Options Terms Key Options Trading Definitions

Option Premium

We’ve explored the Option Premium concept repeatedly, so you’re likely familiar with it by now. To summarise, the Premium represents the payment from the option buyer to the option seller/writer for the entitlement to either purchase or sell (depending upon the option type) at the strike price following expiry.

As you progress through this module, it’ll become evident why the entirety of option theory revolves around option premiums.

Let’s revisit the Vikram-Suresh case we examined in the preceding chapter.

Consider the circumstances under which Suresh agreed to accept Vikram’s premium of Rs 1,75,000.

1. Speculation about the motorway project circulated widely, yet no certainty existed regarding whether construction would actually proceed.

Clearly, Vikram holds the advantage here; two of the three possible scenarios discussed in the previous chapter favoured him. Furthermore, since the motorway news remains purely speculative, there’s even greater reason to believe he could benefit from it.

2. Six months were allocated to determine whether the project would materialise. Within that timeframe, it was established whether success was achievable or not.

This point clearly favours Suresh. With an extended duration, the likelihood that he will benefit from the event increases significantly. To illustrate further., if you were asked to run 12 kilometres, in which timeframe would success be most probable: 35 minutes or 100 minutes? Longer durations enhance the probability of success.

We shall now examine each of these factors objectively and observe their effect on the option premium. When Vikram and Suresh’s agreement was finalised, the speculation was such that Vikram gladly accepted the Rs 1,75,000 premium under the assumption that more substance existed beyond mere rumour, perhaps a regional politician hinted during a press conference about a potential motorway passing through the area. This transforms it from being just hearsay to having some plausibility, although still subject to uncertainty.

Considering the property’s potential, Vikram may not accept Rs 1,75,000 as a premium. He is willing to accept risk, though, if the offer presented is more appealing. A premium of Rs 2,50,000 could make the agreement more attractive to him.

Let’s examine this from a stock market perspective. If Infosys trades at Rs 1,400 currently, then the 1,450 Call option with a one-month expiry would be priced at Rs 35. For Vikram (the option writer), would it make sense to enter into such an agreement in exchange for only Rs 35 per share as a premium?

By entering this options agreement, you are granting the buyer the entitlement to purchase Infosys at Rs 1,450 one month from today.

Assume for the forthcoming month, no potential corporate action exists that will cause Infosys’ share price to increase. In that case, you could accept the Rs 35 premium.

What if a corporate event occurs, such as declaring quarterly results, which could lead to equity price appreciation? Accepting Rs 35 as the premium for the agreement may not justify the risk.

Although the proposed arrangement isn’t too costly, someone may be willing to provide Rs 120 as opposed to the typical Rs 35. Taking advantage of this opportunity might be the superior choice despite any potential risks that may accompany it.

Let us set this discussion aside and now turn our attention to the second point, which is ‘time’.

When Suresh initially had six months, he knew the uncertainty would eventually resolve, and the truth would be revealed regarding the motorway project. But what if he only had 18 days? There wouldn’t be sufficient time for things to come to light, not leaving him with much incentive to pay Vikram’s Rs 1,75,000 premium. In this case, Suresh may opt for a lesser sum, such as Rs 65,000.

What I’m attempting to convey is that premiums aren’t always fixed. They can be influenced by several factors, some make them increase, others lower them. We call these five factors the Option Greeks and will be examining them in greater detail later in this module.

Option premium is defined as the amount remitted by the buyer to purchase the option from the seller. You should recall and consider that option premium is a cost that must be added to benefit from its advantages.

Key Points:

1. Option Theory depends upon the notion of premium
2. The cost of a premium is never static; instead, it fluctuates according to various factors
3. Premiums in real markets fluctuate frequently, often changing on a minute-by-minute basis

If you’ve absorbed these ideas, you’re certainly heading in the right direction.

Options Settlement

This Call Option, as highlighted in green, allows you to buy MN Enterprises at Rs 45, expiring on 28th March 2024. The premium is highlighted in red at Rs 3.20, and the market lot is 8,000 shares.

Let’s assume two traders, ‘Trader X’ and ‘Trader Y’. If Trader X desires to be an option buyer, and Trader Y is happy to write the agreement for a contract of 8,000 shares, the subsequent cash flow would look like this:

Since the premium is Rs 3.20 per share, Trader X is required to pay a total of: = 8,000 × 3.20 = Rs 25,600 as the premium amount to Trader Y.

Trader Y must sell Trader X 8,000 shares of MN Enterprises if he decides to exercise his agreement on 28th March 2024. It is important to remember that options are cash-settled in India. Thus on that date, all that would be required is for Trader Y to pay the cash differential to Trader X instead of transferring the shares.

On 28th March 2024, MN Enterprises is trading at Rs 52, providing the option buyer (Trader X) with the right to purchase 8,000 shares of MN Enterprises at Rs 45. Effectively, they are able to buy MN Enterprises at Rs 45 whilst it is available on the open market for Rs 52.

Typically, the cash flow should appear in the following manner:

• On 28th March 2024, Trader X exercises his right to buy 8,000 shares from Trader Y
• The predetermined transaction price is set at Rs 45, known as the strike price
• Trader X pays Rs 3,60,000 (8,000 × 45) to Trader Y
• Against this payment, Trader Y releases 8,000 shares at Rs 45 to Trader X
• Trader X promptly sells these shares in the open market at a rate of Rs 52 per share, resulting in a total of Rs 4,16,000 received
• Trader X makes a profit of Rs 56,000 (4,16,000 – 3,60,000) on this transaction

Trader X stands to gain Rs 7 per share (52-45), which will be cash-settled instead of giving the option buyer 8,000 shares. Meaning that the option seller directly provides Trader X with the money equivalent of the profit he would have made. = 7 × 8,000 = Rs 56,000 from Trader Y.

The option buyer spent Rs 25,600 to acquire the right to benefit from this investment opportunity, thus making their real profits: = 56,000 – 25,600 = Rs 30,400

In fact, when considering the percentage return, this results in a substantial gain of approximately 119% (without annualising).

Options are immensely popular with traders because of the opportunity to make large asymmetric returns. This is why they’re a highly desirable trading instrument.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding premium dynamics and settlement mechanisms proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, options contracts offer sophisticated mechanisms for capitalising on market movements.

Visit https://stoxbox.in/ for comprehensive educational resources on options premium valuation and settlement procedures.