What Are Options?
Just as futures contracts minimize risks for buyers by setting a predetermined future price for an underlying asset, options contracts do the same, however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
If you’re trading in NSE, you have the option of VIX Futures that can help you quantify the volatility of the market.
Options are contracts that give the bearer the right—but not the obligation—to either buy or sell an amount of some underlying asset at a predetermined price at or before the contract expires. Like most other asset classes, options can be purchased with brokerage investment accounts.
Options trading allows you to buy or sell stocks, ETFs etc. at a specific price within a specific date. This type of trading also gives buyers the flexibility to not buy the security at the specified price or date.
While it is a little more complex than stock trading, options can help you make relatively larger profits if the price of the security goes up. That’s because you don’t have to pay the full price for the security in an options contract. In the same way, options trading can restrict your losses if the price of the security goes down, which is known as hedging.
The right to buy a security is known as ‘Call’, while the right to sell is called ‘Put’.
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. In fact, options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.
Imagine that you want to buy technology stocks, but you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if the underlying price moves against their trade—especially during a short squeeze.
- Derivative. Options are what’s known as a derivative, meaning that they derive their value from another asset. Take stock options, where the price of a given stock dictates the value of the option contract.
- Call option and put option. A call option gives you the opportunity to buy a security at a predetermined price by a specified date while a put option allows you to sell a security at a future date and price.
- Strike price and expiration date. That predetermined price mentioned above is what’s known as a strike price. Traders have until an option contract’s expiration date to exercise the option at its strike price.
- Premium. The price to purchase an option is called a premium, and it’s calculated based on the underlying security’s price and values.
- Intrinsic value and extrinsic value. Intrinsic value is the difference between an option contract’s strike price and current price of the underlying asset. Extrinsic value represents other factors outside of those considered in intrinsic value that affect the premium, like how long the option is good for.
- In-the-money and out-of-the-money. Depending on the underlying security’s price and the time remaining until expiration, an option is said to be in-the-money (profitable) or out-of-the-money (unprofitable).
Options can also be used for speculation. Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders because options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
Types of Options: Calls and Puts
Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Think of a call option as a down payment on a future purchase.
A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising, since it has unlimited upside potential but the maximum loss is the premium (price) paid for the option.
Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the underlying stock at the strike price on or before expiration. A long put, therefore, is a short position in the underlying security, since the put gains value as the underlying’s price falls (they have a negative delta). Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
Call option example
A call option gives the buyer of the option the right to buy an asset. On the other hand, the seller of the option has no such right, and is mandated by the option contract to sell the asset to the buyer (if the buyer exercises his right to purchase).
In exchange for effectively giving up his rights, the seller of the option charges a certain amount from the option buyer, termed as the ‘premium.’ Consider this ‘premium’ amount as a kind of a security deposit charged by the option seller to indemnify himself in the event of the buyer not exercising his option.
Let’s take a look at an example to better understand the concept of call options.
Assume that TATA MOTORS is trading at Rs. 200 today. In the near future, say one month down the line, you expect the price of this stock to rise. So, you wish to lock in the current price today, so you can buy at this low price in the future.
However, you’re also cautious by nature, so you want to account for the alternative outcome too – what if the prices fall instead? So, basically, you want the choice (and not the obligation) to buy the share at Rs. 200 in the future.
Here’s where an options contract can help. And this kind of an options contract – one that gives you the right to buy an asset at a predetermined price, on a future date – is known as a call option.
Meanwhile Raz, another trader, is 100% certain that the price of TATA MOTORS shares will fall in the near future. In other words, he’s keen on entering into a contract that will help him sell the share one month later at Rs. 200, since he believes the prices at that time will be much lower.
So, the two of you enter into a contract. You buy a call option from Raz. In other words, you buy the right to purchase the share of TATA MOTORS from him at Rs. 200 one month from now. By that point, you expect the price to be higher than Rs. 200. Ram, meanwhile, sells you that right to purchase the share of TATA MOTORS at Rs. 200.
This price (Rs. 200) is known as the strike price of the option.
Here, you’re the buyer of the options contract and the purchaser of the asset. And Raz is the seller of the options contract and the seller of the asset.
As a result of selling you the right to purchase the share, Raz is effectively obligating himself to sell you the shares in the process. And, as a compensation for any loss that he might incur if you decide to not exercise your option, Raz charges you a premium amount of say Rs. 20.
It is the price you pay to the seller of the option for entering into the contract. You pay the broker the fee which is passed to the writer on the exchange and thereon. Premium is a percentage of the underlying, which is calculated by several factors, including the intrinsic value of the contract options. Premiums continue to adjust, depending on whether the option is in-the-money or out-of-money
- American and European Options
‘American options’ are options that can be exercised on or before their expiry date at any time. ‘European options’ are options that can be exercised only on the expiry date.
- Open Interest
It applies to the cumulative number of available positions on an options contract at any given point in time among all market participants. Open Interest becomes zero for a given contract after the expiration date.
Options may seem like complicated derivative instruments, but they can prove to be quite useful financial instruments, providing you with the risk mitigation or the leverage that you need, while also protecting any downside risk. If you’re well-versed in online trading options, there are sophisticated trading strategies in India such as a straddle, strangle, butterfly and collar that can be used to optimise returns.