Options Terms Key Options Trading Definitions

We’ve gone over the idea of an Option Premium a few times already, so by now you’re likely well-versed. To recap, Premium is the payment from the option buyer to the option seller/writer for the right to either buy or sell (depending on what kind of option it is) at the strike price after expiry.

As you continue through this module, it’ll become clear why the whole of option theory is hinged upon option premiums. 

We shall take a second look at the Rahul-Arjun case we discussed in the preceding chapter. 

Let us contemplate the conditions under which Rahul agreed to accept Arjun’s premium of Rs.150,000/-.

1. Rumours about the highway project were rampant, yet there was no certainty as to whether it would actually be constructed.

It’s clear that Arjun has the advantage here; two of the three possible scenarios discussed in the previous chapter were in his favour. Furthermore, since the news about the highway is only speculative, there’s even more reason to believe he could benefit from it.

2.           Six months were allotted to figure out if the project would come to fruition. Within that period of time, it was determined whether success was achievable or not.

This point clearly favours Rahul. With an increased amount of time, the likelihood that he will benefit from the event rises significantly. To illustrate this further – if you were asked to run 10 kilometres, in which timeframe would it be most likely for you to succeed: 30 minutes or 90 minutes? Longer durations increase the probability of success.

We will now look at each of these factors objectively and see what effect they have on the option premium. When Rahul and Arjun’s deal was finalised, the speculation was such that Arjun gladly accepted the Rs.150,000/- bonus under the assumption that there was more to this news than mere rumour though, perhaps a local politician hinted in a press conference about a potential highway passing through the area. This transforms it from being just hearsay to having some plausibility – although still subject to uncertainty.

Considering the potential of the land, Arjun may not take Rs.150,000/- as a premium. He is willing to accept a risk, though, if the offer presented is more appealing. A premium of Rs.200,000/- could make the agreement more attractive to him.

Let’s look at this from a stock market point of view. If TCS is at Rs.3000/- currently, then the 3100 Call option with a 1-month expiry would be priced at Rs.30/-. For Arjun (the option writer), would it make sense to enter into such an agreement in exchange for only Rs.30/- per share as a premium?

By entering into this options agreement, you are granting the buyer the right to purchase TCS option at Rs. 3100 one month from today.

Assume for the upcoming month, there is no possible corporate action that will cause TCS’ share price to increase. In that case, you could accept the Rs.30/- premium.

What if there is a corporate event, such as reporting quarterly results, which could lead to a stock price increase? Accepting Rs.30/- as the premium for the agreement may not be worth the risk.

Although the planned gathering is not too pricey, someone may be willing to provide Rs.100/- as opposed to the typical Rs.30/-. Taking advantage of this opportunity might be the better choice despite any potential risks that may come with it.

Let us put this discussion to the back of our minds and now turn our attention to the second point, which is ‘time’.

When Rahul initially had 6 months, he knew the dust would eventually settle, and the truth would be revealed regarding the highway project. But what if he only had 15 days? There wouldn’t be enough time for things to come to light, not leaving him with much of an incentive to pay Arjun’s Rs 150,000 premium. In this case, Rahul may opt for a lesser sum, such as Rs 50,000.

What I’m trying to say is that when it comes to premiums, they’re not always fixed. They can be affected by several factors – some make them go up, others lower them. We call these five factors the Option Greeks and will be getting into them in more detail later on in this module.

Option premium is defined as the amount paid 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.

1. Option Theory is dependent on 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 taken in these ideas, you’re certainly heading in the right direction.

Options Settlement

This Call Option, allows you to buy PA Associates at Rs.30/-, expiring on 26th March 2022. The premium is highlighted in red, and the market lot is 10,000 shares.

Let’s assume two traders, ‘Trader A’ and ‘Trader B’. If Trader A desires to be an option buyer, and Trader B is happy to write the agreement for a contract of 10,000 shares, the subsequent cash flow would look like this:

Since the premium is Rs.2.50/- per share, Trader A is required to pay a total of:

= 10,000 * 2.50

= Rs.25,000/- as the premium amount to Trader B.

Trader B must sell Trader A 10,000 shares of PA Associates if he decides to exercise his agreement on 26th March 2022. It is important to remember that options are cash-settled in India. Thus on that date, all that would be required is for Trader B to pay the cash differential to Trader A instead of having the shares.

On 26th March 2022, AP Associates is trading at Rs.35/-, providing the option buyer (Trader A) with the right to purchase 10,000 shares of AP Associates at Rs.30/-. Effectively, they are able to buy AP Associates at Rs.30/- while it is available on the open market for Rs.35/-.

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

• On 26th March 2022, Trader A exercises his right to buy 10,000 shares from Trader B.
• The predetermined transaction price is set at Rs.30, known as the strike price.
• Trader A pays Rs.300,000/- (10,000 * 30) to Trader B.
• Against this payment, Trader B releases 10,000 shares at Rs.30 to Trader A.
• Trader A promptly sells these shares in the open market at a rate of Rs.35 per share, resulting in a total of Rs.350,000/- received.
• Trader A makes a profit of Rs.50,000/- (350,000 – 300,000) on this transaction.

Trader A stands to gain Rs.5/- per share (35-30), which will be cash-settled instead of giving the option buyer 10,000 shares. Meaning that the option seller directly provides Trader A with the money equivalent of the profit he would have made.

= 5*10,000

= Rs.50,000/- from Trader B.

The option buyer spent Rs.25,000/- to acquire the right to benefit from this investment opportunity, thus making their real profits –

= 50,000 – 25,000

= Rs.25,000/-

In fact, when considering the percentage return, this results in a substantial gain of 100% (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.