The structure of a futures contract eliminates counterparty/default risk. Instead, there is price risk to be aware of; exchanges aid in mitigating this by blocking margin when buyers and sellers enter into the trade, as well as running a daily mark to market process.
Margins ensure a stake in the endeavour, while the mark to market process ensures profits and losses accrued daily are appropriately credited/debited.
Having explained the technicalities of margins and mark to market in the futures module, I want to switch our focus back to options. Please keep these concepts in mind.
Visualize yourself as an options buyer. The cost of buying such options will be the rate of the premium multiplied by the lot size and the number of lots. Altogether, it will add up to the total amount which needs to be paid.
For example, if I want to buy one lot of Reliance 2500 Call option –
The call option is trading at 76, lot size is 250, therefore –
As long as I have 19K sitting in my account, I can purchase the RIL 2500 CE. Essentially, this is a cash and carry agreement, thus making it discernible that two facts are certain:
When you purchase either a call or put option, the risk is already established and does not continue indefinitely like with the purchase of futures. Additionally, it’s a cash transaction so there won’t be any worries of defaulting on payments.
Given that the risk of default is zero, it is illogical to block margins for an option buyer; this should be clear.
Do we need to tally up the daily profits and losses for the option buyer? We will answer that soon.
Consider the position of the person selling the option.
An option seller’s risk is much higher than an option buyer’s. It is comparable to that of a futures trader.
The risk of option selling is open-ended, and that introduces the risk of default as well.
Much like futures, options selling also carries a certain amount of default risk. Therefore, the exchange requires option sellers to pay a margin (SPAN + Exposure) to ensure that they are covered in the event of a loss.
For example, if I were to sell the RIL 2500 CE, the margin I need to bring to the table is Rs.1,36,530/-.
In contrast to a futures contract, no mark to market is necessary in options. This is because, when entering into a trade, only the seller must deposit margin, while the buyer fully pays the premium upfront.
A mark to market in options implies that notional gains or losses need to be credited or debited to the purchaser of the option, without any margins being placed on the exchange.
Hence there is no concept of mark to market (M2M) in options.
The lack of a mark to market raises a commonplace question: how are profits and losses determined for options?
Option P&L is relatively straightforward, and the absence of mark to market makes it simpler to comprehend when compared to grasping the Profit and Loss of futures.
The complexity of comprehending P&L implications arises from the various market situations related to the position at hand.
A trader has the choice to take a long or short position on a call option, with the potential profit and loss changing depending on whether they hold it up until expiry or close it earlier.
The same goes with the put option –
To be successful as an options trader, you must be able to accurately calculate the gain or loss in each situation.
Fortunately, we can use the same P&L for both long and short trades when we close before expiry.
At expiry, physical settlement comes into play, making it a bit complex to grasp.
The trader’s P&L can be estimated if they choose to close their position prior to the expiration date. This will hold true for both calls and puts traders.
P&L = [Difference between buying and selling price of premium] * Lot size * Number of lots.
If I purchase two lots of Reliance 2500 CE at 76 and then, a few hours later, sell them at 79, I have realized a profit.
= [ 79 – 76] * 250 * 2
= 3 * 250 * 2
Of course, 1500 minus all the applicable charges.
The P&L calculation is the same for long put options, squared off before expiry.
When a trader shorts an option, margins are blocked in accordance with SPAN and Exposure.
Margin charged is a function of premium price and the volatility of the underlying. Generally, margin increases if –
o The price of the option (premium) moves against your position
o Volatility increase
Both don’t need to happen; margins can increase even if one of them occurs.
Let’s take the example of the Reliance 2500 put option, with a lot size of 250. Writing this option means that, despite volatility remaining unchanged, the cost of premium rises to 130, resulting in an extra of 50 Rupees per unit and therefore a margin hike of Rs.12,500 (50*250).
When you write the option, volatility increases and the price stays constant. Moreover, margins go up. As discussed in the chapter about volatility, this usually leads to an increase in option premium.
In order to embark on a covered call writing strategy with Reliance 2500 CE at 76 per lot, a margin of Rs.1,36,530 needs to be invested. If the price subsequently escalates to 126, then the required margin will become substantially greater.
50 * 250
Therefore, the new margin required is –
= 136530 +12500
The broker will now alert parties to bring in extra margins (margin call) since the margin utilization rate is at –
Current margin / Margin at the time of writing the option
= 149030 / 136530
If you do not manage to bring in the extra margins, the agent can close your short position due to the fines put in place by the peak margin policy. Generally speaking, 120% is the limit for margin utilization, and if it goes beyond this limit, your broker will instantly close your position.
Continuing on with our example, as soon as the premium hits 126 and you no longer want to keep your position (by putting more money into your account), you can decide to close it.
The P&L is –
[Difference between the buy price and sell price of premium] * lot size * number of lots
= 50 * 250 * 1
Once the position is squared off, the margin will be released after taking account of any gain or loss. If you need to make a withdrawal, your profit and loss will be settled on a T+1 basis.
Now let’s shift focus to options trades held to expiry.
Options held to expiry that are In the Money (ITM) will be physically settled. However, if the option is Out of the Money (OTM), then the buyer forfeits their premium and the seller retains it.
In this chapter, we have examined physical settlement in detail; for the sake of providing a thorough overview, let us now quickly discuss only the P&L element.
Figuring out the P&L for a long call position until it matures can be a little complicated, since the stock options are physically settled.
Continuing with the example, assuming Reliance settles at 2650 on expiry, the 2500 call option is In the money (ITM), meaning it must be physically settled. This gives the option buyer the right to purchase Reliance at the strike price of 2500 and they have paid a premium of 76 in doing so.
The effective price at which you get the shares is strike price + premium paid. In this case,
2500 + 76
Assuming the stock price on Monday is 2650, the profit you’ll make here is –
2650 – 2576
As you are aware, derivatives expire on the last Thursday of every month and shares are then delivered two business days later, typically falling on the Monday.
The option seller, in this instance, dispenses their 2500 CE at 76 and must supply the relevant number of shares. However, they benefit from a premium of 76, thereby reducing the effective price.
2500 + 76
The stock is trading at 2650, but the seller sells the same at 2576. The loss for the option writer is –
2650 – 2576
The shares will be debited from the seller’s Demat account and credited to the buyer’s Demat account.
Let us change the example from Reliance to TCS, to break the monotony
Here are the trade details –
Underlying = TCS
Strike = 3520
Premium = 55
Option type = Put
Position = long
Settlement price = 3390
Since the settlement price is 3390, 3520 is an ‘In the Money’ (ITM) option that requires a physical delivery. Therefore, the buyer of a put option will have the right to either sell it or hand over the underlying asset.
The put option buyer will pay a premium and deliver shares at 3520. The effective cost of that delivery is thus, higher.
Strike – Premium
= 3520 – 55
The put seller gets to sell the stock at 3465 when the same stock is trading at 3390. The gain here is –
3465 – 3390
The put option seller has to accept delivery of the shares at the settlement price, in this case 3390. However, they have been rewarded with a premium which brings down the effective cost of taking delivery to –
Strike – premium
= 3520 – 55
The put option seller has to accept delivery of the shares at a cost of 3465, whereas the market rate for the underlying is 3390 – resulting in a loss of 75.
Of course, if you have two ITM options in opposite positions, physical settlement of these options is net off. An example of this could be a spread position; one option with a ‘give delivery’ obligation and another option with a ‘take delivery’ obligation. I recommend reading this chapter to gain better understanding of position offsets.