Q4.1: What is an “option”?
A: An option is the right, but not the obligation, to buy or sell something at a stated date
at a stated price. A “call option” gives one the right to buy, a “put option” gives one the
right to sell.
Consider a typical transaction. On 1 July 2000, S sells a call option to L for a price of
Rs.3.25. Now L has the right to come to S on 31 Dec 2000 and buy 1 share of Reliance
at Rs.500. Here, Rs.3.25 is the “option price”, Rs.500 is the “exercise price” and 31 Dec
2000 is the “expiration date”.
L does not have to buy 1 share of Reliance on 31 Dec 2000 at Rs.500 from S (unlike
a forward/futures contract which is binding on both sides). It is only if Reliance is above
Rs.500, on 31 Dec 2000, that L will find it useful to exercise his right. If L chooses to
exercise the option, S is obliged to live up to his end of the deal: i.e. S stands ready to
sell a share of Reliance to L at Rs.500 on 31 Dec 2000.
Hence, at option expiration, there are two outcomes that are possible: an option could
be profitably exercised, or it could be allowed to die unused. If the option lapses unused,
then L has lost the original option price (Rs.3.25) and S has gained it.
When L and S enter into a futures contract, there is no payment (other than initial
margin). In contrast, the option has a positive price which is paid in full on the date that
the option is purchased.
Options come in two varieties – european and american. In a european option, the
holder of the option can only exercise his right (if he should so desire) on the expiration
date. In an american option, he can exercise this right anytime between purchase date and
the expiration date.
The price of an option is determined on the secondary market. An option always has
a non-negative value: i.e., the value of an option is never negative. ••

Q4.2: How would index options work?
A: As with index futures, index options are cash settled.
23

Table 4.1 Option prices: some illustrative values
Option strike price
1400 1450 1500 1550 1600
Calls
1 mth 117 79 48 27 13
3 mth 154 119 90 67 48
Puts
1 mth 8 19 38 66 102
3 mth 25 39 59 84 114
Assumptions: Nifty spot is 1500, Nifty
volatility is 25% annualised, interest rate
is 10%, Nifty dividend yield is 1.5%.
Suppose Nifty is at 1500 on 1 July 2000. Suppose L buys an option which gives him
the right to buy Nifty at 1600 from S on 31 Dec 2000. It turns out that this option is worth
roughly Rs.90. So a payment of Rs.90 passes from L to S for having this option.
When 31 Dec 2000 arrives, if Nifty is below 1600, the option is worthless and lapses
without exercise. Suppose Nifty is at 1650. Then (in principle) L can exercise the option,
buy Nifty using the option at 1600, and sell off this Nifty on the open market at 1650. So
L has a profit of Rs.50 and S has a loss of Rs.50. In this case, “cash settlement” consists
of NSCC imposing a charge of Rs.50 upon S and paying it to L. ••

Q4.3: What kinds of Nifty options would trade?
A: The strike prices and expiration dates for traded options are selected by the exchange.
For example, NSE may choose to have three expiration months, and five strike prices
(1200,1300,1400,1500,1600). There would be two types of options: put and call. This
gives a total of 30 distinct traded options (3 × 5 × 2), with 30 distinct order books and
prices.
A typical set of option prices is shown in Table 4.1. It illustrates the intruiging nature
of option prices.
When Nifty is at 1500, the right to buy Nifty at 1600 one month away is worth little
(Rs.13). The buyer of this option puts down Rs.13 when the option is purchased, and this
fee is non–refundable. If Nifty turns out to be above 1600 after a month, this option will
prove to be valuable. If Nifty proves to be at 1602 after a month, the option will pay Rs.2.
Conversely when Nifty is at 1500, the right to sell Nifty at 1400 one month away isn’t
worth much (Rs.8): this is the “insurance premium” for protecting yourself against a fall
in Nifty of worse than a hundred points.
However, when we increase the time to expiration of the option, there is a greater
chance that prices can move around, and these same options become worth more: e.g. the
right to sell Nifty at 1600 is worth Rs.25 when we consider a three–month horizon (i.e.
insurance against a hundred–point drop on a three–month horizon). •• Also see: Hull (1996).

Q4.4: When would one use options instead of futures?
A: Options are different from futures in several interesting senses.
At a practical level, the option buyer faces an interesting situation. He pays for the
option in full at the time it is purchased. After this, he only has an upside. There is no
possibility of the options position generating any further losses to him (other than the
funds already paid for the option). This is different from a futures: which is free to enter
into, but can generate very large losses. This characteristic makes options attractive to
many occasional market participants, who cannot put in the time to closely monitor their
futures positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance
which reimburses the full extent to which Nifty drops below the strike price of the
put option. This is attractive to many people, and to mutual funds creating “guaranteed
return products”. The Nifty index fund industry will find it very useful to make a bundle
of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund,
which gives the investor protection against extreme drops in Nifty.
Selling put options is selling insurance, so anyone who feels like earning revenues by
selling insurance can set himself up to do so on the index options market.
More generally, options offer “nonlinear payoffs” whereas futures only have “linear
payoffs”. By combining futures and options, a wide variety of innovative and useful
payoff structures can be created. •• Also see: Mariathasan (1997).

Q4.5: What are the patterns found, internationally, in options
versus futures products on a given underlying?
A: In general, both futures and options trade on all underlyings abroad. Indeed, the international
practice is to launch futures and options on a new underlying on the same day.
••

Q4.6: What determines the price of an option?
A: Supply and demand on the secondary market drives the option price.
On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31 Dec 2000 with
a strike of 1500” will trade at a price that purely reflects supply and demand. There is a
separate order book for each option which generates its own price.
The values shown in Table 4.1 are derived from a theoretical model. If the secondary
market prices deviate from these values, it would imply the presence of arbitrage opportunities,
which (we might expect) would be swiftly exploited. But there is nothing innate
in the market which forces the prices in the table to come about. ••