Basics of options
This sub‑topic introduces the fundamentals of options, the building blocks for equity derivatives. Understanding basic option concepts is essential for NISM Series VIII because most exam questions test definitions, payoff calculations and the ability to differentiate calls from puts. The content links directly to later sections on pricing, strategies and risk management.
Learning Objectives
- 1Define what an option is and identify its key components.
- 2Explain the terminology used in option contracts.
- 3Distinguish between call and put options and their payoff structures.
- 4Recognise common exam traps related to option basics.
What is an Option?
An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specified date (the expiry date).
In the Indian market, options are listed on recognised stock exchanges such as NSE and BSE and are regulated by SEBI. The two primary types are call options (right to buy) and put options (right to sell). The buyer pays a premium to the seller (writer) for this right.
For the NISM exam, you must be able to state this definition verbatim, identify each component in a contract excerpt, and know that the premium is the price paid for the right. Many questions present a contract snippet and ask you to label the strike price, expiry, or premium.
- Remember: "right, not obligation" is the hallmark of an option.
- Premium is a non‑refundable cost for the holder.
Key Terminology
The most frequently used terms are:
Underlying asset – the security on which the option is written, e.g., shares of Reliance Industries Ltd.
Strike price (K) – the price at which the holder may buy (call) or sell (put) the underlying.
Premium (P) – amount paid by the buyer to the writer; expressed per share and quoted in rupees.
Expiry date – the last day on which the option can be exercised; in India, options expire on the last Thursday of the contract month.
Holder vs Writer – the holder purchases the right; the writer sells the right and receives the premium. The writer’s risk profile is opposite to the holder’s.
Exam relevance: Questions often ask you to match a term with its definition or to calculate the total premium paid for a contract of 500 shares.
Unlike futures, an option does not obligate the holder to transact. Futures require both parties to settle at expiry, while options give a unilateral right only to the buyer.
Types of Options
The two basic categories are:
Call option – grants the right to purchase the underlying at the strike price. If the market price (S) exceeds K, the holder can buy at K and realise a profit equal to (S‑K) minus the premium paid.
Put option – grants the right to sell the underlying at the strike price. If S falls below K, the holder can sell at K, earning (K‑S) less the premium.
Both contracts are European (exercise only at expiry) or American (exercise any time up to expiry). The NISM syllabus focuses on the payoff at expiry, so concentrate on the European style for calculations.
Exam tip: Remember that calls benefit from rising prices, puts from falling prices. Questions may present a market scenario and ask which option would be profitable.
Comparison of Call and Put Options
| Feature | Call Option | Put Option |
|---|---|---|
| Right to | Buy the underlying | Sell the underlying |
| Profit when | Underlying price rises above K | Underlying price falls below K |
| Maximum loss for holder | Premium paid | Premium paid |
| Maximum gain for writer | Premium received | Premium received |
Option Payoff Profiles
Payoff diagrams illustrate the profit or loss at expiry for a single option position. The X‑axis represents the underlying price (S) at expiry, while the Y‑axis shows the payoff before accounting for the premium.
For a call, the payoff line is flat at zero until S reaches K, after which it rises linearly with a slope of 1. For a put, the line is flat at zero until S drops to K, then it rises as K‑S.
Understanding these shapes helps you quickly answer exam items that provide a graph and ask you to identify the contract type.
Where:
S= Spot price of the underlying at expiry (₹)K= Strike price of the option (₹)Worked Example
Given S = 120, K = 100: Step 1: Compute S - K = 120 - 100 = 20 Step 2: Apply max function: max(20, 0) = 20 Payoff = 20 Verification: max(120 - 100, 0) = 20.
Where:
S= Spot price of the underlying at expiry (₹)K= Strike price of the option (₹)Worked Example
Given S = 85, K = 100: Step 1: Compute K - S = 100 - 85 = 15 Step 2: Apply max function: max(15, 0) = 15 Payoff = 15 Verification: max(100 - 85, 0) = 15.
Option Premium Components
The premium consists of two parts: intrinsic value and time value. Intrinsic value is the amount by which an option is in‑the‑money (ITM). For a call, it is max(S‑K,0); for a put, max(K‑S,0).
Time value reflects the probability that the option will become more valuable before expiry. It depends on volatility, time to expiry, risk‑free interest rate, and expected dividends. Higher volatility or longer time increases time value.
In the exam, you may be asked to decompose a quoted premium into intrinsic and time components, or to identify why a deep‑ITM option still trades above its intrinsic value.
Students often subtract only the intrinsic value from the premium and treat the remainder as zero. Remember that even out‑of‑the‑money options have a positive premium due to time value.
Option Pricing Models Overview
The NISM syllabus mentions two widely used models: the Black‑Scholes‑Merton (BSM) model for European options and the Binomial Tree model for American options. Both models incorporate the same five inputs: underlying price, strike price, time to expiry, risk‑free rate, and volatility.
While the exact BSM formula is not required for the exam, you should know that higher volatility or longer time raises the option premium, and that the risk‑free rate influences call and put prices differently (calls rise, puts fall).
Typical exam questions present a change in one input (e.g., volatility rises from 20% to 30%) and ask how the premium will move. Apply the qualitative relationships rather than calculating the full BSM value.
Effect of Time to Expiry on Option Premium (Illustrative)
Example: Buying a Call
Scenario
Rohit buys one lot (500 shares) of a TCS call option with a strike price of ₹3,200, expiring in 30 days. The premium is ₹120 per share. At expiry, TCS closes at ₹3,450.
Solution
Step 1: Compute intrinsic value per share = max(3,450 - 3,200, 0) = 250. Step 2: Payoff per share = 250. Step 3: Total payoff = 250 × 500 = ₹125,000. Step 4: Total premium paid = 120 × 500 = ₹60,000. Step 5: Net profit = 125,000 - 60,000 = ₹65,000. The profit is positive, confirming that buying the call was beneficial.
Conclusion
The example shows how to calculate payoff, premium cost, and net profit – a typical NISM calculation.
Risk and Reward
For the option holder, the maximum loss is limited to the premium paid, while the upside can be unlimited for a call (price can rise indefinitely) and substantial for a put (price can fall to zero). This asymmetric risk‑reward profile is a key reason why options are used for hedging and speculation.
The writer, however, faces the opposite risk. A call writer’s loss can be unlimited if the underlying price surges, whereas a put writer’s loss is limited to the strike price minus zero, multiplied by the contract size.
SEBI mandates that option writers maintain adequate margin. In the exam, you may be asked to identify who bears unlimited risk in a given scenario or to select the correct margin requirement category.
⭐Exam Takeaways
- An option gives the holder a right, not an obligation, to buy (call) or sell (put) the underlying at a predetermined strike price.
- Key terms – underlying, strike price, premium, expiry, holder, writer – must be memorised and linked to their definitions.
- Call payoff = max(S‑K,0); Put payoff = max(K‑S,0). Remember to subtract the premium to obtain net profit.
- Premium = intrinsic value + time value; time value rises with volatility and time to expiry.
- Maximum loss for the holder equals the premium paid; the writer can face unlimited loss for a call.
Practice Questions
8 questions on Basics of options
An option is a financial contract that gives the holder the right, but not the obligation, to
In an option contract, the premium is
A European call option has strike price K=100 and the underlying spot price at expiry S=120. What is the payoff before premium?
Which scenario will make a put option profitable at expiry?
Rohit buys one lot (500 shares) of a TCS call with strike ₹3,200 and premium ₹120 per share. At expiry S=₹3,450. What is his net profit?
Which party can incur unlimited loss when the underlying price rises sharply?
If volatility increases while all other inputs remain unchanged, what is the expected effect on the option premium?
In the Indian market, options typically expire on which day?