Capital
Market : European Stock Options Vs Physical Settlement
of American Stock Options
Alex
K. Mathews, Research Head
The latest development to attract investor participation in
the options segment- NSE has decided to start European style stock options
trading from early January 2011. To
counter this move from NSE, Bombay Stock Exchange decided to start physical
settlement against the current practice of cash settlement.
The NSE decision will attract a lot of investors in the
stock options segment, which currently lacks liquidity. Only few stocks were actively being traded in
the stock options segment because of high risk associated with option writers. In the American style stock option, the buyer
of the option has the right to exercise his purchased option position if there
is no buyer with intrinsic value. For
example Infosys spot price is Rs.2950, and the 2900
strike premium should be anywhere around Rs. 50. If the 2900 strike price call option premium
is lesser than its intrinsic value of Rs. 50, the
call option buyer can exercise his option and thereby he can get Rs.50. Here the problem arises with the writer, because
the option buyer’s assignment will be known to the writer only on the next day. The next day the price of the stock can open
with a gap down or gap up making life tougher for him.
In the case of European options it can trade below intrinsic
value, because it can be exercised only on the last trading day of the contract
expiry. This technical edge will give a
lot of freedom to the writer of the European stock options like Index options. This will create enormous liquidity in the
options segment. Here the writer of the
European option gets time till expiration, and he can easily mitigate his
options risk the way he wants to.
Now we will look at how BSE is going forward with its new initiative
of physical settlements against cash settlement. Physical settlement reduces part of the
uncertainty of American stock options. An
early assignment can be settled by stock delivery. For example let us assume that Reliance
Industries Rs.1000 strike price call option is trading at Rs.
15 while the stock is trading at Rs. 1025. The call option holder, if he exercises his
call option, can get Reliance Industries stock at Rs.
1025 due to low intrinsic value. Here
the risk of the writer is low provided he holds the particular stock in his
portfolio. In the same way the writer of
the American put option has to have sufficient cash in his portfolio, because
if the buyer of the put option exercises his right the writer has the
obligation to take delivery by paying the strike price.
The new products will give a lot of freedom to investors who
will now have various options to trade in the option segment.