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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