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Sunday, July 08, 2001













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Options with diverse value

B. Venkatesh

THE Securities and Exchange Board of India (SEBI) has directed that option premiums should be fixed based on whether the options are in-the-money, at-the-money or out-of-money?

What do these terms mean?

Suppose you buy an August call option on Infosys with a strike price of Rs 3,500. This option gives you the right to buy Infosys at Rs 3,500 before end August.

Suppose Infosys is currently trading at Rs 3,250 but a fortnight later, the price of the stock in the spot market rises to Rs 3,750. This means you have an option to buy Infosys at Rs 3,500 against the spot price of Rs 3,750. You, thus, gain Rs 250 per share if you exercise your option. The option is, therefore, said to be in-the-money to the extent of Rs 250.

What if Infosys is instead trading at Rs 3,500? Notice that the spot price of Infosys is now same as the option's strike price. The option is then said to be at-the-money. You do not gain by exercising the option.

Finally, if Infosys trades at any price below the strike price of the call option you have bought, the option is said to be out-of-money. An out-of-money option expires without the buyer exercising the contract.

When option writers sell contracts that are in-the-money, they charge higher option premiums. The reason is that the option sellers incur losses if the buyers exercise such contracts.

In the above case, if you exercise a call option at a strike price of Rs 3,500 when Infosys is trading at Rs 3,750, the option writer loses Rs 250 per share. Notice that your gain per share is exactly the option writer's loss. This is because options contract is a zero-sum game.

Now, suppose Infosys trades at Rs 4,000 against a strike price, say, Rs 3,250. Since this call option fetches you more money, the market terms such contracts as deep in-the-money. Similarly, a deep out-of-money option refers to options whose strike prices are way above the spot price of the underlying stock.


Section  : Personal Finance
Previous : Option Basics - VII
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