Option contractOptions Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.
Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.
Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame.
As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.
OPTIONS NOMENCLATUREOPTION HOLDER; OPTION WRITERThe option holder is the person who buys the right conveyed by the option.
EXAMPLE: The holder of a physical delivery XYZ call option has the right to purchase shares of XYZ Corporation stock at the specified exercise price upon exercise prior to the expiration of the option. The holder of a physical delivery XYZ put option has the right to sell shares of XYZ Corporation at the specified exercise price upon exercise prior to the expiration of the option. The holder of a cash-settled option has the right to receive an amount of cash equal to the cash settlement amount (described below) upon exercise prior to the expiration of the option.
The option writer is obligated, if and when assigned an exercise to perform according to the terms of the option. The option writer is sometimes referred to as the option seller. An option writer who has been assigned an exercise is known as an assigned writer.
EXAMPLE: If a physical delivery XYZ call option is exercised by the holder of the option, the assigned writer must deliver the required number of shares of XYZ common stock. He will be paid for the shares at the specified exercise price regardless of their current market price. If a physical delivery put option is exercised, the assigned writer must purchase the required number of shares at the specified exercise price regardless of their current market price. If a cash-settled option is exercised, the assigned writer must pay the cash settlement amount.
No certificates are issued to evidence options. Investors look to the confirmations and statements that they receive from their brokerage firms to confirm their positions as option holders or writers.
CASH SETTLEMENT AMOUNT, SETTLEMENT CURRENCY and EXERCISESETTLEMENT VALUEThe cash settlement amount is the amount of cash that the holder of a cash-settled option is entitled to receive upon exercise. It is the amount by which the exercise settlement value of the underlying interest of a cash-settled call exceeds the exercise price, or the amount by which the exercise price of a cash-settled put exceeds the exercise settlement value of the underlying interest, multiplied by the multiplier for the option.
EXAMPLE: Assume that a holder of a cash-settled call on the XYZ index that has an exercise rice of 80 exercises it when the exercise settlement value of the index is 85. If the multiplier for XYZ index options is 100, the assigned writer would be obligated to pay, and the exercising holder would be entitled to receive, a cash settlement amount of $500 ($85 minus $80 multiplied by 100=$500).
The currency in which the cash settlement amount is payable is called the settlement currency. The settlement currency for all cash-settled options with standardized terms that are trading at the date of this booklet is U.S. dollars. It is possible that another currency will be the settlement currency for some options introduced in the future.
The manner of determining the exercise settlement value for a particular option series is fixed by the options market on which the series is traded. The exercise settlement values for options on a particular underlying interest traded in one options market will not necessarily be determined in the same manner as the exercise settlement values for options or futures on the same underlying interest that may be traded in other markets.
Options markets may change the method of determining exercise settlement values for particular options series on specified days or on all days. These changes may be made applicable to series outstanding at the time the changes become effective. Alternatively, an options market might phase in a change in the method of determining exercise settlement values by opening new series of options identical to outstanding series in all respects other than the method for calculating exercise settlement values. Such new series would trade alongside the old series until both series expire, but the two series would not be interchangeable. In the future, options markets may, subject to regulatory approval, introduce options whose exercise settlement values may not exceed a specified maximum amount.
ADJUSTMENT and ADJUSTMENT PANELAdjustments may be made to some of the standardized terms of outstanding options upon the occurrence of certain events. Adjustments that may be made to a particular type of options are discussed in the chapter relating to that type. The determination of whether to adjust outstanding options in response to a particular event, and, if so, what the adjustment should be, is made by a majority vote of an adjustment panel. Every determination by an adjustment panel is within its sole discretion and is binding on all investors.
PREMIUMThe premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. It is the price set by the holder and writer, or their brokers, in a transaction in an options market where the option is traded. It is not a standardized term of the option. The premium does not constitute a "down-payment." It is simply and entirely a non-refundable payment in full-from the option holder to the option writer-for the rights conveyed by the option. The premium is not fixed by the options markets. Premiums are subject to continuous change in response to market and economic forces, including changes in the trading conditions on the markets where the particular options are traded. The factors which may generally affect the pricing of an option include such variables as the current value of the underlying interest and the relationship between that value and the exercise price, the current values of related interests (e.g., futures on the underlying interest or other interests related to the underlying interest), the style of the option, the individual estimates of market participants of the future volatility of the underlying interest, the historical volatility of the underlying interest, the amount of time remaining until expiration, cash dividends payable on the underlying stock (in the case of stock and stock index options), current interest rates, current currency exchange rates (in the cases of foreign currency options and options whose premiums or cash settlement amounts are payable in a foreign currency), the depth of the market for the option, the effect of supply and demand in the options market as well as in the markets for the underlying interest and for related interests, the information then available about current prices and operations in the markets for the underlying interest and related interests, the individual estimates of market participants of future developments that might affect any of the foregoing, and other factors generally affecting the prices or volatility of options, underlying interests, related interests or securities generally. Also see the discussion below of "Intrinsic Value and Time Value." Readers should not assume that options premiums will necessarily conform or correlate with any theoretical options pricing formula, chart, last sale, or the prices of the underlying interest, related interests or other options at any particular time.
The currency in which the premium is payable is called the premium currency. The premium currency for most options is U.S. dollars. However, the premium currency for cross-rate foreign currency options is a foreign currency, and other options with premiums payable in a foreign
currency may be introduced after the date of this booklet.
OPENING TRANSACTIONThis is a purchase or sale transaction by which a person establishes or increases a position as either the holder or the writer of an option.
CLOSING TRANSACTIONThis is a transaction in which, at some point prior to expiration, the option holder makes an offsetting sale of an identical option, or the option writer makes an offsetting purchase of an identical option. A closing transaction in an option reduces or cancels out an investor's previous position as the holder or the writer of that option.
EXAMPLE: In June an investor buys a December XYZ 50 call at an aggregate premium of $500. By September the market price of the option has increased to $700. To seek to realize his $200 profit, the investor can direct his broker to sell an offsetting December XYZ 50 call in a closing transaction. On the other hand, if by September the market price of the option has decreased to $300, the investor might still decide to sell the option in a closing transaction, thereby limiting his loss to $200.
POSITION LIMITSThe rules of the options markets generally limit the maximum number of options on the same side of the market (i.e., calls held plus puts written, or puts held plus calls written) with respect to a single underlying interest that may be carried in the accounts of a single investor or group of investors acting in concert. These limits which are called position limits-differ for options on different underlying interests. Information concerning the position limits for particular options is available from the options market on which those options are traded or from brokerage firms.
COMBINATIONS; SPREADS and STRADDLES Combination positions are positions in more than one option at the same time. Spreads and straddles are two types of combination positions. A spread involves being both the buyer and writer of the same type of option (puts or calls) on the same underlying interest, with the options having different exercise prices and/or expiration dates. A straddle consists of purchasing or writing both a put and a call on the same underlying interest, with the options having the same exercise price and expiration date.
LONG and SHORT The word long refers to a person's position as the holder of an option, and the word short refers to a person's position as the writer of an option.
COVERED CALL WRITERIf the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, he is said to be a covered call writer
EXAMPLE: An individual owns 100 shares of XYZ common stock. If he writes one physical delivery XYZ call option-giving the call holder the right to purchase 100 shares of the stock at a specified exercise price-this would be a covered call. If he writes two such XYZ calls, one would be covered and one would be uncovered.
The distinction between covered and uncovered call writing positions is important since uncovered call writing can involve substantially greater exposure to risk than covered call writing. A call option writer who is not a covered writer may hold another option in a spread position and thereby offset some or all of the risk of the option he has written. However, the spread may not offset all of the risk of the uncovered writing position. For example, if the long portion of the spread has a higher exercise price than the exercise price of the short, or if the long has an earlier expiration date than the expiration date of the short, then the writer may still be exposed to significant risks from his uncovered writing position.
AT THE MONEYThis term means that the current market value of the underlying interest is the same as the exercise price of the option.
IN THE MONEYA call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option. A put option is said to be in the money if the current market value of the underlying interest is below the exercise price of the option.
EXAMPLE: If the current market price of XYZ stock is $43, an XYZ 40 call would be in the money by $3.
OUT OF THE MONEYIf the exercise price of a call is above the current market value of the underlying interest, or if the exercise price of a put is below the current market value of the underlying interest, the option is said to be out of the money by that amount.
EXAMPLE: With the current market price of XYZ stock at $40, a call with an exercise price of $45 would be out of the money by $5 as would a put with an exercise price of $35.
INTRINSIC VALUE and TIME VALUEIt is sometimes useful to consider the premium of an option as consisting of two components: intrinsic value and time value. Intrinsic value reflects the amount, if any, by which an option is in the money. Time value is whatever the premium of the option is in addition to its intrinsic value. An American-style option may ordinarily be expected to trade for no less than its intrinsic value prior to its expiration, although occasionally an American-style option will trade at less than
its intrinsic value. Because European-style and capped options are not exercisable at all times, they are more likely than American-style options to trade at less than their intrinsic value when they are not exercisable.
EXAMPLE OF A CALL WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 40 call would have an intrinsic value of $6 a share. If the market price of the stock were to decline to $44, the intrinsic value of the call would be only $4. Should the price of the stock drop to $40 or below, the call would no longer have any intrinsic value.
EXAMPLE OF A PUT WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 50 put would have an intrinsic value of $4 a share. Were the market price of XYZ stock to increase to $50 or above, the put would no longer have any intrinsic value.
EXAMPLE OF TIME VALUE: At a time when the market price of XYZ stock is $40 a share, an XYZ 40 call may have a current market price of, say, $2 a share. This is entirely time value.
An option with intrinsic value may often have some time value as well-that is, the market price of the option may be greater than its intrinsic value. This could occur with an option of any style.
EXAMPLE: With the market price of XYZ stock at $45 a share, an XYZ 40 call may have a current market price of $6 a share, reflecting an intrinsic value of $5 a share and a time value of $1 a share.
An option's time value is influenced by several factors (as discussed above under "Premium"), including the length of time remaining until expiration. An option is a "wasting" asset; if it is not sold or exercised prior to its expiration, it will become worthless. As a consequence, all else remaining the same, the time value of an option usually decreases as the option approaches expiration, and this decrease accelerates as the time to expiration shortens. However, there may be occasions when the market price of an option may be lower than the market price of another
option that has less time remaining to expiration but that is similar in all other respects.
An American-style option's time value is also influenced by the amount the option is in the money or out of the money. An option normally has very little time value if it is substantially in the money. Although an option that is substantially out of the money has only time value, the amount of that time value is normally less than the time value of an option having the same underlying interest and expiration that is at the money.
Another factor influencing the time value of an option is the volatility of the underlying interest. All else being the same, options on more volatile interests command higher premiums than options on less volatile interests.
Time value is also influenced by the current cost of money. Increases in prevailing interest rates tend to cause higher premiums for calls and lower premiums for puts, and decreases in prevailing interest rates tend to cause lower premiums for calls and higher premiums for puts.
The following is a description of the terminology applicable to capped options:
CAP INTERVALThe cap interval is a constant established by the options market on which a series of capped options is traded. The exercise price for a capped-style option plus the cap interval (in the case of a call) or minus the cap interval (in the case of a put), equals the cap price for the option. For example, if a capped call option with an exercise price of 360 has a cap interval of 30, then the cap price at which the option will be automatically exercised would be 390.
CAP PRICEThe cap price is the level that the automatic exercise value of a capped option must reach in order for the option to be automatically exercised. The cap price of a call option is above, and of a put option below, the exercise price of the option.
EXAMPLE: A 360 ABC capped call index option has an exercise price of 360 and a cap interval of 30. The call option has a cap price of 390.
EXAMPLE: A 310 XYZ capped put index option has an exercise price of 310 and a cap interval of 20. The put option has a cap price of 290.
AUTOMATIC EXERCISE VALUEThe automatic exercise value of a capped option is the price or level of the underlying interest determined in a manner fixed by the options market on which the option is traded for each trading day as of a specified time of that day.
EXAMPLE: A 310 XYZ capped put index option has a cap interval of 20, and therefore has a cap price of 290. Assume that the options market on which the option is traded has specified the close of trading on each trading day as the time for determining the automatic exercise value on the XYZ index, and that the index level reaches a low of 289 during a particular trading day, but is at 291 at the close. The automatic exercise value has not reached the cap price, and the automatic exercise feature of the option is not triggered, because the index level was not at or below the cap price at the time of day specified by the options market for determining the automatic exercise value.
CASH SETTLEMENT AMOUNTThis is the cash amount that the holder of a cash-settled capped option is entitled to receive upon the exercise of the option. In the case of a capped option that has been automatically exercised, the cash settlement amount is equal to the cap interval times the multiplier for the option, even if the automatic exercise value on the day that the automatic exercise feature is triggered exceeds (in the case of a call) or is less than (in the case of a put) the cap price. If the capped option is voluntarily exercised at expiration, the cash settlement amount is determined in the same manner as for other styles of cash settled options.
EXAMPLE: A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100. The automatic exercise value of the ABC index is 396 on a particular trading day. The call option is automatically exercised, and the cash settlement amount is $3000 (equal to the cap interval of 30 times the multiplier of 100).
EXAMPLE: A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100. The automatic exercise value of the ABC index never equals or exceeds the cap price of 390 during the life of the option, and the exercise settlement value of the option is 367 on the final trading day. Upon exercise of the option, the holder is entitled to receive a cash settlement amount of $700 (equal to the multiplier of 100 times the difference between the exercise settlement value of 367 and the exercise price of 360).
