How Options Work in the Indian Stock Market

Written By: Ansh Jain

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price (the strike price) on or before a certain date (the expiration date). They are versatile tools that can be used for various purposes, including hedging, speculation, and income generation.

How Options Work:

1. Buying a Call Option: If you believe the price of an asset will go up, you can buy a call option. If the price rises above the strike price, your option becomes valuable, and you can either exercise it to buy the asset at the lower strike price or sell the option contract for a profit.  
2. Buying a Put Option: If you believe the price of an asset will go down, you can buy a put option. If the price falls below the strike price, your option becomes valuable, and you can either exercise it to sell the asset at the higher strike price or sell the option contract for a profit.  
3. Selling (Writing) Options: When you sell an option, you receive the premium but take on the obligation to fulfill the buyer’s right if the option is exercised. This can be riskier than buying options.

1. Key Elements of Options Trading in India:

• Trading: Options are traded on major stock exchanges in India, primarily the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).  
• Contracts: Options contracts are standardized, meaning they have fixed expiry dates and strike prices.
  • Expiry: Indian options typically expire on the last Thursday of the expiry month.  
  • Lot Size: Each option contract represents a fixed number of shares of the underlying asset (this varies depending on the stock or index).  
• Premium: Buyers pay a premium to the sellers for the right granted by the option.  
• Settlement: Options are settled in cash in India. If you exercise an option, you receive the difference between the market price and the strike price in cash.  

2. Who trades options in India?

• Hedgers: To protect their existing investments from adverse price movements.  
• Speculators: To profit from anticipated price movements.  
• Arbitrageurs: To exploit pricing inefficiencies for risk-free profits.  

Process of buying and selling of options in NSE / BSE

The process of buying and selling options on the NSE (National Stock Exchange) and BSE (Bombay Stock Exchange) is very similar, as both exchanges follow SEBI regulations and have standardized procedures. Here’s a breakdown of the process:

1. Understanding Options Contracts:

• Underlying asset: Choose the stock or index on which you want to trade options (available on the NSE/BSE).  
• Strike price: Select the strike price that aligns with your market view. Both exchanges list a range of strike prices for each underlying asset.  
• Time to expiry: The time remaining until the option contract expires. Indian options typically expire on the last Thursday of the expiry month.  
• Volatility: The degree of fluctuation in the underlying asset’s price.  
• Interest rates: Affect the cost of carrying the underlying asset.  
• Option Type: Decide whether to buy a call option (right to buy) or a put option (right to sell).

2. Placing Orders:

• Trading Platform: Use your broker’s trading platform (website or mobile app) to access the options trading segment of the NSE/BSE.  
• Order Entry: Enter the details of the option contract you want to trade:
  • Symbol of the underlying asset
  • Expiry date
  • Strike price
  • Option type (Call/Put)
  • Order side (Buy/Sell)
  • Quantity (number of contracts)
  • Order type (market order, limit order, etc.)

• Order Confirmation: Review and confirm your order details before submitting it.

3. Order Execution and Matching:

• Order Matching: The exchange’s trading system matches buy and sell orders based on price and time priority.  
• Order Confirmation: Once your order is executed, you’ll receive a confirmation message from your broker.

4. Monitoring and Managing Positions:

• Track Your Positions: Monitor your open options positions on your broker’s platform.  
• Market Monitoring: Track the price movements of the underlying asset and how they affect your option’s value.
• Risk Management: Consider using stop-loss orders or other strategies to manage potential losses.

5. Squaring Off or Exercising:

• Square Off: Before expiry, you can sell the option contract in the market to realize profits or losses. This is the most common way to exit an options position.  
• Exercise: On or before the expiry date, you can choose to exercise your option if it’s in-the-money (profitable). In India, options are settled in cash.  

Key Points to Note:

• Margin Requirements: NSE and BSE have margin requirements for options trading, which can vary based on the risk profile of the position.  
• Trading Hours: Options trading on both exchanges aligns with the regular trading hours for equities.
• Settlement: Options are settled in cash on the next trading day (T+1).

Let’s take an example: –

Reliance Industries is currently trading at ₹1250. You believe the stock has the potential to rise significantly in the coming months, perhaps due to positive news about its telecom or retail businesses.

Example with a Call Option:

• You buy a call option: Let’s say you buy a call option on Reliance with a strike price of ₹1350 and an expiry date of February 29, 2024. This option gives you the right, but not the obligation, to buy Reliance shares at ₹1350 on or before February 29th, regardless of the market price at that time.
• Premium: You pay a premium for this right, say ₹30 per share. Since options contracts usually cover a fixed number of shares (the lot size), you’ll pay a premium multiplied by the lot size.  
• Possible outcomes:
  • Reliance price rises: If Reliance’s price goes up to ₹1500 by February 29th, your call option becomes valuable. You can exercise your option to buy shares at ₹1350 and immediately sell them in the market at ₹1500, making a profit (minus the premium paid).
  • Reliance price stays the same or falls: If Reliance’s price remains below ₹1350, your call option expires worthless, and you lose the premium you paid.

Example with a Put Option:

• You buy a put option: Say you’re bearish on Reliance and believe its price might fall. You buy a put option with a strike price of ₹1200 and the same expiry date of February 29, 2024. This gives you the right to sell Reliance shares at ₹1200.
• Premium: You pay a premium for this right, say ₹20 per share.
• Possible outcomes:
  • Reliance price falls: If Reliance’s price drops to ₹1100 by expiry, your put option is valuable. You can buy shares in the market at ₹1100 and exercise your option to sell them at ₹1200, making a profit.
  • Reliance price stays the same or rises: If Reliance’s price stays above ₹1200, your put option expires worthless, and you lose the premium.

Regulatory requirements for Options Trading in India

The Securities and Exchange Board of India (SEBI) is the primary regulator for the options market in India. Here are some key regulatory requirements for options trading:

1. Eligibility:

• Trading Account: You need a trading account with a SEBI-registered broker to trade options.
• KYC Compliance: You must complete Know Your Customer (KYC) norms, providing necessary identification and financial documents.
• Option Approval: Your broker may require you to get specific approval for options trading by assessing your understanding of options and risk profile.

2. Margin Requirements:

• SPAN Margin: SEBI mandates brokers to collect Standardized Portfolio Analysis of Risk (SPAN) margin from traders. This margin covers potential losses based on a sophisticated risk assessment model.  
• Exposure Margin: An additional margin may be required based on your overall position and risk exposure.
• Mark-to-Market (MTM) Settlement: Daily MTM settlements require traders to settle their profits and losses on their positions every day.

3. Position Limits:

• Individual Limits: SEBI limits the maximum number of options contracts an individual can hold on a single underlying asset.  
• Client-level Limits: Brokers also impose their limits on client positions to manage risk.

4. Contract Specifications:

• Standardized Contracts: SEBI defines the specifications for options contracts, including expiry dates, strike prices, and lot sizes.  
• Expiry Day: Options contracts in India typically expire on the last Thursday of the expiry month.  

5. Other Regulations:

• Risk Management: Brokers are required to have robust risk management systems in place to monitor and manage risks associated with options trading.  
• Investor Protection: SEBI has measures in place to protect investors, including grievance redressal mechanisms and investor education initiatives.  
• Reporting and Disclosure: Brokers and traders need to comply with reporting and disclosure requirements to ensure transparency.

Recent Changes:

• Increased Contract Value: SEBI has recently increased the minimum contract value for index derivatives, making it more challenging for smaller retail traders to participate.  
• Extreme Loss Margin (ELM): An additional ELM is levied on short index options contracts on the expiry day to increase tail risk coverage.  
• Upfront Premium Collection: Brokers will be required to collect option premiums upfront from February 1, 2025, to discourage excessive intraday leverage.