A stock option is a type of derivative that gives you the right, but not the obligation, to purchase a certain quantity of a particular stock at a predetermined price at a set date in the future. To understand exact stock options meaning it’s essential to take into account `right, not the obligation’. What this means is that when you buy this type of contract, you can choose whether or not to buy it at that particular price.
These were introduced in India in India in 2002. Today you can trade in futures and options on the exchanges in as many as 175 securities.
Stock options explained
Why would anyone want to trade in them? Well, for one, you can do so by investing a fraction of the capital. Let’s see how that works.
Let’s say; you are expecting shares of Company ABC to increase in the future from Rs 100 to Rs 120 and want to take advantage of it. You then purchase 1,000 options contracts of the stock at Rs 120 each (the `strike price’) for Rs 120,000. The best part of it is that you don’t have to pay the entire Rs 120,000, but only the premium when you enter into the contract. The premium is only a fraction of the value of the underlying asset (stock). So if the stock price rises to Rs 120, you can make a profit of Rs 20,000 (120-100×1000) without having to spend Rs 120,000!
If the stock moves in the opposite direction and falls to Rs 80, you have the choice of not exercising your right to buy the shares. In that case, the only amount you stand to lose is the premium. Therefore the losses you will make is restricted to the premium paid, even if the share prices go into a freefall to Rs 50!
Another advantage is the leverage you get. Since the premium is only a fraction of the value of the underlying (stock), you can trade much higher volumes. Let’s say, if you had Rs 1 lakh to invest and purchased stock, whose prices then went up by 10 percent to Rs 110,000, you would have made a profit of Rs 10,000. If you invest that Rs 1 lakh, you would get exposure to Rs 10 lakh worth of shares (assuming premium is 10 percent). If stock prices rise by 10 percent, you will stand to gain Rs 90,000!
How to invest in stock options
You can trade in these options, just like shares. You have to pay a premium, which is determined by several factors like the length of time between the beginning of the contract and the expiry date, the current price of the stock, and so on. The premium keeps changing over time, depending on developments in the stock. You have to pay premium to the broker, which is passed to the exchange, when then passes it on the seller of the stock option, or `writer’.
Stock options contracts are for periods of 1, 2 or 3 months. However, a buyer can exit the contract at any time before the expiry date either to book profits or to contain losses. The options seller or writer too can exit the contract if prices don’t move favourably. But in this case, he would have to pay a premium to the buyer. This premium will be higher since the contract is in the buyer’s favour, and not in the seller’s.
Types of stock options
There are two basic types of stock options. One is the call option , which gives you the right to buy stock. Another is the put option, which gives you the right to sell the stock. Generally, call options are preferred when stock prices are expected to go up. Put options are preferred when stock prices are expected to go down.
For the risk-wary investor, stock options offer an excellent way of getting into the stock market. Since there is no compulsion to buy/ sell at the end of the expiry period, your potential losses are limited. It is better than buying the stock itself since your downside in case its price goes into a free-fall is unlimited.