Option buyers have to merely pay the premium and no margins are applicable to them. The exchanges levy margins on options writers as they face unlimited losses.
The margining system currently adopted buy India is a sophisticated, mechanism based on SPAN software, a program developed by Chicago Mercantile Exchange. This program creates 16 imaginary scenarios for each option position. These scenarios are based on varying levels of price movements and volatility movements. After accounting for all these, the maximum possible loss that an investor incurs is calculated. This maximum possible loss is the margin amount to be paid by an investor. An option writer should be prepared to bring in margins of around 20 to 40 percent of the National Contract Value. If volatility of a scrip is high margins are also high.
The investor has to pay this margin to his broker in cash equivalents or equity securities. Cash equivalents comprise government securities, debt securities, bank guarantees, fixed deposit, and treasury bills.
Example of a Call Option: An investor buys a call option to buy 100 Reliance Shares at a price of Rs 300 on October 15, 2002. The current price is Rs 250 and the premium (price) for the option is Rs 25 per share. The investor will have to pay Rs 2,500 as the premium for buying the call option, which is also referred to as the initial investment. He is entitled to get 100 shares of Reliance at the price of Rs 300 on October 15, 2002. If the market price of Reliance goes up to Rs 400, the investor will exercise his right by paying Rs 30,000 the original contract price. He can sell these shares in the market at the current price of Rs 400 and get Rs 40,000 . The net gain to investor is Rs 7,500 [(spot price – strike price) – strike price) – premium], that is (Rs 40,000 – Rs 30,000 – Rs 2,500). Suppose the price of Reliance shares goes down to Rs 200 by October 15, the investor will not exercise his option as he is under no obligation to buy the shares. His loss will be only Rs 2,500 the premium he had paid to buy the call option.
A call option unlimited profit potential a there is no upper limit to the stock price:
Example of a Put Option: An investor buys out options to sell Reliance shares at a price of Rs 300 by October 15, 2002. He pays a premium of Rs 25 share to buy this option. Now if the share price of Reliance goes down, to say, Rs 200 the investor can exercise his right to sell these 100 shares at the strike price of Rs 300. He will buy 100 shares at Rs 200 per share to sell them at Rs 300 per share. His net gain is Rs 7,500 [(strike price – spot price) – premium)] = (Rs 30,000 – Rs 20,000 – Rs 2,500 premium) Suppose, the share price of Reliance goes up to Rs 350, the investor will not exercise his options and his loss will be Rs 2,500 he had paid as premium. It is worthwhile exercising a put option only if the market price of the stock turns out to be lower than the strike price. If the strike price is greater than the stock price, the option has an intrinsic value. The buyer of an option pays a premium which consists of the intrinsic value, if any, plus time value. The maximum profit from buying a put option is limited only by the fact that the stock price cannot fall below zero.
At any point, several puts are quoted in the market. For instance, Reliance 320, 300, 280, 260 ad 220. There are minimum of five strike prices available. On volatile scrips the number of strike prices is around seven on an average. In case of puts, higher strike prices carry a higher premium and lower strike prices carry a lower premium. With lower strike puts, the protection starts late and the investor should be willing to bear loss till the scrip reaches the strike price. With higher strike puts, protection starts the moment the scrip quotes below the strike price.