the same day again. Repeating the process just FIVE times will get you as many as 50 FREE lots. You can sure have many more, depending upon how many times you repeat the operative. We suggest you begin small and increase the stakes gradually as you gain more experience & confidence.
Each and every penny earned on these FREE lots will be your profit.
20 x 150 x 50 = 1,50,000 rupees(selling at a reasonable 20 premium) 50% return10 x 150 x 50 = 0,75,000 rupees(selling at a mere 10 premium) 25% return05 x 150 x 50 = 0,37,500 rupees(selling at a rock-bottom 05 premiun) 12.5% return
All the percentage returns shown above are merely single-transaction returns. One can easily repeat the process over and over again, at least on certain definitely bullish days.
Good assured (almost) monthly income ??Unleashing the power of OPTIONS as we said !!
50% monthly return, 600% annualised !!! Any takers ???
No other trade operative makes this even remotely possible !
The beauty of these free calls is that you’ll never be in a hurry to square them off, so you can easily wait for your expected premium value. Even if some of these calls expire worthless, you don’t lose a penny as the calls were already free to you !
Please note that to be on the conservative side, we have suggested selling the initial 40 lots only at a premium of 10 (easily attainable for Reliance). You can always sell these at higher premium, thus earning yourself proportionately higher number of FREE Call lots. If you can’t sell off these initial 40 the same day, you can always wait for a day or two. Do make the usual allowance for brokerage payment please.
CAUTION : If you propose to buy/sell as many as 50 to 100 lots in a day, first please assure from the NSE web site (or through your own trading software) that there is sufficient volume available in the strike level of your choice. Even if you need to transact a costly Call, it really doesn’t matter much (beyond the higher initial investment), as you will get your entire investment back the moment you sell off the stipulated no. of Calls.
Our attempt is to provide you a basic understanding of what stock and index options are all about without confusing you with any unnecessary and avoidable details. Though there indeed are lots of online resources on options, hardly any of them deal with the typical Indian equity market scenario - we bring you one right here - perhaps the first Indian OPTIONS BLOG.
New to OPTIONS ? It is so very easy. Just follow these basics for a quick launch into the wonderful world of OPTIONS trading :The equity market permits you to either purchase/sell shares (called CASH segment), or trade in FUTURES and/or OPTIONS (called the DERIVATIVES segment). FUTURES and OPTIONS segment in popularly referred to as FnO. However, here we talk only about OPTIONS and not about FUTURES at all. Why ? Because in OPTIONS the possible extent of loss is very limited, whereas in FUTURES loss can be potentially unlimited !
Basic Call Options
Buying a call option gives you the right to purchase a given number of shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the last Thursday of a specific month (called the expiration date). You can just as easily sell (square off) your purchased Call options, without necessarily having to exercise them to procure a company’s shares prior to the stipulated expiry date. That is why it is usually said that buying a Call options gives you a right, though not necessarily an obligation.
People buy calls because they hope the stock will go up, and they will make a profit, either by selling the calls at a higher price, or by exercising their option (i.e., buy the shares at the strike price at a point when the market price is higher).
Basic Put Options
Buying a put option gives you the right (though not the obligation) to sell a specified number of shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the last Thursday of a specific month (called the expiration date). You can just as easily sell (square off) your purchased Put options, without necessarily having to exercise them to sell a company’s shares prior to the stipulated expiry date. That is why it is usually said that buying Put options gives you a right, though not necessarily an obligation.
People buy puts, because they hope the stock will go down, and they will make a profit, either by selling the Puts at a higher price, or by exercising their option (i.e., forcing the seller of the Put to buy the stock at the strike price at a time when the market price is lower).
So, as we have explained above, OPTIONS trading has two basic transactional instruments, called Calls & Puts. You can buy and sell both or either. Calls increase in their value as the cash scrip goes up, Puts decrease at the same time. Conversely, as the cash scrip goes down Calls decrease in value and Puts gain at the same time.
For sake of convenience, let us take Reliance as an example. Suppose the cash share of this company is currently trading at 1700. If you wish to purchase Reliance Calls, your broker or your online trading agency will tell you that Reliance Calls are available at different levels. These levels can be below, at or above the currently trading price of Reliance share. For example, Reliance Calls for the month of July are available at 1440, 1470, 1500, 1530, 1560, 1590, 1620, 1650, 1680, 1710, 1740, 1770, 1800, 1830, 1860 levels. These levels are called as Strike levels, Strike price, or simply Strikes for Reliance Calls available in the market. I have shown 1710 in bold as it is closest to the current market price (CMP) of a Reliance share. Such a level would be called as ‘At Money’ or ‘At the Money Level’. All levels below the CMP will be termed as ‘In Money’ or ‘In the Money’ levels (here 1440 till 1680), and, of course, all levels above the CMP will be termed as ‘Out of Money” levels (here 1740 till 1860).
Don’t attempt starting trading right-away. OPTIONS are time-sensitive, scheduled financial contracts. Learn the basic OPTIONS terminology and their basic calendar prior to beginning your first trade.
1. Don’t start trading in options until you are absolutely sure of the terms - ‘Buying a put’ or ‘buying a call’ and ’selling a put’ or ’selling a call’ (Look up in Terminology category). The IMPLICATIONS are different and so are your LIABILITIES .
2. Don’t start trading in options until you are reasonably well versed with short-term movements of the market as a whole (NIFTY, SENSEX), as well as in the stock you select.
3. Don’t become an initial SELLER of options - that is, selling options without having bought them first. This makes you an OPTION WRITER, and you have to pay heavy margins to the stock exchanges. Your losses can be unlimited as well.
4. Don’t select a trend less stock with narrow price movements. You will neither gain on the calls nor the puts and you will lose due to the inevitable time decay.
5. Don’t buy a put option on rising stocks.
6. Don’t buy a call option on declining stocks.
7. Don’t buy a stock where trading volumes are obviously very low.
8. Don’t get into several stock options at the same time. You may find it difficult to follow-up. Limit to two, or at most three.
9. Don’t get into buying an option until you have calculated the actual outflow per option. It may be low for Nifty (lot size merely 50) but extremely high for stocks like GMRINFRA (lot size 1000).
10. Don’t go for extreme ‘out of the money’ or extreme ‘in the money’ options. For call options, ‘in the money’ would mean strike lower than Current Market Price ( CMP ), and for put options, ‘in the money’ would imply a strike higher than CMP (and vice-versa).
11. Don’t place ‘market orders’ for any option. You may end up paying absurdly high rates placed by sellers. These becomes astronomically high when you consider stocks where the number of units per option is large like 7875 per option for IFCI.
12. Don’t buy an option closer than 7 to 10 days prior to expiry date - unless you’re trading intraday where you would be squaring up the same day, or at the most during the next 1 or 2 days.
13. Don’t hold all the options for maximum gains. Start selling a percentage of them at each significant rise. Hold, say 20% towards expiry if you expect further rise in the cash market price. Make sure that the cash market price is already well above your strike plus premium in call options that you are holding to expiry. Reverse for puts of course
14. Don’t shift to higher options in equal numbers as the scrip is rising. Speaking of call options, if you wish to shift, remove part of profits and take lesser number of options at higher strikes and lower premium. Do the reverse for put options.
15. Don’t keep a stop loss in options on the trading screen. It can easily get triggered and then reverse, since options are volatile. Keep a mental stop loss if necessary and exercise the stop loss at will.
16. Don’t utilize 100% of your capital in options. The very advantage of options is lost. If you have Rs 5 lakhs as capital, you can take exposure to the same number of shares with Rs 50000/- worth options. Limit yourself to this 10% percentage of the available capital. As you earn profits with options, you can keep back your entire capital of Rs 5 lakhs, or keep it invested in a stable blue-chip cash scrip like L&T or Reliance and continue playing in options with the profits alone.
17. Don’t play on borrowed money. Once you gain experience, you may get margin funding on your cash shares from your brokerage. Take care not to over leverage. It is quite easy to fall prey to greed in the market, more so with options since investment required is substantially less.
18. Don’t average options during a fall as in long term investment for cash market shares. You may lose big time.
19. Don’t panic seeing intra day volatility in options. It is a natural phenomenon with options.
20. Don’t buy at the opening price since the demands from sellers are often absurdly high on opening. Watch the trend before taking a position.
21. Don’t hesitate to get advice from someone you trust in case of doubt.
Wish to begin your first OPTIONS play just tomorrow ? No problem.
1. Please read this entire blog from A to Z, and in case you have any queries, ask them in the appropriate blog section(s). Don’t begin before you’re 101% sure of what you’re doing. Please note that reading (just quickly going through and making some jottings !) may take only about an hour or so (as of today), but it may result in substantial and far more complete information gain for you before you begin you options foray.
2. We suggest that you begin your OPTIONS practical training lessons with Reliance Calls as they are well traded and less volatile. Such a characteristic takes one important negative variable away - letting you begin your options play on a more positive note. You may either place your buy Call order telephonically with your broker, or, if you’re confident enough with your trading software, you may execute it yourself. PLEASE ALWAYS PLACE A LIMIT ORDER. In case you definitely want to buy at the visible price, just place your order quoting an additional 0.10, and confirm your order execution immediately thereafter. THIS CONFIRMATION OF THE EXECUTED TRADE IS VERY IMPORTANT, and cannot simply be over emphasized.
3. While buying Reliance Calls, regardless of the current price of the cash scrip (say 1900), you will find Calls available at different numerical levels (called strike levels), some less than 1900, others more than 1900. The farther away the Call’s strike level from the CMP, the more inexpensive (carrying less premium) it will be. On the contrary, if the strike level is closer to 1900, exactly at 1900 (if any), or even less than 1900 - it will be relatively more expensive (carrying higher premium). When the cash scrip price moves just a bit, Calls nearer to 1900 (or less) are likely to show much quicker movement (negative or positive), than those further away from 1900. So which strike level do we select for buying. Please see the following point.
4. You may be buying options in either a) a relative bullish scenario, b) an extreme bullish scenario, c) a bearish scenario, d) an extreme bearish scenario, or e) when the market is not showing much movement. Use the following general guidelines for a newbie options player :
Situation label >> recommended option action(example Reliance CMP 1900) :
a) Bullish scenario >>Buy & sell Calls about 1 or 2 notches above 1900 (strikes 1920, 1950)
b) Extreme bullish >>Buy & sell Calls even most distant from 1900 (Puts available very cheap)
c) Bearish scenario >>Just sit back, watch the movements and relax
d) Extreme bearish scenario >>Sell any Puts that you may have bought earlier (Calls available very cheap).
e) Range-bound market (limited, predictable movement) >>Just sit back, watch the movements and relax
Buy Calls at strike levels less than 1900 only if your budget permit. Such Calls carry higher premium. Calls & Puts are REVERSE instruments. -1900 Calls carry heavier premium, and +1900 Puts carry heavier premium too. The deeper inside 1900 the Calls, the heavier the premium, and the farther outside 1900 the Puts, the heavier the premium. For a more professional & safe approach, it pays to be armed with cheaply procured Calls & Puts - as father away from expiry as possible.
5. Don’t just proceed on a Call-buying spree straightaway. Study the Call pricing pattern (rise & decline vis-a-vis the level of indices, NIFTY, SENSEX) at least for a couple of days.
6. For a newbie, it would be safer to buy current month’s Calls any time between the 5th & 10th of the month. Any earlier, and you’ll find the Calls more expensive, and, any later, and you will find yourself perilously close to the month-end expiry (last Thursday of the month, by which date all Calls must be squared up, or, else, they expire automatically).
7. The day you proposed to buy Calls, try buying when the indices and the cash scrip CMP is closest to the lowest for the day. You will sure gain this proficiency by watching the Call/cash pattern for a couple of days.
8. VERY IMPORTANT : Never sell a Call, without having bought it first. Usually your trading software won’t permit you to sell a Call first, but, in case you have sufficient trading balance in your account, it may permit you to. So, please do guard against that. Selling Calls first makes you an option writer (see Terminology category). It may have grave implications if you become an option writer unintentionally.
9. Once you have bought your Calls, double-check the transaction in your trading account. Do ensure the chosen strike level, purchase price, the fact that the Call has indeed been bought and NOT sold first, as also the chosen validity month for the Call of your choice.
10. Don’t panic and sell your Call if you find its premium declining after your purchase. You still have about 10-15 days to exercise your selling OPTION !
11. Sell the Call(s) whenever you realize that the premium you’re getting is good enough for your liking. Don’t be too greedy. If you have purchased more than one Calls, it is usually better to sell in bits, rather than in one go.
12. Please note this VERY IMPORTANT point. If you bought Reliance 1920 strike level Calls at a premium of 30 when Reliance cash share price was just 1900, your total investment was 30 x 150 (shares per lot) x no. of lots purchased. You NEED NOT square off (sell your Calls) at or around expiry if the expected or real cash share price at that time is 1950 or more. Because this increase of 30 in the cash price now equals (and covers) your expenditure. Any more increase will be your profit. If by any chance the premium on your calls exceeds 50 (unlikely), do sell them off. Otherwise, just let your Calls expire, and you will automatically get Rs.50/- (new price 1950 minus old price 1900) x 150 x no. of lots purchased. However, if the cash share price at or around expiry is less than 1950, say 1935, then you need to weigh this against the prevalent premium of your Calls and act accordingly.
13. We strongly recommend that as a newbie you begin slowly, and play it small, safe and secure. Be happy with small & consistent profits. As you gain more exposure and begin to understand and appreciate the complex operatives of options, you will surely have your moments of BIG PROFITS … if, and only if, you carry a balanced head over your shoulders.
It is of utmost importance to know the intrinsic difference between ‘Buying of options‘ and ‘Selling of options‘.
Buying an option
When you buy a Call option or buy a Put option, your commitment to the contract is limited to the premium you pay. For example, if A buys a Call option of Nifty for Rs 50/-, and Nifty falls, the premium on the option will start falling in value , thereby resulting in a loss to A. Even if the Nifty falls by 100, the premium on the option cannot go below zero on to the negative side. Therefore, the loss incurred by A cannot be more than Rs 50/- (i.e.the initial premium paid). But if Nifty rises, the profits can be unlimited - as much as Nifty rises. For example, this month (June) we have seen Nifty Call 4500 rising from about Rs.40/- to about Rs.145/- in just about 7-10 days’ time.
Similarly when you buy a Put option, your commitment is limited to the initial premium paid. Taking a similar example, if A buys a Put option of Nifty for Rs 50/-, and Nifty rises, the value of the Put can decrease to zero but not into negative territory. The maximum loss incurred by A will be Rs 50/- (i.e.the initial premium paid). But if Nifty falls significantly, the profits can be unlimited - proportionately just as much as Nifty rises.
Selling an option
a) You can sell an option you have already bought to square up at a profit or loss. Your contract ends with no further liability.
b) You can be an initial seller of options. This is called short-selling or specifically as OPTION WRITING. This is almost like short-selling in intraday cash share trade, with the difference that you are not necessarily required to square off the transaction (by buying the Call back) during the same trading session. In fact you can square off the transaction any time up to the expiry date - depending upon as to when you’re able to realise your optimum profit.
What are the liabilities of an option writer ?
The option writer who sells Calls or Puts without having initially bought them faces a possibility of unlimited gains or unlimited loss depending on which way the index or scrip moves. When he sells an option, (Call or Put), the premium collected gets credited into his account. But, he has a responsibility to compensate the buyer of the option against any movement in favor of the buyer. For example, if he sells a Call option to A, and if the call premium moves up along with upward movement of the index or scrip, the benefit to A will be provided from the premium collected by the Option Writer. If he sells a Put option to B, and if the call premium moves up along with downward movement of the index or scrip, the benefit to B will be provided from the premium collected by the Option Writer. His liability exists till he squares up his position by buying back the Call or the Put.
To protect the buyer against default by the Option Writer, the latter has to pay a deposit to the Exchange for each option sold. This amounts to about 10% of the total value of the option (not just the premium, but the strike value x units per lot) for Nifty (about Rs 20000/- presently), but is considerably higher for individual scrips. The actual percentage is calculated depending on volatility and open interest position in the derivative. This may vary from day to day or week to week. The deposit is returned to the Option Writer once he has squared up his option (after adjustments for any loss or gain).
How does an option writer make money ?
The gains follow this formula : Selling premium minus buy back premium x units per lot x number of options.
This could be possible in any of the following situations :
a) By buying back if the option premium falls due to volatility of the scrip.b) If the scrip price remains stagnant, the option writer would gain by the inevitable time decay (see under Terminology category) that occurs as the expiry date approaches.
Usually option writers concentrate on large volumes and low profits per option, thereby ensuring consistent profits. Option writing using time-decay is a method of generating a monthly income from the markets as against investing or speculating - that is dependent only on scrip movements.