Tuesday, February 26, 2013

Excellent Trading School - 27 - Frequently Asked Questions about Options Contracts - Part 3

Question: When is an option called in-the-money option?
Answer: Those options, which have certain intrinsic value, are called in the money, by virtue of the fact that they are holding some money right now.
For example, when SBI is quoting at Rs200, an SBI call option with Rs190 strike price is in the money because you have the right to buy at a price lower than the market price of the underlying. All those call options, which have their strike price lower than the spot price of the underlying are in the money.
Similarly when SBI is quoting at Rs200, an SBI put option with Rs210 strike price is in the money because you have the right to sell at a price higher than the spot price of the underlying. All those put options, which have their strike price higher than the spot price of the underlying are in the money.

Question: When is an option called out of the money?
Answer: Those options whose intrinsic value is zero are called out of the money, by virtue of the fact that they are not holding any money right now. For example, when SBI is quoting at Rs200, an SBI call option with Rs220 strike price is out of the money because you have the right to buy at higher price than the spot price of the underlying. All those call options which have their strike price higher than the spot price of the underlying are out of the money.
Similarly when SBI is quoting at Rs200, an SBI put option with Rs180 strike price is out of the money because you have the right to sell at a price lower than the spot price of the underlying. All those put options, which have their strike price lower than the spot price of the underlying are out of the money.

Question: When is an option called near or at the money?
Answer: Those options, which have their strike price closest to the spot price of the underlying are called near-the-money options because these options are due to get in or out of the money. The options whose strike price is the same as the spot price of the underlying are called at-the-money options.

Question: Are options permanently at, in or out of the money?
Answer: No. Options are not permanently in, at or out of the money. It is the movement of the spot price that makes the options in, at or out of the money. The same option which is in the money can become out of the money when the price moves adversely.

Question: How does settlement of the option take place on exercise/expiry?
Answer: Presently stock options are settled in cash. This means that when the buyer of the option exercises an option, he receives the difference between the spot price and the strike price in cash. The seller of the option pays this difference.

 It is expected that stock options would be settled by delivery of the underlying stock. This means that on exercise of a call option, a long position of the underlying stock effectively at the strike price would be transferred in the cash segment in the account of the buyer of the call option who has the right to buy. An opposite short position at effectively the strike price would be transferred in the cash segment in the account of the seller of the call option who has obligation to sell.

Similarly on exercise of a put option, a short position in the underlying stock effectively at the strike price would be transferred in the cash segment in the account of the buyer of the put option who has the right to sell. An opposite long position at effectively the strike price would be transferred in the cash segment in the account of the seller of the put option who has the obligation to buy.

Question: How is the seller chosen against whom the obligation is assigned?
Answer: When a buyer exercises his option, the exchange randomly selects a seller at client level and assigns the obligation against him. This process is called assignment. The seller of an option should be alert all the time as it is possible that an option could be assigned against him. Your broker would inform you about such an assignment.

Question: What can I do with the position so transferred in my account in the cash segment?
Answer: It totally depends upon you. You can square up your position or let it go for the settlement on T+2 days. You receive the shares on payment of money if you have long position. You receive money against delivery of shares if you have short position.

Question: What happens in case the buyer of an option forgets to exercise his option till expiry?
Answer: On the day of expiry if the option is in the money, the exchange automatically exercises it and pays the difference between the settlement/closing price and the strike price to the buyer. The seller of the option pays this difference.

Question: How does the time value vary for at-, in- and out-of-the-money
options?
Answer: The following graph shows how the premium of 30-day maturity, Rs260 strike price call option on Reliance varies with the movement of the spot price of Reliance. Study the price movement of the option carefully. You would find that the time value is the highest when the spot price is equal to the strike price, the option is at the money. As the spot price rises above the strike price, the option becomes in the money and its intrinsic value increases but its time value decreases. In the same way as the spot price falls below the strike price, the option becomes out of the money and its intrinsic value becomes zero while its time value decreases.

Question: How does option premium vary with maturity of the option?
Answer: The buyers of longer maturity options enjoy the right to longer duration and the sellers are subject to risk of price movement of the underlying during a longer term, since the price of both call and put options increases as the time to expiry increases.

Question: How does option premium vary with risk-free interest rate?
Answer: As the risk-free rate of interest increases, the price of call options increases and that of put options decreases and vice-versa.

Question: How does the price of an option vary with the movement of the spot price of the underlying?
Answer: As the spot price of the underlying rises, the value of the call option increases and that of put options decreases. As the spot price of the underlying falls, the price of the call option decreases and that of the put option increases.

Question: What happens to my position in the options contract when corporate announcements like dividend, bonus, stock split, rights etc are made?
Answer: Good question. In the event of such corporate announcements, the exchanges adjust the option positions such that the economical value of your position on the cum-benefit day and the ex-benefit day is the same.

Question: Please explain these adjustments with the help of some examples. What is the effect of dividend on options?
Answer: According to Sebi regulations, if the value of the declared dividend is more than 10% of the spot price of the underlying on the day of dividend announcement, on ex-dividend date the strike price of the options on a stock are reduced by the dividend amount. In case the declared dividend is lower than 10% of the spot price, then there is no adjustment for the dividend by the exchange and the market adjusts the price of options taking the dividend into consideration.

Suppose Reliance is trading at Rs260 and it announces a dividend of Rs30 per share. Since it is more than 10% of the prevailing market price, all the available strike price of Reliance options get reduced by Rs30 on ex-dividend date. The option with strike price of Rs260 stands at Rs230 and so on. If you are long on Reliance call 260. Your position on ex-dividend date would become long on Reliance call 230.

At the same time ACC is trading at Rs160 and it announces a dividend of Rs2 per share. Since it is lower than 10% of the underlying price, no change is made in the option contracts of ACC. The ACC option with a strike price of Rs160 on last cum-dividend date will remain as Rs160 strike price on ex-dividend date. The stock price reduces by the dividend amount on the ex-dividend date. This means the call option price decreases and the put option price increases on exdividend date. In reality the market adjusts the option price as soon as the dividend is announced.

Question: How does bonus affect my position in stock options?
Answer: The lot size and strike price of the stock option contract gets adjusted according to the bonus ratio. For example: if Infosys announces a bonus of 1:1, then the market lot of Infosys changes from 100 shares to 200 shares on ex- bonus day and the strike price of all the options on Infosys are reduced to half. Suppose you are short 100 Infosys put 4300, on ex-bonus day your position would become short 200 Infosys put 2150.
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