Strike price

An option gives its buyer a right, not an obligation, to buy or sell something at a stated price on or before a stated date. The strike price is that stated price. The workbook also calls it the exercise price; the two words mean the same thing.

Keep two numbers apart and options stop being confusing:

• The strike price is written into the contract when the exchange introduces it and never changes. It is part of the contract's identity.
• The premium is what the buyer pays the seller for the right, and it changes every second the market is open. The market trades the premium for a given strike — not the strike itself.

So "Nifty 24000 CE" names a contract: a Call European option struck at 24,000. What flickers on the screen next to it is the premium.

The strike determines whether exercising is worth anything at all. A call is in-the-money when the underlying is above the strike, out-of-the-money when it is below. For a put it is the other way round.

The workbook's illustration: Arvind buys a call on the Nifty from Salim at a strike of Rs 10,000, three months out, paying a premium of Rs 100. If the Nifty settles at Rs 10,200 the option is in-the-money and Arvind exercises — Salim is legally bound to sell at 10,000 even though the market is at 10,200. If the Nifty settles at Rs 9,800 the option is out-of-the-money; there is no sense in paying 10,000 for something worth 9,800, so Arvind lets it lapse and Salim keeps the Rs 100.

That asymmetry is the whole of options. The buyer's loss is capped at the premium; the writer's obligation is not capped.

Exchange specifications the workbook fixes for Indian equity options: only European options are traded in the Indian markets at this time, so they can be exercised only on the expiry date (an American option could be exercised any time up to expiry). A contract coded CE is a Call European, PE a Put European. Options are available on the same indices and stocks as futures, with the same expiry — the last Thursday of the month. The price step is Re 0.05, and the trading lot is set so that the value of the lot at the base price when the contract is introduced is not below Rs 5 lakh. On the expiry date, exercised options are settled at the in-the-money strike price at the close of trading hours, and long positions are assigned at that strike to short positions. Premium is settled daily on a T+1 basis.

For the mechanics of the underlying exchange-traded contract and the margining that supports it, see Future and Extreme Loss Margin — this page is only about the number in the contract.

A Nifty call option struck at 24,000, expiring at the end of the month, quoted at a premium of Rs 120. Take a contract lot of 50 units (exchanges fix the lot so that its value at introduction is not below Rs 5 lakh).

Cost to the buyer = 50 × Rs 120 = Rs 6,000
Breakeven         = Strike + premium = 24,000 + 120 = 24,120

Through every one of those rows the strike stayed at 24,000. The buyer's worst case is the Rs 6,000 he paid, whether the Nifty ends at 23,900 or at 20,000. The writer collected Rs 6,000 and, at 24,600, owes Rs 30,000.

Because it is a European option, none of this can be crystallised early by exercising. The buyer who wants out before expiry does not exercise — he sells the option, at whatever premium the market is then paying for the 24,000 strike.

Chapter 6 (Derivative Markets), section 6.3.3 (Options) for the terminology, and section 6.5.4 (Options: Trading and Settlement Process) for the contract specifications. The examinable core is small and precise: strike price is also called the exercise price; only European options trade in India, exercisable only on expiry; CE and PE coding; Re 0.05 price step; the lot sized so its value is not below Rs 5 lakh; expiry on the last Thursday; and settlement of exercised options at the in-the-money strike price at the close of the expiry day. Questions are usually direct recall, or a simple in-the-money / out-of-the-money identification from a strike and a spot price.

• Strike price is not the premium. The strike is fixed by the exchange when the contract is listed; the premium is what is quoted and traded. Exam options that describe "the price of the option" mean the premium.
• In-the-money is directional. A call is in-the-money when spot is above strike; a put is in-the-money when spot is below strike. Half the marks lost on this section are lost here.
• European in India, and European means expiry-day only. "The buyer can exercise any time before expiry" describes an American option and is wrong for Indian equity options as the workbook states them.
• The buyer has a right, the writer has an obligation. The writer never chooses. If the buyer exercises, the writer must honour it.
• Selling an option is not the same as exercising it. Before expiry a European option holder can only close out by selling in the market.
• The maximum loss for an option buyer is the premium; for the writer it is not capped. The premium received is the writer's maximum gain, not his maximum risk.