Index options: The workings (Part I) - Views on News from Equitymaster

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Index options: The workings (Part I)

Jun 7, 2001

The fallout of the recent scam was that the watchdog SEBI speeded up market reforms. The effort is to separate the cash and the forward markets. While rolling settlement will be introduced and carry forward banned from July 2, SEBI is strengthening the derivatives markets by introduction of more and more instruments. The latest to be introduced are the index options that were introduced by the exchanges recently. To get an idea of what options are please click here

The underlying for the index option is the S&P CNX Nifty in the case of NSE options and BSE Sensex for the BSE options. By buying a put or a call index option a trader will basically take a view on the market.

The NSE has specified a multiplier of 200 and for the BSE the multiplier is specified to be 100. Therefore, if the NSE is at 1, 000, the smallest possible contract on the NSE will be of the size of Rs 0.2 m. If the BSE is at 3,000 then the smallest size of the contract will be Rs 0.1 m.

Underlying Index S&P CNX Nifty
Contract size Permitted lot size shall be 200 or multiples thereof
Price steps Rs.0.05
Price Bands Not applicable
Style European / American
Trading cycle The options contracts will have a maximum tenure of three
months – the near month (one),
the next month (two) and the far month (three)
New contracts will be introduced
on the next trading day following the expiry
of near month contract
Expiry day The last Thursday of the expiry month or the previous
trading day if the last Thursday
is a trading holiday.
Settlement basis Cash settlement on a T + 1 basis
Settlement prices Based on expiration price as may
be decided by the Exchange
Source : NSE

At any point of time three contracts will be available. One that will expire in the current month, one that will expire in the near month and one that will expire in the far month. For example in June the contracts available are those expiring in June (running month), July (near month) and August (far month). When the June contract expires the September series will come into existence. Therefore a contract will have a life cycle of three month. The reasons for having contracts expiring in three different months are to provide the time intervals for which the trader might take a view on the markets.

Again to provide the trader to take view on the levels of the market at any point of time five different strike prices will be available at any point of time. The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying (in this case the S&P or the Sensex). There shall be a minimum of 5 strike prices, namely, two 'in-the-money', one 'at-the-money' and two 'out-of-the-money' for call and put option. The strike price interval will be of 20.

If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that the underlying is at 1410.

Similarly in-the-money strike prices will be 1,370 and 1,390, which are lower than the underlying of 1,410.

At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in.

To buy an option a premium is to be paid, which is calculated using the Black Scholes option model.

Suppose Rajiv is bullish about the markets. He will therefore buy a call option. His level of optimism about the market will decide the strike price at which he will buy the option. If the index is currently at 1,410, the strike prices available to Rajiv will be 1,370, 1,390, 1,400, 1,430 and 1,450. But Rajiv has to buy a minimum of 200 contracts on the NSE. Therefore, depending on the strike price the premium he has to pay to buy the option will vary.

Rajiv brought one contract of Nifty calls, with a strike price of 1,430, for Rs.11.5 each for the month of July. As Rajiv feels the index will move up. The premium paid will be Rs 2,300 (11.5*200). Given these, the break-even level Nifty is 1,441.5. If at expiration Nifty advances by 5%, i.e. 1,470, then

Nifty expiration level 1470.0
Less Strike Price 1430.0
Option value 40.0
Less Purchase price 11.5
Profit per nifty 28.5
Profit on the contract 5,700 (Rs.28.5* 200)

Since the options in existence are european options the can only be exercised on the day of expiry. Therefore, Rajiv will have to wait till the last Thursday realize these gains. The other ways Rajiv can liquidate the options are by squaring of his position i.e. by selling his call options or by abandoning them in which case he will have a loss of Rs 2,300.

Let’s take another example. Suppose, Ajay is bearish about the markets. He therefore buys Nifty puts.

As the Nifty in the cash market is 1,390 the strike prices available to him are 1,350, 1,370, 1,390,1,410 and 1,430. Now suppose, Ajay bought one contract of Nifty June series puts for Rs 11 each at a strike price of 1,370. The premium paid by him will be Rs 2,200 (11*200). Given these, Ajay’s break-even level will be when Nifty is at 1,359 (i.e. strike price less the premium). If at expiration Nifty declines by 5 %, i.e. 1,330, then

Put Strike Price 1370.0
Nifty expiration level 1330.0
Option value 40.0
Less Purchase price 11.0
Profit per nifty 29.0
Profit on the contract Rs 5,800 (Rs.29.0* 200)

In the example mentioned above, Ajay and Rajiv made money because the markets moved the way they had speculated it to move. Had the markets not moved as anticipated they would have lost their investments (i.e. the premium paid to buy the option). Therefore, for retail investors who do not understand the intricacies of market movement it is safer to use options for the purpose of hedging.

In the next part to this article we will take up how to hedge and ‘writing’ of options.

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