1.1– Breaking the Ice

As with any of the previous modules in Varsity, we will again make the same old assumption that you are new to options and therefore know nothing about options. For this reason we will start from scratch and slowly ramp up as we proceed. Let us start with running through some basic background information.

The options market makes up for a significant part of the derivative market, particularly in India. I would not be exaggerating if I were to say that nearly 80% of the derivatives traded are options and the rest is attributable to the futures market. Internationally, the option market has been around for a while now, here is a quick background on the same –

  • Custom options were available as Over the Counter (OTC) since the 1920’s. These options were mainly on commodities
  • Options on equities began trading on the Chicago Board Options Exchange (CBOE) in 1972
  • Options on currencies and bonds began in late 1970s. These were again OTC trades
  • Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982
  • Interest rate options began trading on the CME in 1985

Clearly the international markets have evolved a great deal since the OTC days. However in India from the time of inception, the options market was facilitated by the exchanges. However options were available in the off market ‘Badla’ system. Think of the ‘badla system’ as a grey market for derivatives transactions. The badla system no longer exists, it has become obsolete. Here is a quick recap of the history of the Indian derivative markets –

  • June 12th 2000 – Index futures were launched
  • June 4th 2001 –Index options were launched
  • July 2nd 2001 – Stock options were launched
  • November 9th 2001 – Single stock futures were launched.

Though the options market has been around since 2001, the real liquidity in the Indian index options was seen only in 2006! I remember trading options around that time, the spreads were high and getting fills was a big deal. However in 2006, the Ambani brothers formally split up and their respective companies were listed as separate entities, thereby unlocking the value to the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian markets, creating some serious liquidity. However if you were to compare the liquidity in Indian stock options with the international markets, we still have a long way to catch up.


1.2 – A Special Agreement

There are two types of options – The Call option and the Put option. You can be a buyer or seller of these options. Based on what you choose to do, the P&L profile changes. Of course we will get into the P&L profile at a much later stage. For now, let us understand what “The Call Option” means. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets. So let’s get started.

Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs.500,000/-. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns. If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would make today. However if the ‘highway news’ turns out to be a rumor- which means Ajay buys the land from Venu today and there is no highway  tomorrow, then Ajay would be stuck with a useless piece of land!

So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy.

Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as follows –

  1. Ajay pays an upfront fee of Rs.100,000/- today. Consider this as a non refundable agreement fees that Ajay pays
  2. Against this fees, Venu agrees to sell the land after 6 months to Ajay
  3. The price of the sale( which is expected 6 months later) is fixed today at Rs.500,000/-
  4. Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6 months (if he wants to that is), Venu cannot
  5. In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the upfront fees

So what do you think about this special agreement? Who do you think is smarter here – Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement? Well, the answer to these questions is not easy to answer, unless you analyze the details of the agreement thoroughly. I would suggest you read through the example carefully (it also forms the basis to understand options) – Ajay has plotted an extremely clever deal here! In fact this deal has many faces to it.

Let us break down Ajay’s proposal to understand some details –

  • By paying an agreement fee of Rs.100,000/-, Ajay is binding Venu into an obligation. He is forcing Venu to lock the land for him for the next 6 months
  • Ajay is fixing the sale price of the land based on today’s price i.e Rs.500,000/- which means irrespective of what the price would be 6 months later he gets to buy the land at today’s price. Do note, he is fixing a price and paying an additional Rs.100,000/- today
  • At the end of the 6 months, if Ajay does not want to buy the land he has the right to say ‘no’ to Venu, but since Venu has taken the agreement fee from Ajay, Venu will not be in a position to say no to Ajay
  • The agreement fee is non negotiable, non refundable

Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen. Clearly, the price of the land will vary based on the outcome of the ‘highway project’. However irrespective of what happens to the highway, there are only three possible outcomes –

  1. Once the highway project comes up, the price of the land would go up, say it shoots up to Rs.10,00,000/-
  2. The highway project does not come up, people are disappointed, the land price collapses, say to Rs.300,000/-
  3. Nothing happens, price stays flat at Rs.500,000/-

I’m certain there could be no other possible outcomes that can occur apart from the three mentioned above.

We will now step into Ajay’s shoes and think through what he would do in each of the above situations.

Scenario 1 – Price goes up to Rs.10,00,000/-

Since the highway project has come up as per Ajay’s expectation, the land price has also increased. Remember as per the agreement, Ajay has the right to call off the deal at the end of 6 months. Now, with the increase in the land price, do you think Ajay will call off the deal? Not really, because the dynamics of the sale are in Ajay’s favor –

Current Market price of the land = Rs.10,00,000/-

Sale agreement value = Rs.500,000/-

This means Ajay now enjoys the right to buy a piece of land at Rs.500,000/- when in the open market the same land is selling at a much higher value of – Rs.10,00,000/-. Clearly Ajay is making a steal deal here. Hence he would go ahead and demand Venu to  sell him the land. Venu is obligated to sell him the land at a lesser value, simply because he had accepted Rs.100,000/- agreement fees from Ajay 6 months earlier.

So how much money is Ajay making? Well, here is the math –

Buy Price = Rs.500,000/-

Add: Agreement Fees = Rs.100,000/- (remember this is a non refundable amount)

Total Expense = 500,000 + 100,000 = 600,000/-

Current Market of the land = Rs.10,00,000/-

Hence his profit is Rs.10,00,000 – Rs.600,000 = Rs.400,000/-

Another way to look at this is – For an initial cash commitment of Rs.100,000/- Ajay is now making 4 times the money! Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay. The profit that Ajay makes (Rs.400,000/-) is exactly the notional loss that Venu would incur.

Scenario 2 – Price goes down to Rs.300,000/-

It turns out that the highway project was just a rumour, and nothing really is expected to come out of the whole thing. People are disappointed and hence there is a sudden rush to sell out the land. As a result, the price of the land goes down to Rs.300,000/-.

So what do you think Ajay will do now? Clearly it does not make sense to buy the land, hence he would walk away from the deal. Here is the math that explains why it does not make sense to buy the land –

Remember the sale price is fixed at Rs.500,000/-, 6 months ago. Hence if Ajay has to buy the land he has to shell out Rs.500,000/- plus he had paid Rs.100,000/- towards the agreement fees. Which means he is in effect paying Rs.600,000/- to buy a piece of land worth just Rs.300,000/-. Clearly this would not make sense to Ajay, since he has the right to call of the deal, he would simply walk away from it and would not buy the land. However do note, as per the agreement Ajay has to let go of Rs.100,000/-, which Venu gets to pocket.

Scenario 3 – Price stays at Rs.500,000/-

For whatever reasons after 6 months the price stays at Rs.500,000/- and does not really change. What do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may ask, well here is the math –

Cost of Land = Rs.500,000/-

Agreement Fee = Rs.100,000/-

Total = Rs.600,000/-

Value of the land in open market = Rs.500,000/-

Clearly it does not make sense to buy a piece of land at Rs.600,000/- when it is worth Rs.500,000/-. Do note, since Ajay has already committed 1lk, he could still buy the land, but ends up paying Rs 1lk extra in this process. For this reason Ajay will call off the deal and in the process let go of the agreement fee of Rs.100,000/- (which Venu obviously pockets).

I hope you have understood this transaction clearly, and if you have then it is good news as through the example you already know how the call options work! But let us not hurry to extrapolate this to the stock markets; we will spend some more time with the Ajay-Venu transaction.

Here are a few Q&A’s about the transaction which will throw some more light on the example –

  1. Why do you think Ajay took such a bet even though he knows he will lose his 1 lakh if land prices does not increase or stays flat?
    1. Agreed Ajay would lose 1 lakh, but the best part is that Ajay knows his maximum loss (which is 1 lakh) before hand. Hence there are no negative surprises for him. Also, as and when the land prices increases, so would his profits (and therefore his returns). At Rs.10,00,000/- he would be making Rs.400,000/- profit on his investment of Rs.100,000/- which is 400%.
  2. Under what circumstances would a position such as Ajay’s make sense?
    1. Only that scenario when the price of the land increases
  3. Under what circumstances would Venu’s position makes sense
    1. Only that scenario when the price of the land decreases or stays flat
  4. Why do you think Venu is taking such a big risk? He would lose a lot of money if the land prices increase after 6 months right?
    1. Well, think about it. There are only 3 possible scenarios, out which 2 indeed benefit Venu. Statistically, Venu has 66.66% chances of winning the bet as opposed to Ajay’s 33.33% chance

Let us summarize a few important points now –

  • The payment from Ajay to Venu ensures that Ajay has a right (remember only he can call off the deal) and Venu has an obligation (if the situation demands, he has to honor Ajay’s claim)
  • The outcome of the agreement at termination (end of 6 months) is determined by the price of the land. Without the land, the agreement has no value
  • Land is therefore called an underlying and the agreement is called a derivative
  • An agreement of this sort is called an “Options Agreement”
  • Since Venu has received the advance from Ajay, Venu is called the ‘agreement seller or Writer’ and Ajay is called the ‘agreement buyer’
  • In other words since this agreement is called “an options agreement”, Ajay can be called an Options Buyer and Venu the Options Seller/writer.
  • The agreement is entered after the exchange of 1 lakh, hence 1 lakh is the price of this option agreement. This is also called the “Premium” amount
  • Every variable in the agreement – Area of the land, price and the date of sale is fixed.
  • As a thumb rule, in an options agreement the buyer always has a right and the seller has an obligation

I would suggest you be absolutely thorough with this example. If not, please go through it again to understand the dynamics involved. Also, please remember this example, as we will revisit the same on a few occasions in the subsequent chapters.

Let us now proceed to understand the same example from the stock market perspective.

1.3 – The Call Option

Let us now attempt to extrapolate the same example in the stock market context with an intention to understand the ‘Call Option’. Do note, I will deliberately skip the nitty-gritty of an option trade at this stage. The idea is to understand the bare bone structure of the call option contract.

Assume a stock is trading at Rs.67/- today. You are given a right today to buy the same one month later, at say Rs. 75/-, but only if the share price on that day is more than Rs. 75, would you buy it?. Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs.75!

In order to get this right you are required to pay a small amount today, say Rs.5.0/-. If the share price moves above Rs. 75, you can exercise your right and buy the shares at Rs. 75/-. If the share price stays at or below Rs. 75/- you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case. An arrangement of this sort is called Option Contract, a ‘Call Option’ to be precise.

After you get into this agreement, there are only three possibilities that can occur. And they are-

  1. The stock price can go up, say Rs.85/-
  2. The stock price can go down, say Rs.65/-
  3. The stock price can stay at Rs.75/-

Case 1 – If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs.75/-.

The P&L would look like this –

Price at which stock is bought = Rs.75

Premium paid =Rs. 5

Expense incurred = Rs.80

Current Market Price = Rs.85

Profit = 85 – 80 = Rs.5/-

Case 2 – If the stock price goes down to say Rs.65/- obviously it does not makes sense to buy it at Rs.75/- as effectively you would spending Rs.80/- (75+5) for a stock that’s available at Rs.65/- in the open market.

Case 3 – Likewise if the stock stays flat at Rs.75/- it simply means you are spending Rs.80/- to buy a stock which is available at Rs.75/-, hence you would not invoke your right to buy the stock at Rs.75/-.

This is simple right? If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the finer points, all of which we will learn soon.

At this stage what you really need to understand is this – For reasons we have discussed so far whenever you expect the price of a stock (or any asset for that matter) to increase, it always makes sense to buy a call option!

Now that we are through with the various concepts, let us understand options and their associated terms

Variable Ajay – Venu Transaction Stock Example Remark
Underlying 1 acre land Stock Do note the concept of lot size is applicable in options. So just like in the land deal where the deal was on 1 acre land, not more or not less, the option contract will be the lot size
Expiry 6 months 1 month Like in futures there are 3 expiries available
Reference Price Rs.500,000/- Rs.75/- This is also called the strike price
Premium Rs.100,000/- Rs.5/- Do note in the stock markets, the premium changes on a minute by minute basis. We will understand the logic soon
Regulator None, based on good faith Stock Exchange All options are cash settled, no defaults have occurred until now.

Finally before I end this chapter, here is a formal definition of a call options contract –

The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right”.

In the next chapter, we will look into a few finer details with regard to the ‘Call Option’.

Key takeaways from this chapter

  1. Options are traded in the Indian markets for over 15 years, but the real liquidity was available only since 2006
  2. An Option is a tool for protecting your position and reducing risk
  3. A buyer of the call option has the right and the seller has an obligation to make delivery
  4. The option is only given to one party in the transaction ( buyer of an option)
  5. The option seller is also called the option writer
  6. At the time of agreement the option buyer pays a certain amount to the option seller, this is called the ‘Premium’ amount
  7. The agreement happens at a pre-specified price, often called the ‘Strike Price’
  8. The option buyer benefits only if the price of the asset increases higher than the strike price
  9. If the asset price stays at or below the strike, the buyer does not benefit, for this reason it always makes sense to buy options when you expect the price to increase
  10. Statistically the option seller has higher odds of winning in an typical option contract
  11. The directional view has to pan out before the expiry date, else the option will expire worthless


View all comments →
  1. jagadeesh says:

    Hi Sir,
    Options is like greek and latin to me. Thanks for the analogies. It’s getting a bit clear now. 🙂

    • Karthik Rangappa says:

      Good to know that Jagadeesh 🙂

      • dinesh mohan says:

        can ajay call off the agreement before 6 months if and after he gets confirmation that the highway project was a rumor?

        • Karthik Rangappa says:

          In the options word, he can. However, in this particular land example he cant I guess 🙂

          • Mahesh says:

            Hi Karthik,

            Can retail investor like me buy put option in OTC? if yes how..

            i have a account with zerodha..


          • Karthik Rangappa says:

            No, all derivative contracts are routed via the exchanges. You cannot enter into an OTC arrangement, even if you do, it would not be regulated hence quite dangerous.

          • JEGANNATHAN AROCKIAM says:

            With respect to scenario 3, my query is, if Ajay buys the land paying 500000, at least he would have a property worth of 500000 even though he pays 600000 (100000 + 500000). But if he chose, not to buy the land he still spend 100000 in return for nothing. Which is the wise thing?

          • Karthik Rangappa says:

            Well, the idea is to focus on the pay off from the bet, and not really on the outcome of holding a piece of land 🙂

        • Devayani says:

          What benefit would Ajay get by calling off the deal before the expiry of 6 months?
          I guess nothing.
          He will instead wait for the whole 6 months for any chance of the highway project

      • Dipak jaishee says:

        Can i square off before the expiry…say after 5/6 days ..its way above the strike price i bought..can i exercise the ryt to buy ..within 5/6 days..

        • Karthik Rangappa says:

          You can book your P&L anytime you want, but you can exercise your option only the day of expiry.

          • Raja Sekhar Puligadda says:

            “You can book your P&L anytime you want, but you can exercise your option only the day of expiry” – can u elobarate more? By the way, do we have any mobile app version of learning? Thanks. Super useful!!!

          • Karthik Rangappa says:

            Raja, squaring off a position simply means you book your profit or loss as per your convenience. You can do this anytime you open a position. However, if you decide to hold the position to expiry, then it is deemed ‘exercised’ and instead of you squaring off the position, the exchange will do it for you.
            As far as the app is concerned – coming soon 🙂

          • gaurav mittal says:

            AS you are saying that options are exercised on the day of expiry then same applies app to future too ?

          • Karthik Rangappa says:

            Yes, it does.

      • Akbar Khan says:

        Hi Karthik,

        I bought a call option at a premium of Rs. 5 and sell the same at a premium of Rs. 8. Please confirm it ends here and I will not have any exposure or action to be taken at the time of expiry of the option.

        Or I will have two position at the expiry, buy and sell the underlying assets at strike price

        • Karthik Rangappa says:

          It ends here, Akbar. You have bought and sold a contract and therefore out of the market.

          • Shuyi says:

            Kindly clarify if I can square off the deal much before the expiry date of six month because of a hypothetical situation like thid.supposed state govt has agreed to start the said highway project but it I’d at the fag end of its tenure and i am pretty sure that a new government will come to power and it will cancel the project.So here I want to take chance during the window period as the land price is already high.so my question is whether I can execute the deal any time within six month because I know that the price will come dow in six months and I cannot afford to wait that long.please explain……

          • Karthik Rangappa says:

            Yes, in the options market, you can square off the position whenever you wish, no need to wait till expiry.

    • Sanjay says:

      Sir, can you please explain implied volatility.

    • Ravi says:

      Very good explanation with sample. Though it is my first attempt to understand, I am almost clear on what is option call.

  2. Saurabh says:

    Finally we started with Options! 🙂

    My first question Karthik is this: I checked NIFTY options on NSE .. turns out the expiry date dropdown contains dates till 26th Dec 2019. My questions are:

    1. Why is it then that you have mentioned that like futures there are 3 expiries available?

    2. The dropdown value on the NSE website does not contain all months expiries – after 18th May 2015 we have 25th June 2015 followed by 24th Sept 2015 and then 31st Dec 2015. What happened to the other months? For 2016 to 2019 only June and Dec contracts are available. What happened to the remaining?

    • Karthik Rangappa says:

      Saurabh, glad you noticed it! For all stocks options the expiry is very similar to futures. Hence we have current month, mid month, and far month contracts. However for Nifty there are several different expiry options. If you notice, these are long dated options with expiry in 2016, 2019 etc…options that are long dated has a special name for it, its called ‘Leaps’. So if you are talking about Nifty 8800 Call Option expiring in Dec 2019, then that is a Nifty Leap contract. Leaps are good if you have a super long term view on markets. However the problem with leaps in India is that they are not liquid, there are hardly any trading activity here.

      As far as your send queries goes, honestly I’m not sure why the contracts are so irregular. Guess I will find out the reason and get back to you on that 🙂

  3. Nilesh says:

    Dear Sir,

    As usual, nice and simple explanation…I am not trading in options as I could not understand it well. Now, I think I am clear. Thanks for this.

  4. Ram says:

    Share Spot Price=>67
    Buy call 90 Strike@premium of 5(Deep OTM option), Target on the same day
    If the premium increase from 5 to 8 can i exercise the option?
    Whether profit will be 3(8-5) or -2(8-5-5)
    can u clarify the profit based on premium not SP?

    • Karthik Rangappa says:

      You can exercise the option only on the expiry day, however you can book your profit due to the increase in premium. Your profit will be 8 – 5 = 3 per share.

      • RP HANS says:

        Sir, thanks for the easy concept on option. What I understand we can square off any position in option too before expiry date if profit is decent or stop loss set is triggered, in liquid stocks. Only the thing is that we have to pay the brokerage twice. Is it that we can not put SL for options?
        One more clarification I want to get is that the options are exercised means we have buy the underlying asset or the price difference will be adjusted in cash in case of the share market?

        • Karthik Rangappa says:

          You are right – you can square off anytime you wish…if you let the option for expiry there is no brokerage…otherwise you need to pay twice. But with Zerodha, your brokerage is so low anyway 🙂

          All options upon exercising is cash settled.

          • ashit says:

            I read somewhere if option exercise by exchange then we have to pay a huge penalty. What do u mean by exercise the option

          • ashit says:

            That means we can square off at any point of time (before or on expiry)
            1. Before expiry we have to pay the brokerage twice.
            2. On the expiry no brokerage but we have to do it by our own
            3. Else exchange will exercise that option on our behalf and charge huge penalty.
            1 confusion i have here is
            Exercise the option on expiry day means square off the option on expiry day?

          • Karthik Rangappa says:

            1) No, why do you think you have to pay brokerage twice?
            2) Brokerage is charged
            3) Not a penalty, it is STT

            To exercise, you just let the position run and do not close it.

      • SHIV PAL says:

        Sir , Is it exercising of option and booking of profits are different things ?

        • Karthik Rangappa says:

          Yes they are. Exercising of an option is done upon expiry whereas profit/loss booking can be done anytime after taking the trade.

      • chaitanya says:

        Is there any specific process on zerodha to buy a XYZ stock at strice price or exercise the options. OR a normal stock purchase transaction on expiry day will be treated as exercise? For ex : I have INFYTECH May 980 CE and if I want to exercise INFYTECH stock on exipry day. what is the process to do so?

      • Santhosh says:

        So in this example, when I book profit at 8 before the contract expiry date, will I get Rs 8 or Rs 3? If I get only 3, I would lose Rs. 2 when exercising the option on the expiry date. Is this analysis correct?

        • Karthik Rangappa says:

          You will get the difference between the premium i.e the premium you buy minus the premium you sell at.

  5. krishnan says:

    As usual Karthik at his best starting with options…only concern is the time taken to upload other chapters..: (…hoping to see other chapters at the earliest.Thanks once again Karthik for your splendid efforts…

    • Karthik Rangappa says:

      Thanks Krishnan, it takes a bit of a time to upload chapters (apologies for that)..but we will put our best efforts to ensure the wait if worth your time 🙂

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