Stock price movements and value: An increase in stock price is favourable for the call buyer because he can sell his shares at the higher market price. To him, a drop in price is adverse because it fetches him a lower price and if the price dips below the exercise price he will have to let his option lapse. The call writer sells the "right to buy"; that is, he undertakes the obligation to sell. Hence, while any increase in stock price is adverse to him, a reduction in stock price is favourable.

A put buyer buys the right to sell shares. An increase in stock price is adverse since he has bought the right to sell at a lower price and there is little meaning in buying dear and selling cheap. In contrast, a decrease in price is favourable. The put writer or put seller grants the right to sell; that is, he undertakes the obligation to buy. Hence, any increase in stock price is favourable to him and any reduction, adverse . This has significance in fixing the option premium. Table 1 summarises the position.

In-the-money, at-the-money and out-of-the-money options: An option is said to be "in-the-money" if exercising the option will bring about a gain. An option is said to be "out-of-the-money" if exercising the option will result in a loss. An option is said to be "at-the-money" if exercising the option will result in neither a gain nor a loss. In this context, the option premium paid to buy these options is to be ignored since it represents a sunk cost.

Table 2 drives home the issue in respect of the various situations for an option buyer. Remember, an option buyer either buys the right to buy shares (in which case he is called a call buyer) or buys the right to sell shares (in which case he is called a put buyer)

The position is automatically reverses for the writer of the option, as options are essentially a zero-sum game. If the deal is in-the-money to the buyer it is out-of-the-money to the writer; if the deal is out-of-the-money to the buyer it is in-the-money to the writer; if the deal is at-the-money to the buyer it is at-the-money to the writer as well.

Example: You bought a one-month call option at a premium of Rs 6 with an exercise price of Rs 40. What is the position if the current market price (CMP) is Rs 45, Rs 40 or Rs 35. Will the position change if you had been a put buyer? What is the corresponding position for the call seller and the put seller? (Table 3)

The option premium of Rs 6 is irrelevant being a sunk cost. For the call seller, the position is the reverse of what it is for the call buyer. For the put seller, the position is the reverse of what is for the put buyer.

Intrinsic value and time value: An option's premium consists of two parts — intrinsic value and time value. The former is that part of the option premium which is represented by what is in the money. It is the real worth of the premium. The balance represents the time value and is the premium paid for the time value of money. This means that in respect of options that are at-the-money or out-of-the-money there is no intrinsic value. Time value falls with time and falls to zero on the expiration date. Table 4 elucidates the concept in the case of a call option with an exercise price of Rs 50. Table 5 elucidates the case of put option with an exercise price of Rs 50.

Margins and safety: In India, each option equals a certain number of shares. This is decided by the exchange. Thus, if you buy one option of, say, Infosys, that is buying an option on 100 shares of Infosys. When you buy options, the exchange requires you to maintain a specified margin as initial margin. This margin is a certain percentage of the value of the underlying stock and is decided by the exchange. Margins are required more in the nature of performance guarantee. The margin is required to be maintained both by the buyer and the writer of the option. This margin could be around 15 per cent of the value of stock and is determined by the exchange.

Aside of initial margin, the writer of the option is required to maintain additional margin which is 100 per cent of the changes in market price on a day-to-day basis. This margin is needed because if the price moves up (adverse to the call writer) or price falls (adverse to the put writer) there is little guarantee he would perform. To protect itself, the exchange calls for the maintenance of this margin. Table 6 illustrates the computation of mark-to-market margin in the case of a call writer in respect of 100 shares and is important in the context of decision-making.

The stock price increased from Rs 200 to Rs 205, which puts the writer in a fix. He is, therefore, required to place Rs 5 per share or Rs 500 in this case with the exchange as additional margin also called mark to market. The carrying price is now Rs 205. On October 2, the price moves to Rs 208 putting further pressure on the writer. He will now have to bring in Rs 3 per share or Rs 300 as additional margin and the carrying price moves to Rs 208. On October 3, the price falls to Rs 207. He, therefore, gets a refund of Re 1 per share or Rs 100 for 100 shares and the carrying price is now revised to Rs 207. The mark to market margin keeps changing based on price movements.

An understanding of all these is central to developing appropriate strategies for success.

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