Chapter 10: Learn Advanced Concepts in Options – Part 2

Just like the geographic world is divided based on different continents and countries, some of those divisions exist in Options contracts in terms of how they are exercised. These are American and European Options. Let’s explore these in detail.

American and European Options

There are two kinds of exercise styles that are normally used in the derivatives market, namely European and American.

European Options are those Options that can only be exercised by the long party at their corresponding expiration dates and not at any time before expiry.

On the other hand, American Options are those that allow the flexibility of exercising Options at any point in time till expiry.

European Call and Put Options are denoted by CE and PE respectively, while American Call and Put Options are denoted by CA and PA respectively.

Since all Option contracts in India are European, is it necessary to hold my Option position till expiry?

No, it is not necessary to hold your position till expiry in a European Option. You can square off your position by selling an equal number of Options that you have bought on the same underlying asset with the same maturity and strike price.

For example, if you have bought a 3-month Call Option of Stock A which has a strike price of 1,000 and a contract size of 100. After 1 month, you can square off your position by selling a Call Option on the same underlying with the same strike price and expiry date.

• The difference between the two trades will give you a net premium (premium paid on long Call Options minus the premium received on selling a Call Options) which would be total profit or loss from the trade. 

Exercising Options

The exercising of Option means that an Option holder is ready to either buy or sell the underlying as per the positions held. 

• A Call Option exercised by the Option holder would indicate that he is ready to buy the underlying at the strike price because the spot price is more than the strike price.
• On the other hand, exercising a Put Option would indicate that the Option holder is ready to sell the underlying at the strike price because the spot price is lower than the strike price.

Options are exercised when an Option buyer does not seem to be getting the fair price of the Option in the market. For example, let’s assume you have purchased ABC Ltd. at Rs.100 CE (Call European) at the beginning of a month. On the expiry of the contract, the spot price of ABC Ltd. goes up to Rs. 110. This means that the intrinsic value of the Option is Rs. 10, so the premium on this Option should be Rs. 10. If in the market, the quoted premium is less than Rs. 10, you can exercise your right at the time of expiry to get the full benefit of intrinsic value in case of a European Option. However, in an American Option, it is possible if you want to exercise your right before expiry.

• If you choose to exercise the European Option, you will get the intrinsic value of the Option on the expiry irrespective of the market price.
• In this case, the Call Option is assigned to the Option writer and he will be forced to pay the intrinsic value to the Option holder.

Put Call ratio (PCR) and its significance

Put-Call ratio (PCR) is determined by dividing the total number of tradable contracts on Put Options by the total number of tradable contracts on Call Options. Put Option indicates the right to sell the asset and Call Option indicates the right to buy the asset at a particular price at a specified date.

The PCR is one among the most important tools to gauge the sentiment of the market at any given point in time. If the PCR is greater than 1, it would signify a bearish market (traders are buying more Puts as compared Calls) and if it is less than 1, then it would imply that (traders are buying more Calls as compared to Puts), indicating a bullish market.

• For example, if the PCR of Nifty is 1.35, it indicates more Puts in line as compared to Calls, (bearish signal) or we could alternately say that 135 Puts are bought for every 100 Calls.
• The Traders also interpret PCR in contrary. If a high PCR of 1.35 signifies a bearish trend, traders think there is an opportunity to take a reverse position (Buy Calls or Sell Puts) to make a profit. Similarly, if PCR signifies a bullish trend, traders may think of taking a reverse position (Buy Puts or Sell Calls) to make a profit.

Summary

• There are two kinds of exercise styles used in the derivatives market: European and American.
• European Options are those Options that can only be exercised by the long party at their corresponding expiration dates and not at any time before expiry.
• American Options are those that allow the flexibility of exercising Options at any point in time till expiry.
• It is not necessary to hold your position till expiry in a European Option. You can square off your position by selling an equal number of Options that you have bought on the same underlying asset with the same maturity and strike price.
• The exercising of Option means that an Option holder is ready to either buy or sell the underlying as per the positions held. 

In the next chapter, we will look at different Options Greeks that define the impact of the various factors on the Options price.