NISM Series VIII · Unit 4 of 10 · about 25% of the paper
Introduction to options: NISM Series VIII notes and practice questions
Options are the second heavy unit. Calls, puts, moneyness, premium, Greeks, put-call parity and the payoff of each position.
What to know in Unit 4
- Payoffs and break-even of calls and puts.
- Intrinsic value and time value.
- The Greeks.
- Settlement and exercise.
Key terms, examples and exam traps
Call option buyer
The buyer of a call pays a premium and has the right to buy the underlying at the strike. Maximum loss is the premium and the potential profit is unlimited.
Example. A trader pays ₹20 for the right to buy at ₹500 and expects a rise.
Exam trap. This statement is false: A call buyer has unlimited loss.
Call option seller
The call seller (writer) receives the premium and must sell the underlying at the strike if exercised. The maximum profit is the premium and the loss is potentially unlimited.
Example. A trader receives ₹20 and must sell if the price rises sharply.
Exam trap. This statement is false: A call writer has unlimited profit and limited loss.
Put option buyer
The buyer of a put pays a premium and has the right to sell at the strike. Maximum loss is the premium; profit rises as the price falls to zero.
Example. A trader pays ₹15 for the right to sell at ₹500 and expects a fall.
Exam trap. This statement is false: A put buyer benefits when the price rises.
Put option seller
The put seller receives the premium and must buy the underlying at the strike if exercised. Maximum profit is the premium; loss can be large if prices fall.
Example. A trader receives ₹15 and must buy at ₹500 if the price collapses.
Exam trap. This statement is false: A put writer has unlimited profit.
In-the-money
A call is in the money when spot is above the strike; a put is in the money when spot is below the strike. It has positive intrinsic value.
Example. A call with strike 500 when spot is 550.
Exam trap. This statement is false: A call is in the money when spot is below the strike.
At-the-money
An option is at the money when the strike equals the spot price. Its intrinsic value is zero.
Example. A call with strike 500 when spot is 500.
Exam trap. This statement is false: An at-the-money option has high intrinsic value.
Out-of-the-money
A call is out of the money when spot is below the strike; a put when spot is above the strike. It has no intrinsic value, only time value.
Example. A put with strike 500 when spot is 550.
Exam trap. This statement is false: An out-of-the-money option has the highest intrinsic value.
Intrinsic value
Intrinsic value is the amount by which an option is in the money, and is never negative. For a call it is the greater of (spot − strike) and zero.
Example. A call with strike 500 and spot 560 has a value of ₹60 on exercise.
Exam trap. This statement is false: Intrinsic value of an option can be negative.
Time value
Time value is the part of the premium above intrinsic value, reflecting the chance of further favourable moves; it falls to zero at expiry.
Example. An option with intrinsic value ₹60 and premium ₹75 has ₹15 of this.
Exam trap. This statement is false: Time value rises as expiry approaches.
Option premium determinants
The premium depends on spot, strike, time to expiry, volatility, interest rates and dividends; higher volatility and longer time raise it.
Example. An option on a very volatile stock costs more than one on a stable stock.
Exam trap. This statement is false: Volatility has no effect on option premium.
Implied volatility
Implied volatility is the volatility the market's option prices imply for the underlying, derived from the option price.
Example. Option prices suggest the market expects larger swings.
Exam trap. This statement is false: Implied volatility is the volatility in the past year.
Delta
Delta measures the change in an option's price for a ₹1 change in the underlying. Calls have delta between 0 and 1; puts between −1 and 0.
Example. A call with delta 0.5 gains about ₹0.50 if the underlying rises ₹1.
Exam trap. This statement is false: Delta measures the effect of time decay.
Gamma
Gamma measures how much delta changes for a ₹1 move in the underlying. It is highest for at-the-money options near expiry.
Example. The sensitivity of delta is greatest for options near the strike.
Exam trap. This statement is false: Gamma is the change in price for time decay.
Theta
Theta measures the loss in option value as one day passes, other things equal. It hurts option buyers and helps sellers.
Example. An option loses a little value each day as expiry nears.
Exam trap. This statement is false: Theta helps option buyers.
Vega
Vega measures the change in an option's price for a 1% change in volatility. Higher volatility raises both call and put prices.
Example. An option's price rises when volatility increases.
Exam trap. This statement is false: Vega measures the effect of interest rate changes.
Rho
Rho measures the change in an option's price for a 1% change in the interest rate.
Example. An option's sensitivity to the interest rate.
Exam trap. This statement is false: Rho measures the effect of volatility on price.
European option
A European option can be exercised only on the expiry date. All options on Indian exchanges are European style.
Example. A holder can exercise an option only on the last day.
Exam trap. This statement is false: A European option can be exercised any time before expiry.
American option
An American option can be exercised at any time up to and including expiry.
Example. A holder can exercise whenever she chooses before expiry.
Exam trap. This statement is false: An American option can be exercised only at expiry.
Exercise and assignment
When a buyer exercises, a seller is assigned at random or by rule and must perform the obligation under the contract.
Example. A call buyer exercises and a writer is called to deliver.
Exam trap. This statement is false: The option buyer is always obliged to exercise.
Settlement of index options
Index options are cash settled at expiry on the closing index value; in-the-money options are exercised automatically.
Example. An in-the-money index option ends with a cash credit.
Exam trap. This statement is false: Index options are settled by delivering all index shares.
Settlement of stock options
Stock options are physically settled; in-the-money stock options at expiry result in delivery of shares.
Example. A call buyer who is in the money at expiry gets shares delivered.
Exam trap. This statement is false: Stock options are always cash settled.
Put-call parity
For European options, the call price minus the put price equals the present value relationship of spot and strike; deviations offer arbitrage.
Example. A call and put with the same strike and expiry are linked by spot and strike.
Exam trap. This statement is false: Calls and puts are priced independently.
Long call payoff
A long call's profit at expiry = max(spot − strike, 0) − premium; break-even = strike + premium.
Example. A call with strike 500 bought at ₹20 breaks even at 520.
Exam trap. This statement is false: A long call's break-even is strike minus premium.
Long put payoff
A long put's profit at expiry = max(strike − spot, 0) − premium; break-even = strike − premium.
Example. A put with strike 500 bought at ₹15 breaks even at 485.
Exam trap. This statement is false: A long put's break-even is strike plus premium.
Short call payoff
A short call's profit at expiry = premium − max(spot − strike, 0); break-even = strike + premium.
Example. A writer who sold a 500 call at ₹20 starts losing above 520.
Exam trap. This statement is false: A short call is profitable at any rise in price.
Short put payoff
A short put's profit at expiry = premium − max(strike − spot, 0); break-even = strike − premium.
Example. A writer who sold a 500 put at ₹15 loses below 485.
Exam trap. This statement is false: A short put is profitable at any fall in price.
Option writer margin
Option sellers must deposit margin because of their potential large losses; option buyers pay only the premium and need no margin.
Example. A seller deposits margin while the buyer only pays the premium.
Exam trap. This statement is false: Option buyers must deposit margin like sellers.
Premium settlement
Premium is paid by the buyer and received by the seller on the next working day after the trade.
Example. The premium for an option traded today is settled the following business day.
Exam trap. This statement is false: Premium is paid only at expiry.
Option chain
An option chain lists the available strikes and premiums of calls and puts for a given underlying and expiry.
Example. A table showing calls on one side and puts on the other by strike price.
Exam trap. This statement is false: An option chain shows only futures prices.
Weekly options
Exchanges list options with weekly expiries on selected indices, subject to regulatory limits on the number of contracts.
Example. Some index options expire every week.
Exam trap. This statement is false: All stock options expire weekly.
Early exercise of European options
Because European options cannot be exercised early, holders who want to exit before expiry sell the option in the market.
Example. A holder sells the option in the market a week before expiry.
Exam trap. This statement is false: A European option holder may exercise any day.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which term is described here? A short put's profit at expiry = premium − max(strike − spot, 0); break-even = strike − premium.
- SEBI Act
- Short put payoff
- Reverse cash-and-carry
- L.C. Gupta Committee
Q2. Which statement best describes “European option”?
- The Dr. L. C. Gupta Committee (1998) recommended the introduction of derivatives trading in India and laid out the regulatory framework.
- Exchange-traded derivatives have standardised terms, are cleared by a clearing corporation and carry lower counterparty risk.
- A European option can be exercised only on the expiry date. All options on Indian exchanges are European style.
- Orders on the exchange are matched on price-time priority: the best price first, and among equal prices the earliest order.
Q3. Which term is described here? The premium depends on spot, strike, time to expiry, volatility, interest rates and dividends; higher volatility and longer time raise it.
- L.C. Gupta Committee
- Option premium determinants
- Haircut
- SEBI Act
Q4. Which statement best describes “Put option buyer”?
- A long strangle buys an out-of-the-money call and an out-of-the-money put, costing less than a straddle but needing a bigger move.
- A hedger uses derivatives to reduce an existing price risk rather than to profit from price moves.
- A speculator takes positions in derivatives to profit from expected price changes and accepts the risk.
- The buyer of a put pays a premium and has the right to sell at the strike. Maximum loss is the premium; profit rises as the price falls to zero.
Q5. Which term is described here? Time value is the part of the premium above intrinsic value, reflecting the chance of further favourable moves; it falls to zero at expiry.
- SEBI Act
- Time value
- Certification requirement
- SCRA
Q6. Which statement best describes “Vega”?
- The equity derivatives segment trades during regular market hours, 9:15 am to 3:30 pm, on business days.
- Intermediaries must have a grievance mechanism and resolve client complaints promptly, and escalate to the exchange or SEBI if not resolved.
- A protective put buys a put against a held position, setting a floor under the loss at the cost of the premium.
- Vega measures the change in an option's price for a 1% change in volatility. Higher volatility raises both call and put prices.
Frequently asked questions
How much of NISM Series VIII comes from Unit 4?
Unit 4 (Introduction to options) usually carries about 25% of the questions. The whole exam has 100 questions and the pass mark is 60%.
What should I study in NISM Series VIII Unit 4?
Payoffs and break-even of calls and puts. Intrinsic value and time value. The Greeks. Settlement and exercise.
Are these NISM Series VIII practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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