Derivatives

Will ITM option premium become zero on expiry?

Akhil Nallamuthu BL Research Bureau | Updated on December 19, 2020

As ITM options premium becomes nil, what is the best possible way to hedge options of Nifty 50, especially on expiry day? And say, we take one put sell and another call sell (both ITM), will our position be safe? What precaution, other than exercising stop-loss, can be taken if index moves out-of-money (OTM)?

- Rathnakara Shetty

Regarding your question, the premium of ITM (in-the-money) options will not erode completely on expiry because of the intrinsic value attached to it. Of course, the time value will come down to zero. However, the intrinsic value will not become zero because it is the difference between closing price of the underlying and the strike price of the option on expiry, which will be positive. It is the premium of OTM (out-of-money) options that becomes zero at expiry.

For example, suppose you hold call options of Nifty 50 with strike price of 13,700 (13700CE) and 13,500 (13500CE) and the index closes at 13,600 on expiry. Here, 13500CE will become ITM and 13700CE will be OTM. So, on expiry the premium of 13500CE will be about ₹100 (13,600-13,500) whereas premium of 13700CE will be zero.

With respect to selling one call option (CE) and one put option (PE) on the index (assuming that it is done simultaneously), you can hedge by buying equivalent amount of CE with higher strike price and buying equivalent amount of PE with lower strike price. For instance, say you have sold 13700CE and 13500PE. You can hedge this combined position by buying 13800CE and 13400PE.

That way, you can reduce your loss. On the other hand, you will also be compromising on profit. Please note that an option seller can make profit if option expires OTM.

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Published on December 19, 2020
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