Options are a type of derivative, and hence their value depends on the value of an underlying instrument. The underlying instrument can be a stock, but it can also be an index, a currency, a commodity or any other security.
Now that we have understood what options are, we will look at what an options contract is. An option contract is a financial contract which gives an investor a right to either buy sell an asset at a pre-determined price by a specific date. However, it also entails a right to buy, but not an obligation.
When understanding option contract meaning, one needs to understand that there are two parties involved, a buyer (also called the holder), and a seller who is referred to as the writer.
When the Chicago Board Options Exchange was set up in 1973, modern options came into being. In India, the National Stock Exchange (NSE) introduced trading in index options on June 4, 2001.
Features of an option contract
- Premium or down payment:The holder of this type of contract must pay a certain amount called the ‘premium’ for having the right to exercise an options trade. In case the holder does not exercise it, s/he loses the premium amount. Usually, the premium is deducted from the total payoff, and the investor receives the balance.
- Strike price:This refers to the rate at which the owner of the option can buy or sell the underlying security if s/he decides to exercise the contract. The strike price is fixed and does not change during the entire period of the validity of the contract. It is important to remember that the strike price is different from the market price. The latter changes during the life of the contract.
- Contract size:The contract size is the deliverable quantity of an underlying asset in an options contract. These quantities are fixed for an asset. If the contract is for 100 shares, then when a holder exercises one option contract, there will be a buying or selling of 100 shares.
- Expiration date:Every contract comes with a defined expiry date. This remains unchanged until the validity of the contract. If the option is not exercised within this date, it expires.
- Intrinsic value:An intrinsic value is the strike price minus the current price of the underlying security. Money call options have an intrinsic value.
- Settlement of an option:There is no buying, selling or exchange of securities when an options contract is written. The contract is settled when the holder exercises his/her right to trade. In case the holder does not exercise his/her right till maturity, the contract will lapse on its own, and no settlement will be required.
- No obligation to buy or sell:In case of option contracts, the investor has the option to buy or sell the underlying asset by the expiration date. But he is under no obligation to purchase or sell. If an option holder does not buy or sell, the option lapses.
Types of options
Now that it is clear what options are, we will take a look at two different kind of option contracts- the call option and the put option.
A call option is a type of options contract which gives the call owner the right, but not the obligation to buy a security or any financial instrument at a specified price (or the strike price of the option) within a specified time frame.
To buy a call option one needs to pay the price in the form of an option premium. As mentioned, it is upon the discretion of the owner on whether he wants to exercise this option. He can let the option expire if he deems it unprofitable. The seller, on the other hand, is obliged to sell the securities that the buyer desires. In a call option, the losses are limited to the options premium, while the profits can be unlimited.
Let us understand a call option with the help of an example. Let us say an investor buys a call option for a stock of XYZ company on a specific date at Rs 100 strike price and expiry date is a month later. If the price of the stock rises anywhere above Rs 100, say to Rs 120 on the expiration day, the call option holder can still buy the stock at Rs 100.
If the price of a security is going to rise, a call option allows the holder to buy the stock at a lower price and sell it at a higher price to make profits.
Call options are further of 2 types
In the money call option: In this case, the strike price is less than the current market price of the security.
Out of the money call option: When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.
Put options give the option holder the right to sell an underlying security at a specific strike price within the expiration date. This lets investors lock a minimum price for selling a certain security. Here too the option holder is under no obligation to exercise the right. In case the market price is higher than the strike price, he can sell the security at the market price and not exercise the option.
Let us take an example to understand what a put option is. Suppose an investor buys a put option of XYZ company on a certain date with the term that he can sell the security any time before the expiration date for Rs 100. If the price of the share falls to below Rs 100, say to Rs 80, he can still sell the stock at Rs 100. In case the share price rises to Rs 120, the holder of the put option is under no obligation to exercise it.
If the price of a security is falling, a put option allows a seller to sell the underlying securities at the strike price and minimise his risks.
Like call options, put options can further be divided into in the money put options and out of the money put options.
In the money put options: A put option is considered in the money when the strike price is more than the current price of the security.
Out of the money put options: A put option is out of the money if the strike price is less than the current market price.
There is another options strategy known as the straddle. This strategy is used by an investor when the price movement of the stock is not apparent. The straddle option consists of two options contracts, a call option and a put option. For the straddle option to be used correctly, both the call and the put options have to have the same expiration date and the same strike price. As we have seen the call option gives you the right to buy the stock at a set strike price any time before the expiration date. The put option gives you the right to sell the stock at the same strike rate before the date of expiration. You would need to pay the premium to buy both these options and the total premium you pay equals the maximum loss you are exposed to. In volatile markets, only one of the options will have intrinsic value when the expiration date arrives. However, the investor bets that the value of that option will give him enough profits to make up for the option premiums he has paid.
Let us take an example to see how a straddle option works. Let us say an investor exercises a straddle option for a strike price of Rs 100 and pay Rs 20 as premium. In a scenario where the stock price remains at Rs 100 at the end of the expiration period, both the options expire without any value, and he loses Rs 20. But if the market moves, either way, there are chances of making profits. Let us say that the stock price rises to Rs 130. In this scenario, the put option expires without any value, but the call option has a value of Rs 30. If the stock price falls to Rs 70, the opposite happens. In this case, the call option expires worthless, but the put option is worth Rs 30. Straddles make the most sense when the markets are most volatile and can move either way, especially in events when a stock is going to announce its earnings figures.
Options can also be classified on the exercising style into American and European options.
American options: These are options that can be exercised at any time up to the expiration date. Select security options available at NSE are American style options.
European options: These options can be exercised only on the expiration date. All index options traded at NSE are European options.
How options work
Now that we have understood what are options, andwhat is an option contract, let us now understand how options work:
If you have but any security, let us say a stock, you want to sell it at a future date at a higher price. To make a profit, you have to buy it at a lower price and sell it at a higher price. However, since the markets are unpredictable, it is not possible to be sure what the prevalent market price will be. To protect yourself from any potential losses, you can buy a put option. This lets you sell the stock at a predetermined rate, either before or on the expiration date. Because an options contract does not come with any obligations, it is a kind of insurance.
If the price of the stock is indeed lower than the strike price, you can exercise the option and sell your shares at the agreed price that is mentioned on the options contract. By doing so, you make a profit.
In another situation, the market price for stocks can be higher than expected, leading up to the expiration date. In that case, the options contract become useless as you can directly sell the shares in the market at a higher price. So an options contract provides a sort of protection against market situations one has no control over.
Here we have to understand that options are all about determining how prices of a security will move in the future. If the chances of something happening, say the price of security rising, is more likely, an option which would profit from such an event would be more expensive.
Another essential factor to consider is time. The value of an option will decrease as the time to expiry decreases because the chances of the price of the underlying security moving in that period go down as the date moves towards expiry. So, a six-month option will be less valuable than a one year option and so on.
By the same logic, volatility also increases the value of options. This is because more volatile the market for the underlying security, the odds of a profitable outcome from an options contract is even higher. More volatility will mean that the price of the underlying security has more chances of moving up and down and hence higher the volatility, higher the price of an option.
What are options in investing: Now we will see the use of options in investing. Let us say that the stock for YXZ company is at Rs 250. If an investor is bullish on the stock, he may buy a call option with a strike price of Rs 260. For that, he will have to pay a premium. But let us say that the price of the stock for XYZ company moves up to Rs 280 within the period specified, the investor can buy the stock for Rs 250 and sell it at Rs 280 to make a profit.
On the other hand, if an investor is bearish about a stock, he can buy a put option. Let us say that the share of XYZ company is trading at Rs 250. If an investor buys a put option for a strike price of Rs 240, if the stock price falls and is at Rs 220 on the expiration date, the investor can still sell the shares for Rs 240 and hedge his loss.
Understanding how options are priced
Someone who wants to trade in options should also have an idea of how options are priced. There are a lot of variables that determine the value of an option. These include the current stock price, the intrinsic value, the time to expiration, which is also known as the time value and also other factors like volatility, interest rates, and so on. Several option pricing models use the above values to arrive at the price of an option. Out of these, the most popularly used is the Black-Scholes model.
However, certain things hold when it comes to option pricing. The longer the period between the day the option is purchased and the expiry date, the more valuable the option. That is because there is more time for the current market price to reach the strike price. The price of an option can decrease even as the price of a stock goes up if the expiry date is nearing. As the chances of the price rising to meet the strike price decrease, the price of the option will also start decreasing as the one approaches the expiration date.
Advantages of options
Now that we have understood what are options, we will look into some of the advantages of options.
- Low cost of entry:The first advantage of options is that it allows the investor or trader to take a position with a small amount as compared to stock transactions. If you are buying actual stocks, you have to shell out a large sum of money which would be equal to the price of each stock multiplied into the number of stocks you buy.
The other option is to buy call options of the same stock, which will cost much lower. However, if share prices go up in the way you have predicted, you would benefit just as much in terms of percentage as if you had shelled out money to buy the actual stock. In this case, you would have to pay less out of your pocket but reap the same benefits.
Let us take an example. Suppose you buy 100 shares of company XYZ at Rs 100 per share for Rs 10,000. After a certain period, the shares are selling for Rs 120. You sell the shares and make a profit of Rs 2,000.
Suppose you had bought a call option for the same shares at Rs 10 per share premium. When the price of the stock hits Rs 120, you can exercise the call option to buy the shares at Rs 100. You can then sell the shares at Rs 120 and make a profit of Rs 20 per share. So you make the same profits, but instead of investing Rs 10,000, you spend only pay Rs 1,000. This is a very simplified example, and in reality, option is not so simple, but it gives you an idea of how options can be a low-cost entry option of taking a position as far as the underlying price of a security is concerned.
- Hedging against risks:Options are an excellent way of protecting your stocks portfolio. Buying options is actually like buying insurance for your stock portfolio and minimising your exposure to risk. If the price of the underlying security for a call option does not rise above the strike price when the option expires, your option becomes useless, and you lose all the money you paid up front. However, the premium you end up paying is the maximum limit of your risk. Otherwise, in the case of the above example, if the price of a security falls to Rs 80 from a strike price of Rs 100, you would have lost Rs 20 per share. With the option, you lose just the premium amount, which is much lower.
- Flexibility:Options gives the investor the flexibility to trade for any potential movement in an underlying security. As long as the investor has a view regarding how the price of a security will move shortly, he can use an options strategy. If an investor feels that the price of a security is likely to rise, he can buy a call option and fix the price of the security at a certain level. If the price of the underlying security goes up, he can purchase the securities at the strike price and then sell it at the market price to make profits. On the other hand, if an investor feels that the price of a particular security is going to fall, he can buy a put option for a certain strike price. Even if the price of the security falls below the strike price, he can still sell the securities at the strike price and lock a specific price for selling the security. Options thus work in all kinds of market conditions.
Disadvantages of options
Trading in options also come with a set of drawbacks. Let us take a look.
Lower liquidity: One of the most significant disadvantages of options is that they are not liquid as not many people trade in the options market. Due to low liquidity, it is not easy to buy and sell options. This could often mean buying at a higher rate and selling at a lower rate as compared to other more liquid investment options.
Risk: As we have seen that the risk in case of options is limited to the options premium. However, if the movement in the price of the security is not favourable, an investor stands to lose the entire option premium.
Complicated: Options are a complicated investment tool for beginners. Even for some advanced investors, investing in options can be a challenging prospect. One needs to take a call on the price movement of a particular security and the time by which this price movement will occur. Getting both right can be tough.
As we have seen above, options have both benefits and disadvantages, both of which should be considered before someone decides to trade in options.