How do options work?

Options are derivatives of an underlying financial instrument such as stocks, indices, commodities, and currencies. A good analogy is curd, which is a derivative of milk. Just as a rise or fall in the price of milk increases or decreases the price of curd, fluctuations in the price of the underlying asset also affect the price of options.

Options are traded on the MSE, MCX, etc. exchanges, just like stocks and commodities. Each option contract specifies the strike price, premium, lot size, and expiration date.

• Strike price: The price that the buyer and seller of an option agree to pay to enter into the option contract.
• Premium: The payment that the buyer makes to the seller to acquire his right to an option contract.
• Expiry date: The last day on which the option holder can exercise his right.
• Lot size: The specified number of units of the underlying asset that are part of a single option contract.

As with any other business transaction, there are buyers and sellers in options trading. The buyers of options have rights or a choice and the sellers have obligations. Buyers have the choice to exercise their right to buy/sell an option before expiration or to exit and let the option expire.

There are two types of options: Calls and Puts. A call option gives you the right to buy the option, while a put option gives you the right to sell the option.

The expiry date of options in India

In India, four types of options can be traded, which expire on different dates.

1. Stock options: Stock options have monthly contracts and expire on the last Thursday of every month.
2. Index options: For index options, there are monthly and weekly contracts. Monthly contracts expire on the last Thursday of each month. Weekly contracts expire on Thursdays.
3. Commodity options: Commodity options expire three business days prior to the tender period of the underlying commodity futures.
4. Currency options: Currency options expire two business days prior to the last business day (i.e., the last trading day) of the expiration month.

Option Settlement

When options are settled, either the cash amount is paid or the underlying asset is delivered after the trade has been executed.

1. Stock options: Stock options are settled either in cash or physically. Stock options are settled two days after the execution date, i.e. T+2.
2. Index options: Index options are settled in cash. Index options are settled one day after the execution date (T+1).
3. Commodity options: Commodity options are settled either in cash or physically. All ITM commodity option contracts are converted into the corresponding futures contract of the current month on the expiration date. ITM contracts held until the expiration date require a margin payment equal to the futures contract, which is transferred on the next trading day.
4. Currency options: Currency options are settled by cash settlement.