Options basics: premium, strike, expiry and time decay

A call option gives the buyer the right, but not the obligation, to buy the underlying at the strike price at expiry. A put gives the right to sell. The buyer pays a premium; the seller receives it and takes on the obligation. Index options are settled in cash. Stock options that are in the money at expiry are settled by delivery of the shares, which needs their full value, or the shares themselves.

Premium = intrinsic value + time value.

• Intrinsic value: what the option would be worth at expiry if the price stayed where it is. For a call, how far the underlying is above the strike; for a put, how far below. Never less than zero.
• Time value: the rest of the premium, paid for the chance of a further move before expiry. It depends on the time left and on how much movement the market expects (implied volatility).
• In the money: has intrinsic value. At the money: strike near the current price. Out of the money: no intrinsic value, so the premium is all time value.

Time value shrinks as expiry approaches, and faster in the final days. Theta is the estimated fall in premium per day if nothing else changes. At expiry, time value is zero and only intrinsic value remains.

For a buyer, the underlying has to move far enough and soon enough to outrun the decay. A view that is right but slow can still lose money on an option.

Options trade in lots. A buyer pays premium × lot size: a premium of 80 on a lot of 65 costs ₹5,200. The most a buyer can lose is that amount plus costs. A seller receives it, must post margin, and can lose many times it.

• Check which price each level refers to: the option's premium, or the underlying index or stock. A stop on the underlying can mean a large fall in premium before it is reached.
• Check the strike and the expiry. The same view in a different strike or expiry is a different trade.
• Size on the premium: risk per lot = (entry premium − stop premium) × lot size. An entry of 80 and a stop of 56 on a lot of 65 risk ₹1,560 per lot.
• Premiums can move several per cent in seconds, and the gap between buy and sell quotes is wider in far strikes. Limit orders keep the fill near the plan.
• Holding a bought option into expiry means its time value goes to zero; only intrinsic value is left.

• Before you trade futures and options
• How to read a research call: lot size for F&O and MCX
• Position size calculatorEnter premiums as the entry and stop, and the lot size