Options: Choices of action.

CHOICES OF ACTION – for the holder and writer.

After a person has bought an option, what are the choices of action he has? That’s the next topic we need to discuss.

In the case of the holder of a call, He has 3 choices before him –

  • Do nothing – wait till the expiry
  • Close out – reverse his trade. I.e. if he bought a call, write a matching call.
  • Exercise the option – ( in the case of American options only )


And, what about the writer?

A writer has only two choices.

  • Do nothing – wait till the expiry
  • Close out – reverse his trade. I.e. if he bought a call, write a matching call.

The third option is not there for him as he doesn’t have any right to exercise. An option can be closed out and it doesn’t matter whether the option is American or European.  This was clearly explained in option styles.

There are two more points to discuss in this post. As the expiry date approaches, we need to know -

  • What really happens on the expiry date?  … and
  • What would be the value of options on the expiry date?

1. WHAT HAPPENS ON THE EXPIRY DATE?

Only in-the-money options will be exercised on the expiry date. Both at-the-money and out-of-the-money options will not be exercised by the holders since it is not beneficial for them.

In India, The National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives segment. The NSCCL acts as legal counter-party to all deals on NSE’s F&O segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE, who clear and settle such deals through them.

For example – you have RIL CE 650 28 JUNE. You bought it for a premium of Rs 40.  What does that mean? You are the holder of Reliance industries European call at strike Rs 650 expiring on 28th June 2012. The value you pay for that option is Rs 40. When you buy that, you get a contract giving you the right to buy RIL’s shares at Rs 650 irrespective of it’s settlement price on June 28th 2012. The NSCCL will act as legal counter-party to you and will guarantee settlement. You need not worry about who is going to sell those stocks to you, in case you exercise the option.

Example 2- Today is April 3rd. You write a call that obligates to deliver 100 shares of RIM for the price of Rs 200 within last Thursday of April ( option expiry). Your ‘sell’ is actually bought by the NSCCL and adds it to the several other option writers in its pool. Suppose, someone, say Mr. A, buys a call in the same series that you sold.  He actually buys it from the NSCCL and he get the contract that grants him the right to buy 100 shares of RIM t Rs 200 within option expiry.

Now, let’s assume that on April 10th, you decide to close your short position by buying a call with the same terms that you wrote, resulting in a profit or loss.  Mr. A on the other hand decides to keep his long position till option expiry. This can be done since, NSCCL is the legal counter party and Mr. A will be guaranteed his shares by NSCCL, should he exercise his option to buy.

Thus, the NSCCL allows each investor to act independently of the other.

2. WHAT WOULD BE THE VALUE OF OPTION ON EXPIRY DATE?

As we learnt in the article option premium, an option gains value when it’s in the money. In the case of a call option it means that, if on the expiry date, the stock price finishes above the strike price, the option will have the value which is ( market price – strike price).In all other cases, the value of the option will be ‘0’.

In the case of a put option, it means that, if on the expiry date, the stock price finishes below the strike price, the option will have the value which is ( strike price – market price).In all other cases, the value of the option will be ‘0’.

You may like these posts:

  1. Options: Option styles
  2. Options: Understanding strike price.
  3. Options: Kick off

4 Responses to “Options: Choices of action.”

premsunderdas

June 29, 2012 at 4:07 am

In most cases the premium keeps coming down gradually and many times even when the price of share is above strike price there are no profits. Please explain.

J Victor

July 2, 2012 at 8:55 am

Hi

i did not understand your question properly.Does this post answer your question?

http://www.sharemarketschool.com/options-break-even-point/

Nolan

August 9, 2012 at 2:15 am

Thanks Victor for such awesome articles.

I need help in understanding how the matching of orders takes place in the trading application. Like u hav, Market Orders, limit orders, stop loss orders. How do they react in pre-session…post market and so on…in short how the matching takes place…please explain with examples… . Since I am working in capital market domain as a TE…my next project requires me to understand these things….pls help.

Thanks in advance

Regards

Nolan

J Victor

August 11, 2012 at 7:50 pm

definitely.. this section however, is exclusively for derivatives. we will deal with it in some other place.

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