Introduction to Options and Futures

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# Introduction to Option Theory

4.3

We learned how the payoffs work in call and put options contracts in the previous chapter. Now, let’s take some introductory steps into the world of options theory. Basically, this is a set of concepts and metrics that help traders like you understand the profitability of an options contract before entering into a trade using that derivative. The first thing we’ll look into as a part of the options theory is the value of call and put options.

## The value of a call option

Consider a call option with the following parameters.

• Strike price: Rs. 1,500
• Spot price of the underlying stock: Rs. 1,650
• Days to expiry: 10 days

What does this mean? Basically, it implies that the underlying stock is trading in the stock market at Rs. 1,650 currently. But you have a call option that gives you the right to buy this stock for just Rs. 1,500 ten days later. What if you exercised this option today itself instead, hypothetically speaking?

In that case, would you gain or lose? Let’s see.

If you exercise this call option today, you’ll only need to pay Rs. 1,500 for an asset worth Rs. 1,650. That’s a profitable move, right? And what is the amount of your gains?

Well, it’s Rs. 150, right? That is Rs. 1,650 minus Rs. 1,500.

In other words, it’s the spot price minus the strike price. This is the intrinsic value of a call options contract.

 Intrinsic value of a call option = Spot price - Strike price

If the strike price is greater than the spot price, we’ll end up with a negative number. In this case, the intrinsic value is restricted to zero.

## The value of a put option

Now, let’s consider a put option with the following parameters.

• Strike price: Rs. 1,500
• Spot price of the underlying stock: Rs. 1,250
• Days to expiry: 10 days

This implies that the underlying stock is trading in the stock market at Rs. 1,250 currently. But you have a put option that gives you the right to sell this stock for Rs. 1,500 instead, ten days later. Again, what if you exercised this option today itself instead?

In that case, would you gain or lose? Let’s see.

If you exercise this put option today, you can sell an asset worth just Rs. 1,250 for a higher price of Rs. 1,500 instead. Clearly, this is a profitable trade. And what is the amount of your profit?

Well, that would be Rs. 250, that is Rs. 1,500 minus Rs. 1,250.

In other words, it’s the strike price minus the spot price. This is the intrinsic value of a put options contract.

 Intrinsic value of a put option =  Strike price - Spot price

Here too, if the  spot price is greater than the strike price, we’ll end up with a negative number. And just like we saw earlier, in this case, the intrinsic value is restricted to zero.

## Moneyness of an options contract

Based on the intrinsic value of an options contract, we can calculate something called the moneyness of that option. The option moneyness essentially denotes whether you will gain or lose from that option, if you exercise it right away.

There are three kinds of moneyness for any options contract.

1. In the Money (ITM)
2. At the Money (ATM)
3. Out of the Money (OTM)

If the intrinsic value of an options contract is a positive number, then the option is considered to be ‘in the money’. And if the intrinsic value of an option is zero, it is considered to be ‘out of the money’.

In a list of options contracts, the one with a strike price that is equal to the spot price is termed as being ‘at the money.’ Practically speaking, however, it’s only rarely that the spot and the strike price coincide exactly. So, the options contract whose strike price is the closest to the spot price is often considered ‘at the money.’ Sometimes, it’s also referred to as ‘near the money’ instead.

Let’s look at two separate examples to understand the moneyness of a call option and a put option.

## Moneyness of a call option

Let’s begin with some theoretical data to understand the moneyness of a call option better. Take a look at this table. It shows the values of the premium and the strike price for different call options with NIFTY 50 as the underlying asset.

Say that NIFTY 50 is currently trading in the spot market at Rs. 10,700.

 Sr. no. Premium for the call option (in rupees) Strike price (in rupees) Intrinsic value (Spot price minus strike price) Moneyness of the call option 1 322 10,400 300 In the money 2 275 10,450 250 In the money 3 235 10,500 200 In the money 4 195 10,550 150 In the money 5 125 10,650 50 At the money 6 50 10,800 0 Out of the money 7 35 10,850 0 Out of the money 8 23 10,900 0 Out of the money 9 15 10,950 0 Out of the money 10 10 11,000 0 Out of the money

Based on the strike price and the spot price, we’ve calculated the intrinsic value of the call options listed above. You see how from options numbered 1 through 4, the intrinsic value is positive? They’re all considered to be in the money. Option number 5 also has a positive intrinsic value, but since the strike price is closest to the spot price, it’s considered to be at the money. And options numbered 6 through 10 all have negative intrinsic values (restricted to zero), making them out of the money.

Notice how the value of the premium is higher for call options that are in the money? And how the premium gradually decreases as we move from the ITM zone to OTM zone?

## Moneyness of a put option

Again, let’s look at some theoretical data - pertaining to a put option this time - to understand how their option moneyness is calculated. Have a look at this table. Like before, it shows the values of the premium and the strike price for different put options with NIFTY 50 as the underlying asset.

Let’s again say that NIFTY 50 is currently trading in the spot market at Rs. 10,700.

 Sr. no. Premium for the put option (in rupees) Strike price (in rupees) Intrinsic value (Strike price minus spot price) Moneyness of the call option 1 21 10,400 0 Out of the money 2 27 10,450 0 Out of the money 3 34 10,500 0 Out of the money 4 44 10,550 0 Out of the money 5 75 10,650 0 At the money 6 150 10,800 100 In the money 7 185 10,850 150 In the money 8 222 10,900 200 In the money 9 261 10,950 250 In the money 10 308 11,000 300 In the money

Again, we’ve computed the intrinsic value of the put options listed above. For the options numbered 1 through 4, the intrinsic values are negative (and so, restricted to zero). This makes them out of the money. Option number 5 also has a negative intrinsic value, but since the strike price is closest to the spot price, it’s considered to be at the money. And options numbered 6 through 10 all have positive intrinsic values, so they’re all considered to be in the money.

The value of the premium is also higher for put options that are in the money. And the premium gradually increases as we move from the OTM zone to ITM zone.

## Wrapping up

The moneyness of an options contract, whether it is a call or a put, can help traders understand the profitability of the option. This is why option moneyness is a very important aspect in options trading strategies. Understanding the moneyness of options can help you formulate the right trading strategy. In the next chapter, we’ll look at some such options trading strategies.

## A quick recap

• The intrinsic value of a call options contract is the spot price minus the strike price.
• Here, if the strike price is greater than the spot price, we’ll end up with a negative number. In this case, the intrinsic value is restricted to zero.
• The intrinsic value of a put options contract is the strike price minus the spot price.
• Here, if the spot price is greater than the strike price, we’ll end up with a negative number. In this case, again, the intrinsic value is restricted to zero.
• Based on the intrinsic value of an options contract, we can calculate the moneyness of that option. The moneyness essentially denotes whether you will gain or lose from that option, if you exercise it right away.
• Options can be In the Money (ITM), At the Money (ATM), or Out of the Money (OTM).
• If the intrinsic value of an options contract is a positive number, then the option is considered to be ‘in the money’.
• And if the intrinsic value of an option is zero, it is considered to be ‘out of the money’.
• If the strike price of an option is equal to the spot price, it is termed as being ‘at the money.’