Introduction to Options

Learn these topics

• Market X-RayMarket X-Ray
• What an Option Premium Is Made OfLesson

More units in NISM Series VIII

• Basics of Derivatives10
• Understanding the Index6
• Forwards and Futures9
• Application of Futures13
• Application of Options33
• Trading Mechanism11
• Clearing, Settlement and Risk Management16
• Legal and Regulatory Environment17
• Accounting and Taxation9
• Sales Practices and Investor Protection5

Practise all of NISM Series VIII

Exam format

That figure belongs to one published unit covered under these headings — Introduction to Options and Application of Options — so the marks belong to the whole group. They are quoted together because no source divides them among its headings.

Source: Unit 4: Introduction to Options (25) + Unit 5: Option Trading Strategies (3). The bank's two options headings straddle both published units - payoffs and the greeks sit in Unit 4, spreads, straddles and covered calls in Unit 5 - so they share the pair's 28 marks rather than a split of either number that no source supports.

All 21 questions on Introduction to Options, with answers

1. Q1A buyer of an equity call option obtains the:

   • A

     Option A. Obligation to buy the underlying at the strike price whenever the option seller demands it

     Why it is wrong: The buyer has a right, not an obligation imposed at the seller’s discretion.

   • B

     Option B. Right, but not the obligation, to buy the underlying at the strike price subject to the contract terms — Correct answer

   • C

     Option C. Right, but not the obligation, to sell the underlying at the strike price subject to the contract terms

     Why it is wrong: The right to sell is associated with a put option.

   • D

     Option D. Obligation to sell the underlying at the strike price whenever the option is exercised

     Why it is wrong: An obligation to sell is associated with the writer of a call, not the buyer.

   Answer: B. A call option gives its buyer the right, but not the obligation, to buy the underlying at the strike price according to the option contract. The option seller carries the corresponding obligation if the option is validly exercised/settled. Remember: Call buyer = right to buy. Put buyer = right to sell.

   Hint, shown before you answer in practice mode: Common mistake: Confusing the buyer’s right with the seller’s obligation.

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2. Q2Ignoring transaction costs, what is the maximum loss of a buyer who pays a premium for a plain-vanilla option and holds it to expiry?

   • A

     Option A. Unlimited

     Why it is wrong: Unlimited-loss exposure can arise for certain option writers, not the plain long option buyer.

   • B

     Option B. The premium paid — Correct answer

   • C

     Option C. The strike price

     Why it is wrong: Strike price is an exercise term, not the buyer’s maximum loss.

   • D

     Option D. The full notional value of the underlying

     Why it is wrong: The buyer does not automatically lose the full underlying notional amount.

   Answer: B. An option buyer may choose not to exercise an option that is unfavorable. Therefore the buyer’s maximum contractual loss is the premium paid, assuming no additional transaction costs or other positions. Remember: Long-option risk is limited to premium paid. Reward characteristics depend on whether it is a call or put.

   Hint, shown before you answer in practice mode: Common mistake: Applying the uncovered option seller’s risk profile to the option buyer.

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3. Q3How are NIFTY 50 index options on NSE characterised with respect to exercise style and settlement?

   • A

     Option A. American style and physically settled

     Why it is wrong: NSE index options are not American style and are not physically delivered as index constituents.

   • B

     Option B. American style and cash settled

     Why it is wrong: The settlement description is right but the exercise style is wrong.

   • C

     Option C. European style and compulsorily settled by delivery of all index constituents

     Why it is wrong: The exercise style is right but index options are not settled by delivering every constituent share.

   • D

     Option D. European style and cash settled — Correct answer

   Answer: D. NSE index options are European style, meaning exercise occurs at expiry under the contract framework, and index derivatives are cash settled because an index itself cannot be physically delivered as a basket through option exercise. Remember: Index options on NSE are European-style, cash-settled contracts.

   Hint, shown before you answer in practice mode: Common mistake: Confusing the physical settlement of individual-stock derivatives with index-option settlement.

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4. Q4NIFTY is at 24,800. A NIFTY put option has a strike price of 25,000. The put is:

   • A

     Option A. In the money by 200 points — Correct answer

   • B

     Option B. Out of the money by 200 points

     Why it is wrong: That would describe a put whose strike is below spot by 200.

   • C

     Option C. At the money

     Why it is wrong: Spot and strike are not equal or approximately the same under the exact figures given.

   • D

     Option D. In the money by 25,000 points

     Why it is wrong: Moneyness is based on the strike–spot difference, not the full strike.

   Answer: A. A put has intrinsic value when strike price exceeds spot. Here, intrinsic value = 25,000 − 24,800 = 200 points, so the put is in the money by 200 points. Remember: Put ITM when strike > spot. Call ITM when spot > strike.

   Hint, shown before you answer in practice mode: Common mistake: Applying call-option moneyness rules to puts.

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5. Q5NIFTY is at 25,240. A 25,000 call trades at a premium of 310 points. What are the call’s intrinsic value and time value?

   • A

     Option A. Intrinsic 70, time value 240

     Why it is wrong: It reverses intrinsic and time value.

   • B

     Option B. Intrinsic 310, time value 0

     Why it is wrong: The entire premium is not intrinsic because the option trades above intrinsic value.

   • C

     Option C. Intrinsic 240, time value 70 — Correct answer

   • D

     Option D. Intrinsic 0, time value 310

     Why it is wrong: The call is in the money, so intrinsic value is not zero.

   Answer: C. Call intrinsic value = max(spot − strike, 0) = 25,240 − 25,000 = 240 points. Time value = premium − intrinsic value = 310 − 240 = 70 points. Remember: Option premium = intrinsic value + time value.

   Hint, shown before you answer in practice mode: Common mistake: Treating the full premium of an ITM option as intrinsic value.

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6. Q6At a given instant before expiry, which statement is necessarily true of an out-of-the-money plain call or put option?

   • A

     Option A. It must be exercised immediately

     Why it is wrong: Exercising an OTM option would not be economically rational under ordinary conditions.

   • B

     Option B. Its market premium must be zero

     Why it is wrong: OTM options can have positive time value before expiry.

   • C

     Option C. Its time value must be negative

     Why it is wrong: Standard option time value is not defined as necessarily negative here.

   • D

     Option D. Its intrinsic value is zero — Correct answer

   Answer: D. An out-of-the-money option has no intrinsic value. Before expiry it can still have a positive market premium because time remains for the option to become valuable, so its premium may consist entirely of time value. Remember: OTM does not mean worthless before expiry. It means zero intrinsic value at that moment.

   Hint, shown before you answer in practice mode: Common mistake: Assuming zero intrinsic value means zero option premium.

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7. Q7Which statement about an option writer (seller) is correct?

   • A

     Option A. The writer pays the premium and gets the right to exercise, but carries no obligation

     Why it is wrong: This describes the buyer's payment/right relationship, not the writer's.

   • B

     Option B. The writer can never be required to post margin on the position

     Why it is wrong: Short-option positions are subject to margin requirements.

   • C

     Option C. The writer's maximum loss is always limited to the premium received for every type of option

     Why it is wrong: An uncovered call, for example, has potentially very large loss as the underlying rises.

   • D

     Option D. The writer receives the premium and takes on an obligation if the option is exercised — Correct answer

   Answer: D. The option buyer pays the premium for a right. The option writer receives the premium in exchange for taking the corresponding obligation. Depending on the option and position, a writer's potential loss can greatly exceed the premium received, and short-option positions are subject to margin requirements. Remember: Option buyer = right for a premium. Option writer = premium received plus obligation.

   Hint, shown before you answer in practice mode: Common mistake: Assuming the premium received is also the writer's maximum possible loss.

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8. Q8Which statement correctly compares an option buyer with a futures buyer?

   • A

     Option A. The option buyer has a right, while the futures buyer has an obligation — Correct answer

   • B

     Option B. Both buyers can lose only the premium they paid upfront

     Why it is wrong: Futures do not have an option premium that caps the buyer's loss in the same way.

   • C

     Option C. Neither position is affected by movements in the underlying asset's price

     Why it is wrong: Both instruments derive value from the underlying.

   • D

     Option D. A futures buyer can simply abandon the contract with no settlement consequence

     Why it is wrong: A futures position must be closed or settled under the contract rules.

   Answer: A. An option buyer pays premium to obtain a right. A futures position, by contrast, creates a contractual exposure that is settled according to futures rules. It is not merely an optional right that can be abandoned without consequence. Remember: Options create asymmetric rights for the buyer. Futures create symmetric contractual obligations for long and short.

   Hint, shown before you answer in practice mode: Common mistake: Assuming 'buyer' always means maximum loss is only an upfront premium.

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9. Q9A stock trades at ₹780. Which of the following puts is in-the-money?

   • A

     Option A. ₹740 strike put

     Why it is wrong: Strike ₹740 is below spot, so the put is OTM.

   • B

     Option B. ₹760 strike put

     Why it is wrong: Strike ₹760 is below spot, so the put is OTM.

   • C

     Option C. ₹820 strike put — Correct answer

   • D

     Option D. ₹780 strike put

     Why it is wrong: Strike equals spot, so it is ATM in this simplified classification.

   Answer: C. A put has intrinsic value when its strike price is above the current underlying price. With spot at ₹780, the ₹820 put has ₹40 of intrinsic value. The ₹780 put is at-the-money. The lower-strike puts are out-of-the-money. Remember: For puts, higher strike relative to spot means more intrinsic value. For calls the direction is reversed.

   Hint, shown before you answer in practice mode: Common mistake: Using the call-option moneyness rule for puts.

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10. Q10A stock is at ₹24,600. A ₹24,500 call trades at a premium of ₹180. What are its intrinsic value and time value?

    • A

      Option A. Intrinsic ₹0, time value ₹180

      Why it is wrong: The call is already ₹100 in the money.

    • B

      Option B. Intrinsic ₹80, time value ₹100

      Why it is wrong: The two components have been reversed.

    • C

      Option C. Intrinsic ₹180, time value ₹0

      Why it is wrong: Premium is not automatically all intrinsic value.

    • D

      Option D. Intrinsic ₹100, time value ₹80 — Correct answer

    Answer: D. For a call, intrinsic value = max(spot − strike, 0) = ₹100. Time value = option premium − intrinsic value = ₹180 − ₹100 = ₹80. Remember: Option premium = intrinsic value + time value.

    Hint, shown before you answer in practice mode: Common mistake: Calling the entire premium intrinsic value whenever an option is ITM.

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11. Q11Holding spot, strike, interest rate, dividends and time to expiry constant, what is the usual effect of an increase in expected volatility on the value of both a plain call and a plain put?

    • A

      Option A. Both generally increase — Correct answer

    • B

      Option B. Both generally decrease

      Why it is wrong: Lower, not higher, volatility would generally reduce option value all else equal.

    • C

      Option C. Call increases but put must decrease

      Why it is wrong: Both option types generally benefit from greater uncertainty.

    • D

      Option D. Neither can change

      Why it is wrong: Volatility is a core option-pricing input.

    Answer: A. Greater volatility increases the range of possible future underlying prices. Because an option buyer has asymmetric payoff—downside is limited to premium while favourable moves can increase payoff—higher expected volatility generally raises the value of both calls and puts, other factors held constant. Remember: Vega is typically positive for long vanilla calls and puts: more expected volatility generally means more option value.

    Hint, shown before you answer in practice mode: Common mistake: Thinking higher volatility benefits calls but hurts puts because their directional payoffs differ.

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12. Q12All else equal, which statement best describes the effect of the passage of time on a long plain option as expiry approaches?

    • A

      Option A. Its intrinsic value must increase every day until the option expires

      Why it is wrong: Intrinsic value depends on spot versus strike, not simply calendar time.

    • B

      Option B. Its time value generally erodes, an effect captured by theta — Correct answer

    • C

      Option C. Its strike price automatically falls a little every day

      Why it is wrong: Strike is a contract term and does not automatically fall with time.

    • D

      Option D. Its delta must become exactly zero, whatever the spot price is

      Why it is wrong: Delta changes with moneyness and other factors. It does not necessarily become zero.

    Answer: B. As time passes with other factors unchanged, an option has less remaining opportunity for a favourable move, so its time value generally decays. Theta measures the sensitivity of option value to the passage of time. Remember: Time decay affects time value, not the contractual strike.

    Hint, shown before you answer in practice mode: Common mistake: Assuming theta means the option's intrinsic value falls each day.

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13. Q13Holding other inputs constant, a larger expected cash dividend before option expiry will generally have which directional effect on European equity option values?

    • A

      Option A. Tend to increase call value and reduce put value

      Why it is wrong: This reverses the usual relationship.

    • B

      Option B. Tend to increase both call and put value equally

      Why it is wrong: Dividend effects on calls and puts are not generally equal and positive.

    • C

      Option C. Tend to reduce call value and increase put value — Correct answer

    • D

      Option D. Have no possible effect because dividends are paid only to shareholders

      Why it is wrong: The fact that option holders do not receive the dividend directly does not mean valuation is unaffected.

    Answer: C. An expected dividend tends to reduce the ex-dividend stock price relative to a no-dividend case. Holding other inputs constant, that generally reduces call value and increases put value. Option holders do not directly receive the cash dividend, but expected dividends affect the underlying-price path used in valuation. Remember: Expected dividends enter option valuation through their effect on the underlying's expected ex-dividend price.

    Hint, shown before you answer in practice mode: Common mistake: Assuming dividends cannot affect options because option holders are not shareholders.

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14. Q14For European options on a non-dividend-paying stock, holding other inputs constant, an increase in the risk-free interest rate generally tends to:

    • A

      Option A. Leave both values necessarily unchanged

      Why it is wrong: Interest rates are an option-pricing input.

    • B

      Option B. Reduce both call and put value

      Why it is wrong: Calls generally benefit rather than decline in the stated setup.

    • C

      Option C. Reduce call value and increase put value

      Why it is wrong: This reverses the standard relationship.

    • D

      Option D. Increase call value and reduce put value — Correct answer

    Answer: D. In the standard European option-pricing relationship for a non-dividend-paying stock, a higher risk-free rate reduces the present value of the strike payment. Other things equal, this tends to increase call value and decrease put value. Remember: Know the directional effects of each pricing determinant rather than memorising only volatility.

    Hint, shown before you answer in practice mode: Common mistake: Assuming rates affect futures but not options.

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15. Q15Which model is classically associated with a closed-form valuation framework for European-style options under its standard assumptions?

    • A

      Option A. Black-Scholes model — Correct answer

    • B

      Option B. Free-float index method

      Why it is wrong: Free-float methodology is used in index construction.

    • C

      Option C. SPAN margin system

      Why it is wrong: SPAN is a portfolio-based margin/risk system, not an option-pricing model.

    • D

      Option D. VWAP execution model

      Why it is wrong: VWAP is a trading/execution benchmark, not the pricing model asked for.

    Answer: A. The Black-Scholes framework is a classic option-pricing model and provides closed-form formulas for European-style calls and puts under its assumptions. SPAN is a margin methodology, while free-float weighting and VWAP serve different purposes. Remember: Do not confuse option valuation models with margin models or execution benchmarks.

    Hint, shown before you answer in practice mode: Common mistake: Calling SPAN an option-pricing model because it also uses risk scenarios.

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16. Q16What is a defining feature of a binomial option-pricing model?

    • A

      Option A. It assumes the underlying price can only rise, never fall, at each step

      Why it is wrong: Down moves are explicitly part of a binomial tree.

    • B

      Option B. It models the price as a tree of up and down steps and works backward — Correct answer

    • C

      Option C. It is used only to calculate exchange transaction charges on option trades

      Why it is wrong: The model is for valuation, not fee calculation.

    • D

      Option D. It ignores time to expiry completely when valuing the option

      Why it is wrong: The number and length of time steps are central to the model.

    Answer: B. A binomial model represents possible underlying-price evolution through discrete up/down branches over successive time steps. Option values are then obtained by working backward through the tree using the model's valuation logic. Remember: Black-Scholes and binomial are valuation approaches. The binomial method is built around a discrete price tree.

    Hint, shown before you answer in practice mode: Common mistake: Thinking 'binomial' merely means an option has two payoff states at expiry.

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17. Q17Which sign is normally associated with the delta of a long put option?

    • A

      Option A. Exactly zero for every put

      Why it is wrong: Only special circumstances could make delta near zero. It is not identically zero.

    • B

      Option B. Positive and always above +1

      Why it is wrong: A plain long put does not normally have delta above +1.

    • C

      Option C. Negative — Correct answer

    • D

      Option D. Undefined until expiry

      Why it is wrong: Delta is estimated throughout the option's life.

    Answer: C. A long put generally gains value when the underlying falls, so its delta is negative. For a standard European put, delta typically lies between -1 and 0, subject to the model and inputs. Remember: Call deltas are generally positive. Put deltas are generally negative.

    Hint, shown before you answer in practice mode: Common mistake: Assuming all long positions have positive delta.

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18. Q18A trader says, 'My option's delta will change quickly if the underlying moves.' Which Greek most directly measures that sensitivity of delta?

    • A

      Option A. Rho

      Why it is wrong: Rho measures sensitivity to interest rates.

    • B

      Option B. Theta

      Why it is wrong: Theta measures sensitivity to time passage.

    • C

      Option C. Vega

      Why it is wrong: Vega measures sensitivity to implied volatility.

    • D

      Option D. Gamma — Correct answer

    Answer: D. Gamma measures the rate of change of delta with respect to changes in the underlying price. High gamma means delta itself can change rapidly as the underlying moves. Remember: Delta measures first-order price sensitivity. Gamma measures how delta changes.

    Hint, shown before you answer in practice mode: Common mistake: Confusing gamma with vega because both can be large near certain option states.

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19. Q19A long option has theta of approximately -₹4 per day, with all other pricing inputs assumed unchanged for this simplified illustration. What does that sign most directly indicate?

    • A

      Option A. The option is expected to lose about ₹4 of value in one day — Correct answer

    • B

      Option B. The underlying price must fall by ₹4 during the next day

      Why it is wrong: Theta does not forecast an underlying-price move.

    • C

      Option C. Implied volatility must rise by 4 percentage points a day

      Why it is wrong: Volatility sensitivity is vega.

    • D

      Option D. The strike price of the option will decline by ₹4 each day

      Why it is wrong: The strike is a contract term.

    Answer: A. Negative theta for a long option indicates time decay: in a local approximation, passage of one day reduces option value by the theta amount if other inputs are unchanged. Theta is an estimate/sensitivity, not a guarantee that market premium will actually change by exactly that amount. Remember: Greeks are local sensitivities, not guaranteed realised P&L.

    Hint, shown before you answer in practice mode: Common mistake: Treating theta as a deterministic daily loss regardless of changes in spot or volatility.

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20. Q20An option has vega of 12, using a convention in which vega is the premium change for a one-percentage-point change in implied volatility. If implied volatility rises from 20% to 21% and other inputs are unchanged, the option premium is approximately expected to:

    • A

      Option A. Decrease by 12 premium units

      Why it is wrong: Long vanilla options generally have positive vega.

    • B

      Option B. Increase by 12 premium units — Correct answer

    • C

      Option C. Increase by 1 premium unit only

      Why it is wrong: The sensitivity is 12 units per stated one-point change, not one unit.

    • D

      Option D. Remain unchanged

      Why it is wrong: Vega explicitly measures volatility sensitivity.

    Answer: B. With positive vega of 12 under the stated convention, a one-percentage-point increase in implied volatility produces an approximate 12-unit increase in option premium, holding other inputs constant. Remember: Always read the vega convention stated in the question before doing the arithmetic.

    Hint, shown before you answer in practice mode: Common mistake: Mixing a one-percentage-point IV change with a 1% multiplicative change in the premium.

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21. Q21Which Greek measures an option's sensitivity to a change in the risk-free interest rate, holding other inputs constant?

    • A

      Option A. Theta

      Why it is wrong: Theta measures time decay/sensitivity to time.

    • B

      Option B. Gamma

      Why it is wrong: Gamma measures change in delta as the underlying changes.

    • C

      Option C. Rho — Correct answer

    • D

      Option D. Delta

      Why it is wrong: Delta measures sensitivity to the underlying price.

    Answer: C. Rho measures sensitivity of option value to the risk-free interest-rate input. Delta, gamma and theta measure different dimensions of option sensitivity. Remember: Map each Greek to one risk factor: delta—spot, gamma—delta curvature, theta—time, vega—volatility, rho—rates.

    Hint, shown before you answer in practice mode: Common mistake: Ignoring rho because it is often less prominent for short-dated equity options.

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Application of Options

33 questions on Application of Options. Its quiz opens on that unit.