Loading
Market Intelligence › Basic Terminologies
Contract, premium, Greeks, spreads, margin and settlement — all in one place
Published by The Retail Trader · JUL 23, 2026 · Derivatives (F&O)
The biggest obstacle to understanding derivatives is that people start in the middle — strategies, Greeks and payoff diagrams from day one. The real structure is very simple and has only four parts: an underlying, a fixed time, a fixed price, and two people who agree on it. Everything else is an extension of these four. This article starts from those four and goes all the way to the last minute of expiry, touching along the way everything that affects a retail account's ledger.
A derivative is not an asset in itself. It is a contract whose value comes from something else — that something else is called the underlying. A share, an index, a commodity, a currency, anything can become an underlying. When you buy a derivative, you are not buying any part of the company; you are buying a promise that will settle on some date at some price.
This is why a derivative is always zero sum as far as the contract is concerned. Whatever one side makes, the other side loses, with charges on top. Equity is not like that — the whole market can rise together because the underlying business is growing. A derivative has no such growth, only transfer. Understanding this one point makes a lot of what follows easier.
Every contract has two ends. On one side is the person who took the contract, on the other the person who gave it. The exchange stands in the middle so that neither has to trust the other — it takes the counterparty risk upon itself and asks for margin in return. This one line is the essence of the whole clearing system, and it is why you have to block money to take a position.
There are three kinds of participants in the derivatives market, and all three have different purposes. It is important to understand them separately because the same trade is meant to reduce risk for one and to take risk for another.
Three jobs are being done in the market:
• Hedger — someone who already has an exposure and wants to protect against it. An exporter who is going to receive dollars, a mill that has to buy wheat, an investor who holds a portfolio. They take a derivative so that their existing risk goes down.
• Speculator — someone with no underlying exposure, who is only taking a view on direction or volatility. Most retail activity is here.
• Arbitrageur — someone who earns from the price difference between two places. The gap between cash and futures, or between two exchanges. These are the people who keep market prices tied to one another.
The presence of all three is necessary. If there were only hedgers, nobody would stand on the other side of them. If there were only speculators, prices would break away from the underlying. Without arbitrageurs, the futures price would drift far from cash. When you take a trade, you are standing opposite one of these three — and most of the time you do not know which.
A derivative's price comes from the underlying, but it is not an exact copy of it. In between there is time, there is interest, there is dividend, and there are people's expectations. This is why the futures price stays a little different from spot, and the option premium looks different still.
One important point: a derivative moves the underlying too. In theory the tail does not wag the dog, but when derivative volume becomes many times the cash volume, hedging activity creates buying and selling in the cash market. This effect is most visible on expiry day. So assuming that a derivative is merely a mirror is not the whole truth.
Futures is the most direct derivative. Two people agree today on a price at which a transaction will happen on a future date. That date is called the expiry and that price is the futures price.
In every futures contract, the exchange fixes these things in advance:
• Underlying — which share or index.
• Lot size — how much quantity is in one contract. You do not decide this, the exchange does, and it changes from time to time.
• Expiry — the date on which the contract ends.
• Tick size — in how small a step the price can move.
• Settlement — whether it will be in cash or by delivery.
All of this is standardised so that contracts can be swapped with one another. If every contract were different, nobody else would be ready to take it, and the market would stall without liquidity. Standardisation is what makes a derivative tradeable.
One thing new people miss: because of lot size, the size of your position is not entirely in your hands in futures. You can take one lot or two, but not one and a half. So all position sizing has to be worked out around the lot, and for an account with small capital a single lot is often very large.
The theoretical price of futures sits a little above spot, and the reason is easy to understand. If you buy the share today and hold it, your money is tied up in it — money on which you could have earned interest. With futures you can keep that money with you until expiry. So futures is a little more expensive, and that difference is roughly the interest for that period.
On the other side, if the underlying pays a dividend, the person holding futures does not receive that dividend. So the effect of the dividend is the opposite — it pulls the futures price down. Together the two make up the cost of carry: interest pushes up, dividend pulls down.
This is why a stock's futures can suddenly appear below spot around the dividend record date. It is not a bearish signal, it is just arithmetic. New people take it as a sign of weakness and end up making the opposite decision.
The difference between futures and spot is called the basis. When futures is above, it is said to be at a premium; when below, at a discount. Near expiry the basis moves toward zero by itself, because on expiry day the two become the same thing.
The behaviour of the basis is information in itself. If a stock's futures is running at a deep discount consistently, it can mean that a lot of people are short in it and are ready to carry the position. This is not a guarantee, only an observation that should be read along with other things.
A practical point: if you buy futures and it is at a premium, that premium will erode by expiry. Even if the underlying stays exactly where it is, you will lose a little. It is small but real, and not counting it is a common oversight.
The contract expires, but the view often does not. So before expiry people close the current month's position and open the same position in the next month. This is called rollover, and it can be done in a single spread order.
Rollover data is watched every month. A high rollover percentage means people are carrying their view forward; a low one means positions are being closed. Along with this, the price at which the rollover is happening is also watched — an expensive rollover means those taking the next series are in a hurry.
Rollover has its own cost. Two legs, charges twice, and the spread in between. For people who roll every month, this cost accumulates over the year and becomes large. For a long-term view, futures is an expensive way, and this is why people with long views often stay in cash.
In futures there is an obligation on both sides. In options there is an asymmetry — a right on one side and an obligation on the other. The one who buys the option gets the right; the one who sells takes on the obligation. The price of that right is the premium.
The buyer of a call option gets the right to buy the underlying at a fixed price. The buyer of a put option gets the right to sell at a fixed price. In both there is only a right — if using that right is not profitable, the buyer can let it go, and the loss is only the premium paid.
The seller's position is the reverse. The seller has taken the premium, and in return has taken on an obligation. If the buyer uses the right, the seller has to stand on the other side. The seller's gain is limited to the premium, but the loss has no fixed limit.
The whole options market stands on this one asymmetry, and most retail losses come from not understanding it properly. The buyer's loss is fixed and the gain is open; the seller's gain is fixed and the loss is open. These two lines are the essence of the whole book.
This does not mean buying is good and selling is bad. It means the way of making a mistake is different for each. The buyer dies slowly — a little premium erodes every day. The seller does fine for many months and then one day gives back a great deal. The shape of the loss is different for each, and you need to know, according to your temperament and capital, which shape you can bear.
Another thing that follows from this: probability and payoff run in opposite directions. In option buying the probability of winning is low but the win is big. In selling the probability is high but a single loss eats many wins. Neither side gives free money — the market has priced both properly.
Every option is defined by three things: the underlying, the strike price, and the expiry. The strike is the fixed price at which the right is available. The exchange provides a series of strikes, above and below, at a fixed gap. The more volatile the underlying, the more strikes there are.
Lot size is fixed here too, as in futures. So when you look at an option's premium, it is per share, and you have to pay for the whole lot. New people see a small premium on the screen, place the order, and are startled by a large debit in the ledger. The number on the screen should always be multiplied by the lot.
Expiry has different cycles — weekly, monthly, and some longer. Each cycle has its own character. In weekly options time value erodes fast and the price swings a lot. Monthly options are somewhat steadier. In long-expiry options the effect of volatility is greatest.
An option's position can be of three kinds relative to the underlying's price, and these three names are used everywhere.
The three rings of moneyness:
• In the money — if the option expired right now, it would have some value. For a call this means the underlying is above the strike; for a put, below the strike.
• At the money — strike and underlying roughly equal. This is where time value is highest and where the premium moves fastest.
• Out of the money — if it expired right now, you would get nothing. The entire premium is only the price of hope.
These three labels are not fixed. As the underlying moves, an OTM option becomes ATM and then ITM. On this journey the option's behaviour keeps changing — first it is sluggish, then fast, then it starts moving almost one for one with the underlying. This change is the real purpose of the Greeks, which come up later.
A practical point: a deep OTM option looks cheap because its chance of becoming ITM is low. It looks like a lottery ticket and behaves like one. Being cheap and being value are two different things, and in options this difference is the most expensive lesson.
Options come in two styles, and this difference matters for assignment. A European-style option can be exercised only on expiry day. An American-style option can be exercised on any day while the contract is alive.
The direct meaning of this is for the option seller. With European style, the seller knows assignment will not come before expiry. With American style, the seller has to keep this possibility in mind every day, especially when the option goes deep ITM or around a dividend.
In India the style of index and stock options is written in the contract specification, and it has also changed over time. So instead of trying to remember it, it is better to check the specification each time. One line that always works: before selling, find out when assignment can come, because that is not in your control.
The mechanism of both is the same, but their behaviour is quite different, and this difference should be understood before strategy.
Some big differences visible every day:
• An index is a basket, so it is less volatile than a single stock — news about one company does not move the whole index as much.
• Index options are usually cash settled, so there is none of the headache of physical delivery.
• In the index, liquidity extends to far strikes; in stock options, depth often ends after two or three strikes.
• A company-specific event has a very fast effect on a stock option — results, an order win, regulatory news.
• Stock derivatives can come under restrictions such as the ban period; the index cannot.
This is why most new people start with index options, and that is broadly fine — liquidity is better there and you do not get the jolt of a single stock. But the flip side is that index liquidity and weekly expiry together make a great deal of trading easy, and ease is itself a danger.
Every option's premium can be broken into two parts: intrinsic value and time value. This is so basic that nothing ahead makes sense without it.
Intrinsic value is what you would get right now if expiry were today. For a call it is the underlying minus the strike, if that is positive. Otherwise zero. It is never negative, because there is always the option of not using the right.
Time value is everything else. It is the part of the premium that exists because expiry has not yet arrived and a lot can happen in between. In an OTM option the entire premium is time value. At expiry time value becomes zero — always, every time, without exception.
Time value is made of four things, and they should be looked at separately because each behaves differently.
These things change time value:
• Time remaining — the more time, the more possibility, the more value.
• Expected volatility — the more the underlying is expected to move, the higher the premium.
• Distance between strike and spot — the closer, the more time value.
• Interest rate — it has an effect but is the smallest on retail timeframes.
Of these four, two matter most: time and volatility. The effect of the other two is worth noting but is often not decisive. So when you buy an option, you are really placing a bet on two things — that the underlying will move, and that it will move soon.
This is why an option buyer can lose money even after getting the direction right. The underlying went the way you thought, but so slowly that the loss of time value was bigger than the gain from direction. Almost every option buyer goes through this experience, and this is the turning point where people start reading about the Greeks.
A payoff diagram is in every book, but its most useful purpose is not looking at the chart. Its use is that before taking a position you write down three numbers, and you can get those three numbers even without any diagram.
For every option position, write these three numbers first:
• Breakeven — at what price of the underlying you will be neither in profit nor in loss. For a call buyer it is strike plus premium; for a put buyer, strike minus premium.
• Maximum loss — what is the worst that can happen. For a buyer it is the whole premium; for a naked seller there is no fixed answer, and that is the real answer.
• Maximum profit — what is the best that can happen. For a seller it is the premium; for a buyer it is open.
The real benefit of writing these three numbers is something else. The moment you write the breakeven, a question comes up by itself — can the underlying move that much, in that many days. Often the answer is no. And that one answer stops many bad trades before they begin.
The other thing a payoff makes clear is that the payoff at expiry and the behaviour in between are different. The payoff diagram shows the result at expiry. In between, the premium can sit well above or below that line because of time value and IV. So a position that is in profit at expiry can look like a big loss on some day in between — and if that loss gets bigger than your margin, you will never get the chance to reach expiry.
Time decay means that every passing day eats a little of the premium, whether the underlying moves or not. Its measure is called theta — how much the premium will fall in one day.
Theta runs against the option buyer and for the seller. The buyer wakes up a little poorer every morning and the seller a little richer, if everything else stays where it is. This one line is why people get drawn to option selling, and treating this one line as the whole picture is the mistake that proves costly.
Theta is not free income. It is the price of the risk the seller has taken. The market has set the premium so that over the long run both sides come out roughly equal. Whatever extra you get comes from skill, not from the mechanism.
The most important thing is that time decay does not proceed at a uniform pace. At first it is slow and becomes fast as expiry nears. In the last few days an ATM option's time value falls very quickly.
The practical result is that a long-expiry option erodes less per day. If you are waiting for a big move, buying more time is often cheaper, even if the upfront premium looks big. And if you are selling, it is the opposite — decay is fastest in the last days, but the risk is also fastest there.
Weekly expiry has sharpened this further. The entire life of a weekly option is the part where decay is fastest. So in weekly buying, being right is not enough — being right and being right quickly are both necessary. This is a very harsh condition and most people underestimate it.
Decay runs on calendar days, not trading days. From Friday evening to Monday morning three days pass but the market is closed for two. During that time the premium erodes without the price moving.
This is why many people sell premium on Friday and buy it back on Monday. It is a well-known pattern, and because it is well known, the market has already taken much of its benefit out — the premium is already quoted slightly adjusted.
In a long-holiday week this effect is larger. That week option buying becomes even more expensive, and option selling looks a bit more attractive. Looking attractive and being safe are different things — anything can happen in the world during a holiday, and the market being closed does not close your position.
There are two kinds of volatility, and mixing them up is a common mistake. Historical volatility is what has already happened — how much the underlying moved in the past few days. Implied volatility is what is hidden in the option's premium — how much movement the market is assuming.
Implied volatility is not something quoted separately. It is derived backwards from the premium. You look at the option's price, put it into a model, and ask at what volatility this price would come out. The answer that comes is the IV. So it is right to call IV the market's opinion, not a prediction.
Two options can have different premiums only because their IV is different, even if strike, expiry and underlying are all the same. This is why different strikes of the same expiry have different IV — that pattern is called the volatility smile or skew, and it is a map of the market's fear.
IV keeps rising and falling, and its most dramatic form is seen around events. Before any big event — results, a budget, a policy — people buy hedges, demand rises, premiums become expensive, and IV climbs.
After the event the uncertainty ends. IV falls, and the premium with it. This is called IV crush. Its cruellest form is this: after the event the price moved the way you thought, and yet your option became cheaper, because the loss from IV was bigger than the gain from direction.
So buying an option before an event comes with two conditions, not one. The direction has to be right, and the move has to be big enough to cover the loss from IV falling. For people who do not look at the second condition, every results season is a new lesson.
An absolute IV number says nothing by itself. A number that is normal for one stock can be very high for another. So people look at IV against its own history — where the current IV sits in the last year's range.
These questions are useful when reading IV:
• Where is this IV in the underlying's own past range — high, low, or in the middle.
• Is a known event coming that is holding IV up.
• How much does IV differ across strikes — which way is the skew tilted.
• What is the difference in IV across expiries — is the near one expensive or the far one.
Asking these questions does not mean the answer will produce a trade. It means you know what you are buying. Many people look at the premium only in rupees and do not know whether it is expensive or cheap relative to its own history.
The Greeks are the sensitivities of an option's premium — how much the premium will change when one thing changes. They are not predictions, nor are they any kind of signal. They only tell you how this option is behaving right now.
The Greeks keep changing constantly. Today's delta will not be tomorrow's delta. So the Greeks are used to understand a position, not to make entry and exit rules. People who use the Greeks as signals often make the mistake of treating a constant as a variable.
Delta tells you how much the premium will move when the underlying moves one rupee. A call's delta is between zero and one, and a put's between zero and minus one. A deep OTM option has a delta close to zero — even if the underlying moves, not much happens. A deep ITM option has a delta close to one — it moves almost like the underlying.
Delta has another use as well. It is loosely taken as an estimate of whether the option will finish ITM at expiry. This is not exactly true, but it is a useful way of thinking — buying an option with a very low delta means betting on a low-probability outcome.
Adding up delta at the position level is the most useful thing. If you have several positions, adding their deltas shows how long or short the whole position actually is. Many times people sleep thinking they are hedged, and adding the deltas shows they are actually leaning to one side.
Gamma is the speed at which delta changes. It sounds a little hard to understand, but its practical meaning is direct: gamma tells you how quickly your position will change its character.
Gamma is highest at ATM strikes and becomes even faster near expiry. This is why on expiry day an ATM option's price swings wildly — on a small move, delta jumps between zero and one.
For an option seller, gamma is the biggest danger. The seller earns from theta, but gamma works against the seller. As long as the market is calm, theta wins; on the day the market moves fast, gamma wins, and that win is big. The whole game of option selling is a tug of war between these two, and in the last hours of expiry it is pulled hardest.
Vega tells you how much the premium will change when IV changes by one unit. Long-expiry options have a bigger vega, because they have more time for volatility to show its effect. Near expiry vega becomes small.
Because of vega, two trades in the same direction can give completely different results. If you bought an option when IV was high and IV came down, you can lose even though you were right. The reverse also happens — an option bought at low IV can make a profit when IV rises, without the underlying moving.
So those who take a view with long-dated options are really taking a view on volatility, whether they accept it or not. This is a different game and it needs different preparation.
Rho measures the effect of the interest rate. On retail timeframes it is the smallest Greek and can mostly be ignored. In long contracts like LEAPS its effect starts to show.
Practically, three Greeks are enough for a retail account: delta, theta, and vega. Understanding gamma is necessary, but its concept is more useful than looking at its number. Discussion of the other Greeks is often just noise.
The real learning comes when you stop looking at the Greeks separately and look at their relationship. In every position these three stand against one another.
An option position is always bearing this trade-off:
• The buyer has positive gamma but negative theta — wins from a big move and loses quietly.
• The seller has positive theta but negative gamma — wins quietly and loses from a big move.
• One who is long vega wins when volatility rises; one who is short vega wins when volatility falls.
• Without delta, the meaning of everything else changes too, because direction is the very first question.
No position can be good on all three. Whoever wants positive theta has to take negative gamma. Whoever wants unlimited upside has to pay decay every day. The market has priced this trade-off properly, and every attempt to dodge it has its own cost.
Looking at one option's Greeks is the beginning. The real work comes when you have four or five positions and ask what the Greek profile of the whole account is. Greeks can be added — add up the delta of all positions, add up the theta, add up the vega.
This exercise is often startling. People assume they have a balanced book, and adding up shows the whole book leaning one way. Or that three different structures together form one very large short vega, which was never visible in any single position.
Another benefit is that you find out what your real view is, not the one you think you have. If the theta of the whole book is strongly positive, you are in effect saying the market will stay calm — even if you have never said that sentence yourself. And if you disagree with that, the book and your view are running apart.
You do not need to do this daily. Once a week, or whenever a new position is added, is enough. A small sheet with each position's Greeks written out and their sum at the bottom — it does more than tools because it forces you to look.
Option selling looks attractive because its success rate is high. It is often repeated that most options expire worthless, and broadly that is true. But it is not the whole truth.
The truth is that the probability of winning and the size of the win run in opposite directions. If you win small nine times out of ten and lose very big the tenth time, the result depends purely on how big that tenth loss is. And that is in your hands only if you have made arrangements for it beforehand.
So the real question in option selling is not how often you are right. The real question is how much you lose on the day you are wrong, and whether it breaks your account. For people who do not ask this question, one day a deep pit shows up in the equity curve, and before that everything looks very beautiful.
Selling an option without any hedge is called naked selling. Its loss is theoretically unlimited — truly unlimited for a call, and for a put limited to the strike but still very large.
This sounds bookish until you have seen a gap open. News comes overnight, in the morning the price opens very far away in one jolt, and you get no chance to exit in between. A stop loss is an order, not a guarantee — it works only when the price passes through that level. In a gap it does not pass through, it jumps over.
This is why hedged structures exist. Buying a far option fixes your maximum loss. It has a cost — your earnings reduce. That cost is the insurance premium, and the benefit of insurance is learnt on the day it is needed.
To sell an option, margin is blocked; to buy, only the premium is needed. So selling needs capital, and that capital stays blocked as long as the position is open.
Margin is not fixed. When volatility rises, the exchange raises margin, and that often happens when the market is already moving. This means that on the very day your position is going against you, you are asked for more money. This combination is often the cause of a forced exit.
So using up all your margin is dangerous. Some part should always be kept free — not in the hope that it will ever be needed, but in the knowledge that it surely will be, only you do not know when.
A spread means buying one option and selling another, so that both loss and gain are fixed. Its aim is not to increase earnings but to change the shape of the risk.
Every spread is a trade-off. You give up some upside and in return close off the downside, or you spend something and in return reduce the burden of decay. No structure gives anything for free — whatever comfort you get is paid for somewhere.
The simplest structure. Two different strikes in the same expiry — one bought, one sold. For a bullish view, buy the lower and sell the upper; for a bearish view, the reverse.
The benefit is that the net premium is lower and the effect of decay is smaller. The drawback is that a wall stands on the upper side — however far the price goes beyond it, you get nothing. So a vertical spread is for views where you think the price will go to a certain limit, not without limit.
A practical point: a spread has two legs, so charges are paid twice and the spread loss is incurred twice. In low-liquidity strikes this cost can eat up the whole benefit of the structure. So choosing liquid strikes for a spread is as important as choosing the structure.
These structures bet not on direction but on movement. A straddle has both the call and the put at the same strike; a strangle has them at different strikes.
The buyer is saying the price will move a lot, in either direction. The seller is saying the price will stay within a range. For both, direction has no importance — only the size of the move matters.
The biggest mistake here is that people buy a straddle and think they are safe because both sides are covered. In reality they are paying time value twice, and if the price stays calm, both legs erode. Buying a straddle is an aggressive position, not a defensive one.
An iron condor is a combination of two vertical spreads — one above, one below. It says the price will stay in a wide range, and even if that range breaks, the loss is fixed.
Its appeal is that the probability of winning is high. Its danger is that the win is small and the loss is big, so a few losses can eat many wins. And because wins come often, people slowly keep increasing size — and that increase in size is the thing that finally proves expensive.
Range structures do worst on the days when the market's character changes. After a month of calm, a trending phase begins, and the same structures that were running comfortably have to be adjusted one after another.
A calendar has options of different expiries — the near one sold, the far one bought. It is played on the difference in time decay, because the near one erodes faster.
This structure is the most sensitive to IV. If the IV of the far expiry falls, the structure can go into loss even if the price is exactly where you wanted. So understanding a calendar needs a somewhat deeper understanding of the Greeks.
A ratio structure is one where the quantities of the legs are not equal — one bought and two sold, or some similar proportion. It is often built so that the structure becomes zero cost, or even gives a little earning upfront.
This is where the biggest misunderstanding arises. On the screen it looks like a spread, and people assume it is as safe as a spread. It is not safe. The extra sold leg is naked, and to that extent the whole structure is naked selling — only dressed up as a hedge.
Its payoff is deceptive too. In a wide range it looks very good, and that is why it seems attractive. Outside that range it deteriorates very fast, and that part sits in the corner of the payoff chart where the eye rarely goes. People who decide by looking only at the middle part meet that corner sooner or later.
A simple test can be applied to any structure: count the bought and sold quantities. If the sold quantity is greater, then you have a naked position equal to that difference, whatever the structure is called. This test needs no software, only counting, and it catches almost every hidden risk.
These two structures are for those who already hold the underlying. In a covered call you sell a call against your holding — you earn a little, but your upside gets fixed.
A protective put is the reverse — you buy a put against your holding, like insurance. It has a cost, and if nothing happens, that cost was wasted. But on the day something does happen, it does the very job it was bought for.
The importance of these two is that they take options away from speculation and towards risk management. This is the use for which derivatives were originally created, and it is the use that appears least in retail conversation.
Before choosing a structure, three questions must be answered, and all three answers must come before the structure.
Before every structure:
• What is my view — direction, or the size of the movement, or volatility.
• What is the time frame of that view — this week, this month, or beyond.
• If I am wrong, what is the maximum I will lose, and can I accept it.
• How often will I have to look at this structure to run it — because a structure that needs watching daily should fit your life.
Most people do the opposite — they first pick a structure because they read about it somewhere, and then build a view for it. This is why the same strategy gets applied in every market condition and then there is a complaint that it does not work. No strategy works in every condition; that is a feature, not a bug.
The exchange asks for two kinds of margin. One comes from a statistical model and covers the position's likely loss over one day. The other is an extra cushion taken on top of it.
Besides this, when the position goes against you, the mark to market loss also has to be paid, daily. In futures this settles every day — profit comes in as a credit, loss goes out as a debit. So in futures your loss does not wait for expiry, it arrives every evening.
A practical meaning of this is that you must have cash even when your position is right. The price can first go against you and then come in your favour. If you do not have money during that middle stretch, your position will be closed, and after that the price coming your way is useless.
Derivatives give leverage — a big position with little money. This is always sold as a benefit. Its other side is that leverage multiplies not only profit but mistakes too.
Another thing less often said: leverage steals your time. Without leverage you can be wrong and still wait. With leverage you have to be right and also right quickly, because the drawdown in between will push you out. This is a different game, and it needs a different skill.
So the decision on leverage should come before the decision on strategy. Only after deciding how much leverage to take does the question of what to trade matter. If you do it the other way round, even every good strategy breaks on a bad size.
Stock derivatives have a rule of physical settlement at expiry — meaning ITM positions result in actual delivery. Many retail traders learn of this only when they see a large obligation after expiry.
To avoid physical settlement, it is necessary to know:
• Which contracts settle physically and which in cash — this is written in the contract specification.
• What the broker's own policy is — many brokers close ITM positions themselves before expiry, and there are charges for it.
• An ITM position needs the full contract value, not just margin.
• In the days before expiry margin rises, so the position becomes expensive even earlier.
This is the part where not knowing the mechanism proves most expensive. A tiny option position that looked almost worthless can go ITM on expiry day and become a large obligation. So in expiry week, every position should be examined by asking what happens if it goes ITM.
If the underlying company does a bonus, split, dividend or demerger, the share price changes accordingly. If the derivative contract were left as it is, it would become wrong by itself — after a split, every call option would suddenly look worthless.
So the exchange adjusts the contract. Usually both the strike price and the lot size are changed in that proportion so that the total value of the contract stays what it was before. This adjustment is automatic and the circular comes out in advance.
The practical effect is that after the adjustment strange numbers appear on your screen — the lot size is no longer a round number, and the strike becomes odd too. This is not a mistake. But after that the liquidity of that contract often falls, because new people do not touch those odd strikes. So exiting adjusted contracts becomes harder than before, and this is a risk you will not find written anywhere.
When a stock's derivative open interest crosses a fixed limit, the exchange puts that stock in the ban period. Ban does not mean trading stops — it means new positions cannot be created, only old ones can be closed.
The effect is very direct and very few people are ready for it. If your position is going wrong during a ban, you cannot hedge it, because placing a hedge is a new position. Only one road is left to you — to close it, at whatever price is available.
Price behaviour also changes in the ban period. Only closing trades are happening, so moves become fast in one direction and the spread widens. The ban list is published daily, and checking it before taking a position is one of those small habits that are very useful once or twice a year.
At expiry the contract settles at a single number, and that number is not the last traded price. Usually it is a weighted average over a closing period. This is deliberately done so that nobody can move the settlement by making a single trade in the last minute.
So in the last minutes of expiry, the price on the screen and the final settlement can differ. For people who hold positions until the last seconds, this difference sometimes proves expensive.
When an option buyer uses the right, the seller gets assigned. The seller has no control over this — it is allotted by a random process among the sellers who are short at that strike.
This means that an option seller should assume assignment can happen at any time if the option is ITM. When deciding to keep a position open, this is a separate risk, quite apart from the benefit of the premium.
Brokers have their own cut offs. In an intraday product, the position closes by itself at a fixed time, whether you want it or not. There are charges for it and you get whatever price there is at that moment.
This happens once to every new account. The difference in product codes, the cut off timing, and the fact that the broker's square off happens before the market closes — all three should be read on day one, because reading them later costs more.
Weekly expiry has changed the market's character. Now there is an expiry every week, which means one day every week when gamma is high and the price can move fast even without a reason.
One result of this is that the price action on weekly expiry day is different from other days. It is often created by positions adjusting, not by any new fundamental. Taking that day's moves as information and drawing conclusions for next week from them is a common mistake.
The second result is that the premium in weekly options is small, so it looks cheap, so new people start there. In reality it is the fastest and least forgiving part of the entire spectrum. It is the worst place to begin, and it is also the most crowded place.
Every option has a bid and an ask, and the gap between them is your hidden cost. In liquid strikes this gap is small, in far strikes it is large.
This cost is often bigger than brokerage but does not show separately in the ledger. It hides inside your entry price. This is why people say their brokerage is low and yet the account keeps eroding.
The effect of the spread applies twice on every round trip — while going in and while coming out. For people who trade many times a day, this cost becomes the single biggest factor, bigger even than strategy.
Volume tells you how many contracts traded that day. Open interest tells you how many contracts are currently open. The two are different things and both should be looked at together.
High OI means many people are standing at that strike, which means liquidity will be available there. In strikes with low OI it is hard to get an order filled and harder still to exit. While taking a position, think about whether anyone will be there when you want to exit.
The bid and ask on the screen are only the top line. Behind it is depth — how much quantity is lying at that price and around it. For a small order the top line is enough; as soon as the order is a bit larger, that line is used up and the next price is far away.
In options, a large part of the depth comes from market makers — they keep quotes on both sides and earn from the spread. Their job is to provide liquidity, but there is no promise that they will always be there. When volatility rises suddenly, quotes get thin and spreads widen. That is, exactly when exiting is most necessary, exiting is most expensive.
So position size should be tied not only to capital but also to the depth of that strike. A simple check: if you had to exit immediately, would the market take your entire quantity without moving the price. If the answer is no, the position is too big, however comfortably margin is available.
The decision on order type matters more in options than in equity:
• A market order can give a very bad fill in a low-liquidity strike, because depth is thin.
• A limit order carries the risk of not getting filled, but the price stays in your hands.
• A stop loss market order does not give in a gap the price you had in mind.
• Placing multi leg structures together is better than placing them separately, because the price can move in between.
A practical point: one leg getting filled and the other not is the most common execution problem in spread structures. The risk profile of that incomplete structure is not what you thought — often it becomes a naked position. So when filling legs separately, the leg that closes off the risk should be filled first, not the one that brings in the earning.
The OI number is incomplete by itself. Looking at it with price forms a picture, and even that picture remains an estimate.
Four common combinations, and their usual meaning:
• Price up and OI up — new long positions are being built.
• Price down and OI up — new short positions are being built.
• Price up and OI down — shorts are being closed, meaning covering.
• Price down and OI down — longs are being closed, meaning liquidation.
These four labels are useful, but giving them too much importance is wrong. OI data is not complete — it does not show which position is a hedge and which is speculation. A big short may be the hedge of someone's cash holding, and putting a bearish label on it would give a completely wrong conclusion.
Put call ratio is the ratio of put OI to call OI. People treat it as a sentiment indicator. It should be used with caution because it too cannot tell hedging from speculation.
Max pain is the strike where the most option buyers would lose. Many stories are built around it. Its real limit is that it is a calculation, not a force — it does not say the price will go there, it only tells you where that point is according to today's positions. And that point changes every day.
The best use of these two numbers is not to make them the basis of any decision, only to look at them for context. People who use them as signals are often trying to draw a straight line out of very noisy data.
The cost of derivatives goes well beyond brokerage, and the full account of it is in the contract note. That is the one document that tells the truth.
These lines apply to an F&O trade:
• Brokerage — which is often discussed the most and is often the smallest.
• Exchange transaction charges — on turnover.
• Securities transaction tax — whose rate differs for options and futures, and which in the case of options is applied differently on exercise.
• Stamp duty and GST.
• Regulatory fees.
The sum of all these looks large as a percentage on a small trade. This is why making a great many trades on a very small size becomes, arithmetically, almost a game that cannot be won. This is not an opinion, it is the arithmetic of the contract note.
The tax treatment of F&O profit or loss is different from equity delivery, and it has its own reporting rules. Turnover is also calculated in a different way, and that can affect audit requirements.
Rules keep changing, so writing any rate or limit here is pointless. Two things are always useful: download and keep the broker's P&L statement every year, and if your volume is even somewhat large, talk to a professional before filing. Both of these save a lot of time later.
Writing one line with every trade — why I took it, on what view, where I will admit I am wrong — gives, a year later, something no course can give. You find out which kinds of your trades work.
In options this is even more necessary because mistakes come in many forms here. The direction can be wrong, the timing can be wrong, the structure can be wrong, or only the IV can be wrong. Without records these four blur together and you will keep repeating the same mistake, thinking it was just bad luck.
A deep OTM option is cheap because it often expires worthless. Being cheap is its price, not a discount. Many people choose that strike only because in it they can take more lots than their whole capital would otherwise allow.
The result is often the same. A few times it turns out to be a lottery and that is remembered; the other twenty times it ends at zero and that is not remembered. This selective memory is what keeps the habit alive.
Increasing size after a few good trades is the most common pattern. The problem is that size often rises when confidence is highest, and confidence is often highest after a run of consecutive wins — that is, exactly when the market was moving in favour of your style.
When the market's character changes, that same increased size gives the biggest loss. The decision to increase size should be tied not to results but to capital. It is a rule that should be written down beforehand, because writing it is impossible at the time it is needed.
When a position is going wrong, people adjust it. Many times adjustment comes to mean selling even more, so that the average improves. This is not an adjustment, it is increasing the position.
A real adjustment is one that reduces risk. If after some step your maximum loss has become bigger than before, that was not protection, it was doubling down. This one line can catch most adjustment mistakes.
Derivatives are open every day and something always seems to be happening. This creates the feeling that there should be a position every day. There is no such need. Sitting without a position is also a position, and it is often the best one.
Charges apply every day and opportunities do not come every day. Putting these two lines together changes the year's result a great deal. People who trade less and wait more have better arithmetic automatically, even if their skill is the same.
What gets copied most in options is the position — someone gives a strike and expiry, and people take the same. The problem is that a position is only one third of the information. The other two thirds — at what size it was taken and in what circumstances it will be closed — are never shared.
Without those two, the same position is a completely different thing for you. For one person it is two percent of capital and comes with a hedge; for you it is twenty percent and stands alone. Two completely different trades look alike, and the difference is known only when it goes wrong.
This is why a copied position is the first to be abandoned. When it starts going wrong, you have no reason of your own on which to hold or exit, because that reason was never yours.
Most people learn in the wrong order — first strategy, then Greeks, then risk, and mechanism last of all, often after a loss. It is better to do it the other way round.
A sensible order is something like this:
• First the mechanism — contract, expiry, settlement, margin, charges. All of this can be studied without any position.
• Then the structure of the premium — intrinsic, time value, decay. No trade is needed up to here.
• Then volatility — because without it, a loss even on the right direction does not make sense.
• Then one very small position, only to watch the process — from order to expiry.
• And only after that the structures, once all of this has acquired a grounded meaning.
The benefit of learning in this order is that at each step only one new thing has to be understood. In the reverse order everything comes at once and then it becomes impossible to find the cause of any one mistake.
For derivatives a different thing is true, which is not as strict in the cash market: here a large part of the capital should always stay free. Margin rises, MTM arrives, and on volatile days both happen together.
A useful way of thinking is to write down each position's worst case first — not the exit price, but the price at which a gap could open. If your account keeps running even at that number, the size is right. If not, the size is too big, however safe it looks right now.
After understanding the whole structure of derivatives, one thing becomes clear: this is a tool, not a shortcut. Its oldest and most lasting use is to transfer risk, not to add to it. When the tool is used for leverage, it multiplies every mistake, and that mistake is yours, not the tool's.
People who last a long time in this market do not have any hidden structure. They have three things: complete knowledge of the mechanism, strictness about size, and the habit of sitting without a position. All three take time to learn and none of the three can be bought with money — they are built only through process, one at a time, by watching many expiries.
This article is for educational purposes only — it is not a buy or sell recommendation, it makes no claim of guaranteed returns, and it is not advisory. Rules, rates and mechanics are changed from time to time by the exchanges, SEBI and RBI, so verify every number yourself with your broker or an official source.