Tuesday, February 26, 2013

Excellent Trading School - 25 - Frequently Asked Questions about Options Contracts - Part 1

Question: What is a strike price or exercise price in a option ?
Answer: The price at which you have the right to buy or sell is called the strike price. In the examples given above, the price of Rs250 per share in case of Hindustan Lever is  called strike price or exercise price.

Question: Who decides the strike price?
Answer: The exchanges decide the strike price at which call and put options are traded. Generally to simplify matters, the exchanges specify the strike price interval for different levels of underling prices, meaning the difference between one strike price and the next strike price over and below it.
For example, the strike price interval for Nifty is 100. This means that there would be strike prices available with an interval of Rs10. Typically you can see options on Nifty  with strike prices of 4700, 4800, 4900, 5000, 5100, 5200, 5300, 5400 etc.

Question: What happens when the underlying price moves up or down and I want to buy an option with a strike price that is not available on screen?
Answer: As the price of underlying moves up or down, the exchanges introduce more strike prices in keeping with the strike price interval rules. At any point in time, there are at least five strike prices (one near the stock price, two above the stock price and two below the stock price) available for trading in one-, two- and three-month contracts. Only incase of a very big move strike prices may not be available on an intra-day basis, as they are introduced at the end of the day for next day trading.

Question: How can I buy call and put options?
Answer: Call and put options are traded on-line on the trading screens of the National Stock Exchange and Bombay Stock Exchange like any other securities.

Question: Who fixes the price of call and put options?
Answer: The price of options is decided between the buyers and sellers on the trading screens of the exchanges in a transparent manner. You can see the best five orders by price and quantity. You can place market, limit and stop loss order etc. You can modify or delete your pending orders. The whole process is similar to that of trading in shares.

Question: Do I have to wait till expiry once I buy or sell an option or can I square up my position?
Answer: You are not compelled to wait till expiry of the option once you have bought or sold an option. Instead you can buy an option and square up the position by selling the identical option (same expiry and same strike) at any time before the contract expires. You can sell an option and square up the position by buying an identical option. You can buy first and sell later or you can initiate your position by selling and then buying—there is no restriction on direction. The difference between the selling and buying prices is your profit/loss. The process is similar to that of trading in shares.

Question: What are American style options? Is it possible for the buyer of such options to exercise his option before expiry?
Answer: Ideally the buyer should find a seller in the market to square up his long position, as he would get a better value for his option. However if a seller is not available, he can exercise his option at the end of the trading session. To exercise an option, call your broker before the exercise timings specified by the exchange. Option contracts which can be exercised on or before the expiry are called American options. All stock option contracts are American style.

Question: What are European style options? Is it possible for the buyer of an index option to exercise his option before expiry?
Answer: The options on Nifty and Sensex are European style options—meaning that buyer of these options can exercise his options only on the expiry day. He cannot exercise them before expiry of the contract as is the case with options on stocks. As such the buyer of index options needs to square up his position to get out of the market.
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