What are Options
An Option is a type of derivative; therefore its value is dependent on the value of an underlying instrument.
This particular underlying instrument could be a stock, currency, an index, a commodity, or some other security. Options give a buyer the right but not the obligation for transacting an underlying asset at a predetermined price on a future date.
Features of an option contract
Some features of option contracts are:
- Derivatives: Option contracts are derivatives, as their values are derived from the performance of the underlying asset in the market.
- Expiration: Options are contracts with an expiry date. If the bearer does not exercise the option on or before a certain date, it will become useless.
- Strike Price: Options come with a pre-agreed price, called the strike price, it is a previously agreed upon price at which the contract will be traded.
- Speculation: Options are used for speculation, with strategies. Speculators take a leveraged position using an option at a lower cost than buying stocks directly.
- Hedging: Options are used for hedging by investors to reduce risk on other open positions by taking an opposite position in the market.
- No obligation: The buyer of options contract has the right but is not obligated to exercise the contract. This means that the option buyer isn’t under the obligation to pay for or buy the underlying asset if they don’t want to but can hold the contract and wait for the preferred price movement.
- Settlement: Option contract is settled when the option buyer decides to exercise the right to buy the underlying assets on the expiry date.
- Contract Size: All options contract come with a contract size (lot size) which refers to the volume of the underlying asset linked to the contract.
Types of options
Two types of options are explained below:
Call option
- A call option means the right to buy the underlying asset at a pre-fixed price before the contract expires.
- Traders consider call options in stock market if their analysis shows that the underlying asset price will increase further.
- Call options can benefit traders in the rising markets. Either you can exercise the option and buy the underlying security at the predetermined price or sell the option if the stock price exceeds the break-even price.
Put options
A put option grants the bearer the right to sell the underlying financial asset at a pre-fixed price before the contract expires. Based on your analysis, the underlying asset’s prices are speculated to decline before the contract expires, so you can consider a put option.
- Put options are used to hedge portfolios during plunging markets.
How options work
Suppose you bought a call option consisting of 100 shares ( trading at Rs. 67). The expiration date is November 1, 2022. To benefit from this call option, you must expect a rise in the stock price on or before expiration. Therefore, the strike price is Rs. 70. It means the stock price must increase more than Rs.70 before the option expires to book profits. The premium of the contract is Rs. 1000.
Scenario 1
Before November 1, the stock price rose to Rs.78; therefore, the options contract increased in value. Now you can sell your options contract and take your profits. Alternatively, you can buy the stocks at a lower cost than their market price and gain significantly.
Scenario 2
Opposite to your analysis, if the stock price is reduced to Rs.65, lower than the strike price of Rs.70, you are not bound to buy the stocks. If you do not want to exercise the right, you need not. You will just lose the premium you paid for the option contract.
Understanding how options are priced
The buyer pays a premium for the rights. Options premium is decided based on the intrinsic value (current price - strike price of the underlying asset) and time value also. Long-term expiry and market volatility increases the price of an option.
Advantages of options
- Purchasing options allows you to leverage your position without paying the complete value.
- Options are flexible as traders can employ their strategic moves to make profits before their options contract expires.
Disadvantages of options
- Options carry a substantial risk of loss due to its speculative nature and are not suitable for every trader.
- Options trading strategies are complex in nature.
When used correctly, options contracts offer many advantages that trading stocks alone cannot, like, leveraging - significant returns with the benefit of cost-effectiveness. However, it is very important to understand the Options market and how trading in options work before you choose to trade in them.