Professional Documents
Culture Documents
Var 1
Var 1
The options market makes up for a significant part of the derivative market, particularly in India. I would not be
exaggerating if I were to say that nearly 80% of the derivatives traded are options and the rest is attributable to
the futures market. Internationally, the option market has been around for a while now, here is a quick
background on the same -
• Custom options were available as Over the Counter (OTC) since the 1920's. These options were mainly
on commodities
• Options on equities began trading on the Chicago Board Options Exchange (CBOE) in 1972
https://zerodha.com/varsity/chapter/call-option-basics/ 1/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
• Options on currencies and bonds began in late 1970s. These were again OTC trades
• Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982
• Interest rate options began trading on the CME in 1985
Clearly the international markets have evolved a great deal since the OTC days. However in India from the time
of inception, the options market was facilitated by the exchanges. However options were available in the off
market ' Badla' system. Think of the 'badla system' as a grey market for derivatives transactions. The badla
system no longer exists, it has become obsolete. Here is a quick recap of the history of the Indian derivative
markets-
Though the options market has been around since 2001, the real liquidity in the Indian index options was seen
only in 2006 ! I remember trading options around that time, the spreads were high and getting fills was a big
deal. However in 2006, the Ambani brothers formally split up and their respective companies were listed as
separate entities, thereby unlocking the value to the shareholders. In my opinion this particular corporate event
triggered vibrancy in the Indian markets, creating some serious liquidity. However if you were to compare the
liquidity in Indian stock options with the international markets, we still have a long way to catch up.
Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to
buy 1 acre of land that Venu owns. The land is valued at Rs.500,000/-. Ajay has been informed that in the next 6
months, a new highway project is likely to be sanctioned near the land that Venu owns. If the highway indeed
comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment
he would make today. However if the 'highway news' turns out to be a rumor- which means Ajay buys the land
from Venu today and there is no highway tomorrow, then Ajay would be stuck with a useless piece ofland!
https://zerodha.com/varsity/chapter/call-option-basics/ 2/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the
land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay
is willing to buy.
Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured
arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as
follows-
1. Ajay pays an upfront fee ofRs.100,000/- today. Consider this as a non refundable agreement fees that
Ajay pays
2. Against this fees, Venu agrees to sell the land after 6 months to Ajay
3. The price of the sale( which is expected 6 months later) is fixed today at Rs.500,000/-
4. Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6 months (ifhe wants to
that is), Venu cannot
5. In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the upfront fees
So what do you think about this special agreement? Who do you think is smarter here - Is it Ajay for proposing
such a tricky agreement or Venu for accepting such an agreement? Well, the answer to these questions is not
easy to answer, unless you analyze the details of the agreement thoroughly. I would suggest you read through the
example carefully (it also forms the basis to understand options)-Ajay has plotted an extremely clever deal
here! In fact this deal has many faces to it.
• By paying an agreement fee ofRs.100,000/-, Ajay is binding Venu into an obligation. He is forcing Venu
to lock the land for him for the next 6 months
• Ajay is fixing the sale price of the land based on today's price i.e Rs.500,000/- which means irrespective
of what the price would be 6 months later he gets to buy the land at today's price. Do note, he is fixing a
price and paying an additional Rs. I 00,000/- today
• At the end of the 6 months, if Ajay does not want to buy the land he has the right to say 'no' to Venu, but
since Venu has taken the agreement fee from Ajay, Venu will not be in a position to say no to Ajay
• The agreement fee is non negotiable, non refundable
Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what
would actually happen. Clearly, the price of the land will vary based on the outcome of the 'highway project'.
However irrespective of what happens to the highway, there are only three possible outcomes -
1. Once the highway project comes up, the price of the land would go up, say it shoots up to Rs.10,00,000/-
2. The highway project does not come up, people are disappointed, the land price collapses, say to
Rs.300,000/-
3. Nothing happens, price stays flat at Rs.500,000/-
I'm certain there could be no other possible outcomes that can occur apart from the three mentioned above.
We will now step into Ajay's shoes and think through what he would do in each of the above situations.
Since the highway project has come up as per Ajay's expectation, the land price has also increased. Remember
as per the agreement, Ajay has the right to call off the deal at the end of 6 months. Now, with the increase in the
land price, do you think Ajay will call off the deal? Not really, because the dynamics of the sale are in Ajay's
favor-
https://zerodha.com/varsity/chapter/call-option-basics/ 3/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
This means Ajay now enjoys the right to buy a piece ofland at Rs.500,000/- when in the open market the same
land is selling at a much higher value of-Rs.I0,00,000/-. Clearly Ajay is making a steal deal here. Hence he
would go ahead and demand Venu to sell him the land. Venu is obligated to sell him the land at a lesser value,
simply because he had accepted Rs.100,000/- agreement fees from Ajay 6 months earlier.
Another way to look at this is- For an initial cash commitment ofRs.100,000/- Ajay is now making 4 times the
money! Venu even though very clearly knows that the value of the land is much higher in the open market, is
forced to sell it at a much lower price to Ajay. The profit that Ajay makes (Rs.400,000/-) is exactly the notional
loss that Venu would incur.
It turns out that the highway project was just a rumour, and nothing really is expected to come out of the whole
thing. People are disappointed and hence there is a sudden rush to sell out the land. As a result, the price of the
land goes down to Rs.300,000/-.
So what do you think Ajay will do now? Clearly it does not make sense to buy the land, hence he would walk
away from the deal. Here is the math that explains why it does not make sense to buy the land -
Remember the sale price is fixed at Rs.500,000/-, 6 months ago. Hence if Ajay has to buy the land he has to
shell out Rs.500,000/- plus he had paid Rs.100,000/- towards the agreement fees. Which means he is in effect
paying Rs.600,000/- to buy a piece ofland worth just Rs.300,000/-. Clearly this would not make sense to Ajay,
since he has the right to call of the deal, he would simply walk away from it and would not buy the land.
However do note, as per the agreement Ajay has to let go ofRs.100,000/-, which Venu gets to pocket.
F or whatever reasons after 6 months the price stays at Rs.500,000/- and does not really change. What do you
think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may
ask, well here is the math -
Total = Rs.600,000/-
Clearly it does not make sense to buy a piece ofland at Rs.600,000/- when it is worth Rs.500,000/-. Do note,
since Ajay has already committed Ilk, he could still buy the land, but ends up paying Rs llk extra in this
https://zerodha.com/varsity/chapter/call-option-basics/ 4/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
process. For this reason Ajay will call off the deal and in the process let go of the agreement fee ofRs.100,000/-
(which Venu obviously pockets).
I hope you have understood this transaction clearly, and if you have then it is good news as through the example
you already know how the call options work! But let us not hurry to extrapolate this to the stock markets; we
will spend some more time with the Ajay-Venu transaction.
Here are a few Q&A's about the transaction which will throw some more light on the example -
1. Why do you think Ajay took such a bet even though he knows he will lose his 1 lakh if land prices does
not increase or stays flat?
a. Agreed Ajay would lose 1 lakh, but the best part is that Ajay knows his maximum loss (which is 1
lakh) before hand. Hence there are no negative surprises for him. Also, as and when the land prices
increases, so would his profits (and therefore his returns). At Rs.10,00,000/- he would be making
Rs.400,000/- profit on his investment ofRs.100,000/- which is 400%.
2. Under what circumstances would a position such as Ajay's make sense?
a. Only that scenario when the price of the land increases
3. Under what circumstances would Venu's position makes sense
a. Only that scenario when the price of the land decreases or stays flat
4. Why do you think Venu is taking such a big risk? He would lose a lot of money if the land prices increase
after 6 months right?
a. Well, think about it. There are only 3 possible scenarios, out which 2 indeed benefit Venu.
Statistically, Venu has 66.66% chances of winning the bet as opposed to Ajay's 33.33% chance
• The payment from Ajay to Venu ensures that Ajay has a right (remember only he can call off the deal) and
Venu has an obligation (if the situation demands, he has to honor Ajay's claim)
• The outcome of the agreement at termination (end of 6 months) is determined by the price of the land.
Without the land, the agreement has no value
• Land is therefore called an underlying and the agreement is called a derivative
• An agreement of this sort is called an "Options Agreement"
• Since Venu has received the advance from Ajay, Venu is called the 'agreement seller or Writer' and Ajay
is called the 'agreement buyer'
• In other words since this agreement is called "an options agreement", Ajay can be called an Options Buyer
and Venu the Options Seller/writer.
• The agreement is entered after the exchange of 1 lakh, hence 1 lakh is the price of this option agreement.
This is also called the "Premium" amount
• Every variable in the agreement- Area of the land, price and the date of sale is fixed.
• As a thumb rule, in an options agreement the buyer always has a right and the seller has an obligation
I would suggest you be absolutely thorough with this example. If not, please go through it again to understand
the dynamics involved. Also, please remember this example, as we will revisit the same on a few occasions in
the subsequent chapters.
Let us now proceed to understand the same example from the stock market perspective.
https://zerodha.com/varsity/chapter/call-option-basics/ 5/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
Assume a stock is trading at Rs.67/- today. You are given a right today to buy the same one month later, at say
Rs. 75/-, but only if the share price on that day is more than Rs. 75, would you buy it?. Obviously you would, as
this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs.75!
In order to get this right you are required to pay a small amount today, say Rs.5.0/-. If the share price moves
above Rs. 75, you can exercise your right and buy the shares at Rs. 75/-. Ifthe share price stays at or below Rs.
75/- you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case. An
arrangement of this sort is called Option Contract, a 'Call Option' to be precise.
After you get into this agreement, there are only three possibilities that can occur. And they are-
Case 1 - If the stock price goes up, then it would make sense in exercising your right and buy the stock at
Rs.75/-.
Profit= 85 - 80 = Rs.5/-
Case 2 -If the stock price goes down to say Rs.65/- obviously it does not makes sense to buy it at Rs.75/- as
effectively you would spending Rs.80/- (75+5) for a stock that's available at Rs.65/- in the open market.
Case 3 -Likewise if the stock stays flat at Rs.75/- it simply means you are spending Rs.80/- to buy a stock
which is available at Rs.75/-, hence you would not invoke your right to buy the stock at Rs.75/-.
This is simple right? If you have understood this, you have essentially understood the core logic of a call option.
What remains unexplained is the finer points, all of which we will learn soon.
At this stage what you really need to understand is this-For reasons we have discussed so far whenever you
expect the price of a stock (or any asset for that matter) to increase, it always makes sense to buy a call option!
Now that we are through with the various concepts, let us understand options and their associated terms
Ajay- Stock
Variable Venu Remark
Transaction Example
Do note the concept of lot size is applicable in options. So just like in the
Underlying 1 acre land Stock land deal where the deal was on 1 acre land, not more or not less, the
option contract will be the lot size
Expiry 6 months 1 month Like in futures there are 3 expiries available
Reference
Price Rs.500,000/- Rs.75/- This is also called the strike price
Do note in the stock markets, the premium changes on a minute by minute
Premium Rs.100,000/- Rs.5/-
basis. We will understand the logic soon
https://zerodha.com/varsity/chapter/call-option-basics/ 6/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
None, based St k
Regulator on good E och All options are cash settled, no defaults have occurred until now.
faith xc ange
Finally before I end this chapter, here is a formal definition of a call options contract -
"The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular
commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration
date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or
financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right".
In the next chapter, we will look into a few finer details with regard to the 'Call Option'.
1. Options are traded in the Indian markets for over 15 years, but the real liquidity was available only since
2006
2. An Option is a tool for protecting your position and reducing risk
3. A buyer of the call option has the right and the seller has an obligation to make delivery
4. The option is only given to one party in the transaction ( buyer of an option)
5. The option seller is also called the option writer
6. At the time of agreement the option buyer pays a certain amount to the option seller, this is called the
'Premium' amount
7. The agreement happens at a pre-specified price, often called the 'Strike Price'
8. The option buyer benefits only if the price of the asset increases higher than the strike price
9. If the asset price stays at or below the strike, the buyer does not benefit, for this reason it always makes
sense to buy options when you expect the price to increase
10. Statistically the option seller has higher odds of winning in an typical option contract
11. The directional view has to pan out before the expiry date, else the option will expire worthless
1,149 comments
1. Jagadeesh says:
March 18, 2015 at 12:3112m
Hi Sir,
Options is like greek and latin to me. Thanks for the analogies. It's getting a bit clear now. ·•
RepJY-
https://zerodha.com/varsity/chapter/call-option-basics/ 7/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
can aj ay call off the agreement before 6 months if and after he gets confirmation that the
highway project was a rumor?
In the options word, he can. However, in this particular land example he cant I guess ••
RepJY. .••.
• • Mahesh says:
Augyst 7, 2017 at 8:30 am
Hi Karthik,
Can retail investor like me buy put option in OTC? if yes how..
Thanks
No, all derivative contracts are routed via the exchanges. You cannot enter into an
OTC arrangement, even if you do, it would not be regulated hence quite
dangerous.
With respect to scenario 3, my query is, if Ajay buys the land paying 500000, at
least he would have a property worth of 500000 even though he pays 600000
(100000 + 500000). But ifhe chose, not to buy the land he still spend 100000 in
return for nothing. Which is the wise thing?
Well, the idea is to focus on the pay off from the bet, and not really on the
outcome of holding a piece ofland "
• • Devayani says:
October 25, 2017 at 9:4412m
What benefit would Ajay get by calling off the deal before the expiry of 6 months?
I guess nothing.
He will instead wait for the whole 6 months for any chance of the highway project
https://zerodha.com/varsity/chapter/call-option-basics/ 8/16
05/10/2022, 09:31 Call Option Basics- Varsity by Zerodha
• Dipakjaishee says:
March 29, 2018 at 1:35 P-m
Can i square off before the expiry ... say after 5/6 days ..its way above the strike price i
bought.can i exercise the ryt to buy .. within 5/6 days ..
You can book your P&L anytime you want, but you can exercise your option only the
day of expiry.
RepJY.
t:f.';'o
• ~ Raja Sekhar Puligadda says:
AP-ril 22, 2018 at 9:54 P-m
"You can book your P &L anytime you want, but you can exercise your option
only the day of expiry" - can u elobarate more? By the way, do we have any
mobile app version of learning? Thanks. Super useful!!!
Raja, squaring off a position simply means you book your profit or loss as per
your convenience. You can do this anytime you open a position. However, if you
decide to hold the position to expiry, then it is deemed 'exercised' and instead of
you squaring off the position, the exchange will do it for you.
As far as the app is concerned - coming soon :.:
AS you are saying that options are exercised on the day of expiry then same
applies app to future too?
Yes, it does.
->• +<,.
:~~!
• '>••<' Akbar Khan says:
https://zerodha.com/varsity/chapter/call-option-basics/ 9/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
Hi Karthik,
I bought a call option at a premium of Rs. 5 and sell the same at a premium of Rs. 8. Please
confirm it ends here and I will not have any exposure or action to be taken at the time of
expiry of the option.
Or I will have two position at the expiry, buy and sell the underlying assets at strike price
Akbar
It ends here, Akbar. You have bought and sold a contract and therefore out of the
market.
RepJY-
p.m
• ll"ci Shuyi says:
Augyst 25, 2018 at 5:15 pm
Kindly clarify if I can square off the deal much before the expiry date of six
month because of a hypothetical situation like thid.supposed state govt has
agreed to start the said highway project but it I'd at the fag end of its tenure and i
am pretty sure that a new government will come to power and it will cancel the
project.So here I want to take chance during the window period as the land price
is already high.so my question is whether I can execute the deal any time within
six month because I know that the price will come dow in six months and I
cannot afford to wait that long.please explain .... . .
Yes, in the options market, you can square off the position whenever you wish,
no need to wait till expiry.
o
~
~~ Sanjay says:
July..1, 2018 at 11:03 am
Implied Volatility is the volatility that the market participants collectively expect.
0 Ravi says:
https://zerodha.com/varsity/chapter/call-option-basics/ 10/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
Very good explanation with sample. Though it is my first attempt to understand, I am almost clear
on what is option call.
RepJY.
~ j jO,
,tocjj
2. o~ Saurabh says:
March 18, 2015 at 1:4512m
My first question Karthik is this: I checked NIFTY options on NSE .. turns out the expiry date dropdown
contains dates till 26th Dec 2019. My questions are:
1. Why is it then that you have mentioned that like futures there are 3 expiries available?
2. The dropdown value on the NSE website does not contain all months expiries- after 18th May 2015 we
have 25th June 2015 followed by 24th Sept 2015 and then 31st Dec 2015. What happened to the other
months? For 2016 to 2019 only June and Dec contracts are available. What happened to the remaining?
Saurabh, glad you noticed it! For all stocks options the expiry is very similar to futures. Hence we
have current month, mid month, and far month contracts. However for Nifty there are several
different expiry options. If you notice, these are long dated options with expiry in 2016, 2019 etc .. .
options that are long dated has a special name for it, its called 'Leaps'. So if you are talking about
Nifty 8800 Call Option expiring in Dec 2019, then that is a Nifty Leap contract. Leaps are good if
you have a super long term view on markets. However the problem with leaps in India is that they
are not liquid, there are hardly any trading activity here.
As far as your send queries goes, honestly I'm not sure why the contracts are so irregular. Guess I
will find out the reason and get back to you on that · ·
RepJY-
https://zerodha.com/varsity/chapter/call-option-basics/ 11/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
RepJY.
• • vigneswar says:
December 5, 2017 at 1:17 nm
hi karthik,
The interest rate is an input variable here - please note this is a critical input for
implied volatility model.
3. • Nilesh says:
March 18, 2015 at 1:57 nm
Dear Sir,
As usual, nice and simple explanation ... I am not trading in options as I could not understand it well. Now,
I think I am clear. Thanks for this.
Glad to know this Nilesh, please stay tuned for more ·'
RepJY.
~"'•.P
4. Ir 11 Ram says:
March 18, 2015 at 3:17 nm
You can exercise the option only on the expiry day, however you can book your profit due to the
increase in premium. Your profit will be 8 - 5 = 3 per share.
https://zerodha.com/varsity/chapter/call-option-basics/ 12/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
Repjy,:
•a RP HANS says:
A12ril 5, 2015 at 4:01 am
Sir, thanks for the easy concept on option. What I understand we can square off any position
in option too before expiry date if profit is decent or stop loss set is triggered, in liquid stocks.
Only the thing is that we have to pay the brokerage twice. Is it that we can not put SL for
options?
One more clarification I want to get is that the options are exercised means we have buy the
underlying asset or the price difference will be adjusted in cash in case of the share market?
Repjy,:
You are right - you can square off anytime you wish ... if you let the option for expiry
there is no brokerage ... otherwise you need to pay twice. But with Zerodha, your
brokerage is so low anyway !.:
RepJy,:
.m ashit says:
May,: 17, 2017 at 6:2712m
.m ashit says:
May,: 18, 2017 at 6:5712m
That means we can square off at any point of time (before or on expiry)
1. Before expiry we have to pay the brokerage twice.
2. On the expiry no brokerage but we have to do it by our own
3. Else exchange will exercise that option on our behalf and charge huge penalty.
1 confusion i have here is
Exercise the option on expiry day means square off the option on expiry day?
https://zerodha.com/varsity/chapter/call-option-basics/ 13/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
To exercise, you just let the position run and do not close it.
Yes they are. Exercising of an option is done upon expiry whereas profit/loss booking
can be done anytime after taking the trade.
• chaitanya says:
MaY. 18, 2017 at 4:55 P-m
Is there any specific process on zerodha to buy a XYZ stock at strice price or exercise the
options. OR a normal stock purchase transaction on expiry day will be treated as exercise?
For ex: I have INFYTECH May 980 CE and ifl want to exercise INFYTECH stock on
exipry day. what is the process to do so?
To exercise, you simply have to hold the position and let it expire. However, it may not
be a great idea to let ITM option expire for STT reasons. Check this -
htm://zerodha.com/z-connect/g_ueries/stock-and-fo-g_ueries/stt-OP-tions-nse-bse-mcx-sx
RepJY.
........
.....:i:t}
...........
• lr• Santhosh says:
November 9, 2018 at 1:49 P-m
So in this example, when I book profit at 8 before the contract expiry date, will I get Rs 8 or
Rs 3? lfI get only 3, I would lose Rs. 2 when exercising the option on the expiry date. Is this
analysis correct?
You will get the difference between the premium i.e the premium you buy minus the
premium you sell at.
https://zerodha.com/varsity/chapter/call-option-basics/ 14/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
~3~
~~··~
5. ~/<... krishnan says:
March 18, 2015 at 4:07 P-m
As usual Karthik at his best starting with options . .. only concern is the time taken to upload other
chapters .. :( .. .hoping to see other chapters at the earliest.Thanks once again Karthik for your splendid
efforts . ..
Thanks Krishnan, it takes a bit of a time to upload chapters (apologies for that) .. but we will put our
best efforts to ensure the wait if worth your time · ·
Post a comment
Name (required)
Mail (will not be published) (required)
Comment
I Post comment I
Varsity by Zerodha © 2015 - 2022. All rights reserved. Reproduction of the Varsity materials, text and images,
is not permitted. For media queries, contact P-ress@zerodha.com
Modules
• 1. Introduction to Stock Markets
15 chapters
• 2. Technical AnalY.sis
22 chapters
• 3. Fundamental AnalY.sis
16 chapters
https://zerodha.com/varsity/chapter/call-option-basics/ 15/16
05/10/2022, 09:31 Call Option Basics - Varsity by Zerodha
• 4. Futures Trading
13 chapters
25 chapters
• 6. 0P-tion Strategies
14 chapters
7 chapters
19 chapters
16 chapters
16 chapters
30 chapters
603 chapters
18 chapters
9 chapters
https://zerodha.com/varsity/chapter/call-option-basics/ 16/16