Learn basics of option contracts: Microsec

The previous two sessions on “Knowledge Center: Learning Derivatives” explained the concepts of Future & Option contracts. This session elaborates further on Option contracts. An option contract is a contract which gives one party the right to buy or sell the underlying asset on a future date at a pre-determined price (called the strike price). The option which gives the right to BUY is called the CALL option while the option which gives the right to SELL is called the PUT option.

Call Options:  Let us take an example of ITC, whose lot size is say 1000 and the current market price is Rs 248. Suppose Mr X buys 1 lot of ITC July 250 Call option at Rs 5 (meaning that he has the right to buy 1000 shares of ITC on 26th July 2012 at a price of Rs 250). On the other hand, Mr Y sells 1 lot of ITC July 250 Call option at Rs 5 (meaning that he is obliged to sell 1000 shares of ITC on the expiry date at a price of Rs 250 if the closing price on expiry is above Rs 250).

Put Options: Let us take an example of ITC, whose lot size is say 1000 and the current market price is Rs 250. Suppose Mr S buys 1 lot of ITC July 240 Put option at Rs 2 (meaning that he has the right to sell 1000 shares of ITC on 26th July 2012 at a price of Rs 240). On the other hand, Mr T sells 1 lot of ITC July 240 Put option at Rs 2 (meaning that he is obliged to buy 1000 shares of ITC on the expiry date at a price of Rs 240 if the closing price on expiry is below Rs 240).

Pricing of Option contracts:
Accurate pricing of option contracts is a much complex issue in comparison to pricing of future contracts (which depend on risk-free interest rate, dividends and time to expiry). However, there are six factors that determine the amount of premium at which an option contract trades. Remember that the price of an option contract is the market determined premium at which the trade takes place.

The following are the factors that determine the premium of an option contract:

1. Spot Price: Higher the spot price of the underlying, higher would be the price of a call option, all other things remaining constant. Similarly, lower the spot price, lower would be the price of a call option. In our example (Mr X & Mr Y), if the current market price was 255 instead of 248, the premium would have been higher than Rs 5 (all other factors remaining constant). In the case of a put option, lower the spot price, higher would be the premium. In our example of Mr S & Mr T, had the spot price been Rs 238 instead of Rs 242, the premium would have been higher than Rs 2.

2. Strike Price: Higher the strike price of a call option, lower would be the premium and vice-versa. If the premium of ITC July 250 Call option is Rs 5, the premium of ITC July 260 call option would be lower than Rs 5. In the case of put option, higher strike price would command a higher premium. If the premium on ITC July 240 Put option is Rs 2, the premium on ITC July 250 Put option would definitely be higher than Rs 2 (assuming all other factors remaining the same).

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3. Time to Maturity: Higher the time to maturity, higher would be the premium on both call and put options. This is because the buyer of the option gets the right to buy or sell the underlying for a greater duration of time. Hence, the premium on ITC August 250 Call option would be higher than Rs 5 and the premium on ITC August 240 Put option would be higher than Rs 2.

4. Dividends: Dividends impact the price of option contracts because dividends reduce the spot price on the day the stock goes ex. However, the derivative contract holders are not entitled to any dividends and hence the F&O market adjusts the prices of the contracts to adjust for dividends that are already declared or that could be declared in the underlying asset. Consequently, the price of a Call option would be lower if there is dividend in the underlying asset. The price of a Put option would be higher if there is dividend in the underlying asset. In our example, if there was dividend of Rs 4 on ITC and the ex-date was 18th July 2012, the premium on the July 250 Call option would have been lower than Rs 5 and that of the July 240 Put option would have been higher than Rs 2.

5. Risk Free rate: An increase in interest rates drive up call premiums and cause put premiums to decrease. However, the impact of change in risk free rate on option prices is relatively less significant.

6. Volatility: Volatility is one of the most important factors in determining the option premiums. Also, all the other factors are generally determinable but how volatile the prices of underlying asset might remain in future is not easily determinable. One thing is certain though - Higher the volatility, higher would be the premiums of both the call and put options. Volatility is of two types - Historical volatility and Implied volatility. Historical or realized volatility is calculated by determining the average deviation from the average price of the underlying asset. On the other hand, implied volatility is the perceived volatility that is derived from the actual market premiums of the option contracts.

What is Speculation/Hedging/Arbitrage?

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