An Option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a fixed price on or before a specified date. It's a key tool for managing risk and speculating on future price movements.
Two main types of options exist:
Call Option (CE): Gives the buyer the right to buy an asset.
Put Option (PE): Gives the buyer the right to sell an asset.
The option buyer pays a premium (the cost of the option) for this right. The option seller, or writer, receives this premium but has the obligation to fulfill the contract if the buyer chooses to exercise their right.
🔑 Think of insurance: The buyer pays a small, fixed premium and is protected from large price movements, while the seller receives the premium in exchange for bearing the risk.
4.2 Contract Specifications
Like futures, options have standardized terms defined by the exchange:
Underlying Asset: The stock or index on which the option is based.
Lot Size: The minimum number of units that can be traded in a single contract.
Strike Price: The pre-determined, fixed price at which the underlying asset can be bought or sold.
Expiry Date: The date on which the option contract expires. For NSE, this is the last Thursday of the month.
Premium: The price paid by the option buyer to the seller.
4.3 Moneyness of an Option
"Moneyness" describes an option's relationship between its strike price and the current market (spot) price of the underlying asset.
In the Money (ITM): The option has intrinsic value.
Call Option: Spot Price > Strike Price
Put Option: Spot Price < Strike Price
At the Money (ATM): The option's strike price is equal to the spot price.
Both Call & Put: Spot Price = Strike Price
Out of the Money (OTM): The option has no intrinsic value.
Call Option: Spot Price < Strike Price
Put Option: Spot Price > Strike Price
4.4 Intrinsic Value & Time Value
Intrinsic Value (IV): The value an option has if it were exercised immediately. This value is always non-negative.
Call IV: Max(0, Spot - Strike)
Put IV: Max(0, Strike - Spot)
Time Value (TV): The portion of the premium that is not intrinsic value. It's the value an option has based on the time remaining until expiry and the volatility of the underlying asset.
TV: Option Premium - Intrinsic Value
📈 Time value is highest when there is more time until expiry and when volatility is high. It decays to zero at expiry.
4.5 Payoff Charts for Options
Options have non-linear payoffs, meaning the relationship between the underlying price and the profit/loss is not a straight line. The potential for profit or loss is asymmetric for the buyer and seller.
Long Call (Buy Call): Limited loss (max premium paid), unlimited profit potential.
Short Call (Sell Call): Limited profit (max premium received), unlimited loss potential.
Long Put (Buy Put): Limited loss (max premium paid), profit rises as the underlying price falls.
Short Put (Sell Put): Limited profit (max premium received), potential for large losses if the underlying price falls significantly.
📊 The payoff profile for options is asymmetric, unlike the linear payoff of futures contracts.
4.6 Futures vs Options (Quick Comparison)
Feature
Futures
Options
Obligation
Both parties obliged
Buyer has right, seller has obligation
Payoff
Linear
Non-linear
Margin
Both pay margin
Buyer pays premium, seller pays margin
Risk
Unlimited (both sides)
Buyer’s risk limited to premium
4.7 Basics of Option Pricing & Greeks
An option's price is determined by its intrinsic value and its time value. The price of an option is influenced by a number of factors, including the underlying asset's price, volatility, and time to expiry.
Greeks are a set of risk measures that help traders understand how an option's price is affected by changes in various market variables:
Delta (Δ): Measures the sensitivity of the option's price to a change in the underlying asset's price.
Gamma (Γ): Measures the sensitivity of Delta. It indicates how much Delta will change for a one-point move in the underlying asset.
Theta (Θ): Measures the rate of time decay. It tells you how much the option's price will decrease as one day passes, all other factors being equal.
Vega (ν): Measures the sensitivity of the option's price to a change in the underlying asset's volatility.
Rho (ρ): Measures the sensitivity of the option's price to a change in interest rates.
4.8 Option Pricing Models
The Black-Scholes Model (BSM) is the most common model used to calculate the theoretical price of European-style options. The key inputs for the model are:
Current Spot Price
Strike Price
Time to Expiry
Volatility
Risk-free Interest Rate
Dividends
4.9 Implied Volatility
Implied Volatility (IV) is the market's forecast of a likely movement in the underlying asset's price. It is derived from the option's premium in the market. A higher IV suggests that the market expects larger price swings and, as a result, the option will be more expensive.
4.10 Buyer vs Seller Perspectives
Buyer: Pays a premium, has a limited risk (max loss is the premium), and potential for unlimited gain.
Seller (Writer): Receives a premium, has a limited gain (max profit is the premium), and carries a high risk of unlimited loss.
✅ Key Takeaways
Options give the buyer the right but not the obligation.
Call is the right to buy; Put is the right to sell.
The buyer has limited risk (to the premium paid); the seller has high risk.
Payoffs for options are asymmetric and non-linear.
Moneyness (ITM, ATM, OTM) is crucial for understanding an option's value.
An option's price is a sum of its Intrinsic Value and Time Value.
Greeks like Delta, Gamma, and Theta measure an option's sensitivity to risk factors.
The Black-Scholes Model is a key pricing tool for options.