Capital Market » Option

MEANING OF OPEN INTEREST

capitalmarket — Fri, 23 Dec 2011 13:24:32 +0000

Open Interest also know as OI, is the total number of options and futures contracts that are not closed on a particular day. As you might be aware of volume in a particular stock in equity market, option trading involves the creation of a new option contract when a trade is placed. Open interest
will tell you the total number of option contracts that are currently open.

Open Interest is mostly used to confirm a trend for a particular futures contract, For eg, lets look at Reliance 1000 May CALL, the open interest might tell us that there have been 5 options open in the month of May, a trader might then wonder does this refer to the number of contracts bought or sold.

*Working*
When a trader buy’s or sell’s an option, the transaction needs to be entered as either an opening or a closing transaction. If he buy’s 5 RELIANCE May 1000 CALL, he is buying the calls to ‘open’, i.e he is opening his position in a futures contract, which causes the Open interest to rise by 5, and then after sometime(within) the month he decides to sell his contract i.e close his position in a particular contract, then he is causing the open interest to go down by 5.

Open interest applies primarily to the futures market, it helps the measure the flow of money into the futures Market. For each seller of a futures contract (eg RELIANCE 1000 CALL) there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract.

A rise in open interest in a futures contract along with its price indicates bullishness, which means investors are creating long positions and vice versa.

The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number.

*Advantages of monitoring Open Interest*
Changes in the Open Interst as mentioned earlier can help a trader interpret the future trend of a particular contract.

*Open Interest RISING ->* Indicates that the present trend (up, down, flat) will continue

*Open Interest FALLING->* Indicates that the prest trend(up, down, flat) is likely to change or is coming to and end.

LEVERAGE AND RISK

capitalmarket — Thu, 03 Jun 2010 17:38:34 +0000

Options can provide leverage.This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying equity. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment’s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner’s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.

LONG IN OPTION

capitalmarket — Wed, 02 Jun 2010 18:51:58 +0000

With respect to this booklet’s usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock.

When you are long an equity option contract:

■ You have the right to exercise that option at any time prior to its expiration.

■ Your potential loss is limited to the amount you paid for the option contract.

With respect to this booklet’s usage of the word, longdescribes a position (in stock and/or options) in which youhave purchased and own that security in your brokerageaccount. For example, if you have purchased the right to buy100 shares of a stock, and are holding that right in youraccount, you are long a call contract. If you have purchasedthe right to sell 100 shares of a stock, and are holding thatright in your account, you are long a put contract. If youhave purchased 1,000 shares of stock and are holding thatstock in your brokerage account, or elsewhere, you are long1,000 shares of stock.When you are long an equity option contract:n You have the right to exercise that option at any time priorto its expiration.n Your potential loss is limited to the amount you paid forthe option contract.

INTRODUCTION TO OPTION

capitalmarket — Wed, 02 Jun 2010 18:49:16 +0000

Although this level of knowledge is assumed, a brief review of equity option basics is in order:

■ An equity option is a contract which conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist.The seller of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.

■ Equity option contracts usually represent 100 shares of the underlying stock.

■ Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.The

strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades, which fluctuates daily.

■ Equity option strike prices are listed in increments of 1, 21/2, 5, or 10 points, depending on their price level.

■ Adjustments to an equity option contract’s size and/ or strike price may be made to account for stock splits, mergers or other corporate actions.

■ Generally, at any given time a particular equity option can be bought with one of four expiration dates.

■ Equity option holders do not enjoy the rights due stockholders – e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible

for these rights.

■ Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices.

TIME DECAY

capitalmarket — Wed, 02 Jun 2010 18:39:02 +0000

Generally, the longer the time remaining until an option’s expiration, the higher its premium will be.This is becausethe longer an option’s lifetime, greater is the possibility thatthe underlying share price might move so as to make theoption in-the-money. All other factors affecting an option’sprice remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life.When an option expiresin-the-money, it is generally worth only its intrinsic value.

In-the-money, At-the-money, Out-of-the-money

capitalmarket — Wed, 02 Jun 2010 18:18:57 +0000

The strike price, or exercise price, of an option determines whether that contract is in-the-money, at-the-money, or outof-the-money. If the strike price of a call option is less thanthe current market price of the underlying security, the callis said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stockmarket. Likewise, if a put option has a strike price that isgreater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price whichis greater than the price he would receive selling the stock inthe stock market.The converse of in-the-money is, not surprisingly,out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.

The amount by which an option, call or put, is in-themoneyat any given moment is called its intrinsic value.Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium.This does not mean, however, theseoptions can be obtained at no cost. Any amount by which anoption’s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option’s premium that is affected by fluctuationsin volatility, interest rates, dividend amounts and the passageof time.There are other factors that give options value,therefore affecting the premium at which they are traded.Together, all of these factors determine time value.

Equity call option:

In-the-money = strike price less than stock price

At-the-money = strike price same as stock price

Out-of-the-money = strike price greater than stock price

Equity put option:

In-the-money = strike price greater than stock price

At-the-money = strike price same as stock price

Out-of-the-money = strike price less than stock price

Option Premium = Intrinsic Value + Time Value