Types of Options Contract

6.1 What are Call Options?

What Are Call Options?

A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specified amount of an underlying asset at a predetermined price, known as the strike price, within a certain period. The underlying asset can be stocks, commodities, indices, or other financial instruments. Call options are popular in trading and investing due to their flexibility and potential for significant returns.

How Do Call Options Work?

When an investor buys a call option, they are essentially betting that the price of the underlying asset will rise above the strike price before the option’s expiration date. If the price increases, the investor can exercise the option to buy the asset at the strike price, which is lower than the current market price, allowing them to potentially sell it at the higher market price for a profit. If the price does not rise above the strike price, the investor may choose not to exercise the option, and it will expire worthless.

Components of a Call Option:

1. Underlying Asset: The financial instrument that the option is based on, such as stocks or commodities.
2. Strike Price: The price at which the holder can buy the underlying asset if they choose to exercise the option.
3. Expiration Date: The date by which the option must be exercised or it will expire.
4. Premium: The price paid by the buyer to the seller for the call option. It is determined by factors such as the underlying asset’s price, time to expiration, volatility, and interest rates.

Benefits of Call Options:

1. Leverage: Call options allow investors to control a larger position with a relatively small investment. This leverage can lead to significant returns if the underlying asset’s price rises.
2. Limited Risk: The maximum loss for the buyer of a call option is limited to the premium paid for the option. This limited risk makes call options an attractive choice for many investors.
3. Flexibility: Call options can be used for various strategies, including hedging against potential price increases, generating income, and speculating on market movements.

Examples and Scenarios:

Imagine an investor buys a call option for 100 shares of Company A with a strike price of ₹50, expiring in three months. The premium paid for the option is ₹3 per share, so the total cost is ₹300 (100 shares x ₹3). If the stock price rises to ₹60 before the expiration date, the investor can exercise the option to buy the shares at ₹50 each and sell them at ₹60 each, making a profit of ₹10 per share. After accounting for the premium paid, the net profit is ₹7 per share, or ₹700 in total.

However, if the stock price does not rise above ₹50 by the expiration date, the investor may choose not to exercise the option, resulting in a loss limited to the premium paid, which is ₹300.

When to Use Call Options:

1. Speculation: Investors who anticipate a significant price increase in the underlying asset can use call options to profit from the upward movement.
2. Hedging: Investors who own the underlying asset and are concerned about potential price increases can use call options to hedge against the risk.
3. Income Generation: Investors can sell call options on assets they own (covered calls) to generate additional income from the premiums received.

6.2. What are Put Options? 

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price, known as the strike price, within a certain period. Like call options, put options are versatile instruments used for hedging, speculation, and various trading strategies.

How Do Put Options Work?

When an investor buys a put option, they are essentially betting that the price of the underlying asset will fall below the strike price before the option’s expiration date. If the price decreases, the investor can exercise the option to sell the asset at the higher strike price, allowing them to potentially buy it back at the lower market price for a profit. If the price does not fall below the strike price, the investor may choose not to exercise the option, and it will expire worthless.

Components of a Put Option:

1. Underlying Asset: The financial instrument that the option is based on, such as stocks or commodities.
2. Strike Price: The price at which the holder can sell the underlying asset if they choose to exercise the option.
3. Expiration Date: The date by which the option must be exercised or it will expire.
4. Premium: The price paid by the buyer to the seller for the put option. It is determined by factors such as the underlying asset’s price, time to expiration, volatility, and interest rates.

Benefits of Put Options:

1. Leverage: Put options allow investors to control a larger position with a relatively small investment. This leverage can lead to significant returns if the underlying asset’s price falls.
2. Limited Risk: The maximum loss for the buyer of a put option is limited to the premium paid for the option. This limited risk makes put options an attractive choice for many investors.
3. Flexibility: Put options can be used for various strategies, including hedging against potential price declines, generating income, and speculating on market movements.

Examples and Scenarios:

Imagine an investor buys a put option for 100 shares of Company B with a strike price of ₹50, expiring in three months. The premium paid for the option is ₹3 per share, so the total cost is ₹300 (100 shares x ₹3). If the stock price falls to ₹40 before the expiration date, the investor can exercise the option to sell the shares at ₹50 each and then buy them back at ₹40 each, making a profit of ₹10 per share. After accounting for the premium paid, the net profit is ₹7 per share, or ₹700 in total.

However, if the stock price does not fall below ₹50 by the expiration date, the investor may choose not to exercise the option, resulting in a loss limited to the premium paid, which is ₹300.

When to Use Put Options:

1. Speculation: Investors who anticipate a significant price decrease in the underlying asset can use put options to profit from the downward movement.
2. Hedging: Investors who own the underlying asset and are concerned about potential price declines can use put options to hedge against the risk.
3. Income Generation: Investors can sell put options (naked or cash-secured puts) to generate additional income from the premiums received.

Applications:

Hedging: A common use of put options is to hedge against potential losses in a portfolio. For example, if an investor holds a stock that they believe might decline in value, they can buy a put option on that stock. If the stock price falls, the profits from the put option can offset the losses from the stock, thus protecting the investor’s portfolio.

Speculation: Traders can use put options to speculate on the decline of an asset’s price. If they believe a stock or other asset will decrease in value, they can purchase put options and profit from the price drop without needing to short sell the asset directly.

Income Generation: Selling put options can be a way to generate income. Investors sell put options and collect premiums. If the option expires worthless, the seller keeps the premium as profit. However, if the option is exercised, the seller may be obligated to buy the asset at the strike price, which could result in a loss if the market price is significantly lower.

Put Option Strategies:

1. Protective Puts: An investor who owns a stock and is concerned about a potential decline can buy a put option to protect against losses. This strategy is similar to buying insurance for the stock.
2. Long Put: A speculative strategy where investor buys put options to profit from a decline in the underlying asset’s price.
3. Short Put: A strategy where an investor sells put options to generate income from the premiums received, but with the risk of having to buy the underlying asset if the option is exercised.

6.3. European Options

European options are a type of financial derivative that grants the holder the right, but not the obligation, to buy or sell a specified amount of an underlying asset at a predetermined price, known as the strike price, but only at the option’s expiration date. Unlike American options, which can be exercised at any time before expiration, European options have a more rigid exercise structure, limiting the holder to a single exercise point.

Key Characteristics of European Options:

1. Exercise Date: European options can only be exercised at the expiration date, not before. This restriction makes them less flexible than American options but also simpler to manage and value.
2. Underlying Assets: European options can be based on various underlying assets, including stocks, indices, commodities, currencies, and more. They are commonly used in equity and index options markets.
3. Strike Price: The strike price is the price at which the underlying asset can be bought (call option) or sold (put option) if the option is exercised. The strike price is agreed upon at the time the option contract is created.
4. Expiration Date: The expiration date is the specific date on which the option can be exercised. After this date, the option becomes void and worthless if not exercised.
5. Premium: The premium is the price paid by the buyer to the seller (writer) of the option. It is determined by factors such as the underlying asset’s current price, time to expiration, volatility, and interest rates.

How European Options Work:

When an investor buys a European call option, they are hoping that the price of the underlying asset will rise above the strike price by the expiration date. If the price is higher at expiration, the holder can exercise the option to buy the asset at the lower strike price and sell it at the market price for a profit. Conversely, if an investor buys a European put option, they are hoping that the price of the underlying asset will fall below the strike price by the expiration date. If the price is lower at expiration, the holder can exercise the option to sell the asset at the higher strike price and buy it back at the market price for a profit.

Benefits and Drawbacks of European Options:

Benefits:

1. Simplicity: European options are simpler to manage and value due to their single exercise point. This simplicity makes them attractive to investors who prefer a straightforward approach to options trading.
2. Lower Premiums: Because European options can only be exercised at expiration, they often have lower premiums compared to American options. This lower cost can be advantageous for investors looking to minimize expenses.

Drawbacks:

1. Lack of Flexibility:

The main drawback of European options is their lack of flexibility. Investors cannot take advantage of favourable price movements before the expiration date, which can limit potential profits.

2. Less Suitable for Certain Strategies:

European options may not be suitable for strategies that require early exercise, such as covered calls or protective puts. Investors who need the ability to exercise options before expiration may prefer American options.

Applications of European Options:

Index Options: European options are commonly used in index options trading. For example, options on major stock indices like the S&P 500 or the FTSE 100 are typically European options. These index options allow investors to hedge or speculate on the performance of a broad market index without worrying about early exercise.

Hedging Strategies: European options can be used in various hedging strategies to protect portfolios from adverse price movements. For instance, an investor holding a diversified portfolio might buy European put options on a stock index to hedge against a potential market downturn.

Speculation: Traders can use European options to speculate on the future price movements of underlying assets. By purchasing call or put options, traders can potentially profit from price changes without owning the actual asset.

Example Scenario:

Imagine an investor buys a European call option on 100 shares of Company X with a strike price of ₹50, expiring in three months. The premium paid for the option is ₹2 per share, so the total cost is ₹200 (100 shares x ₹2). If the stock price rises to ₹60 by the expiration date, the investor can exercise the option to buy the shares at ₹50 each and sell them at ₹60 each, making a profit of ₹10 per share. After accounting for the premium paid, the net profit is ₹8 per share, or ₹800 in total. If the stock price does not rise above ₹50 by the expiration date, the investor may choose not to exercise the option, resulting in a loss limited to the premium paid, which is ₹200.

6.4   What are American Options

American options are a type of financial derivative that grants the holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specified amount of an underlying asset at a predetermined price, known as the strike price, at any time before or on the option’s expiration date. This flexibility to exercise the option at any point during its life distinguishes American options from European options, which can only be exercised at expiration.

Key Characteristics of American Options:

1. Exercise Flexibility: American options can be exercised at any time before or on the expiration date. This provides the holder with greater flexibility to take advantage of favourable price movements.
2. Underlying Assets: American options can be based on various underlying assets, including stocks, indices, commodities, and currencies. They are particularly common in equity options markets.
3. Strike Price: The strike price is the price at which the underlying asset can be bought (call option) or sold (put option) if the option is exercised. The strike price is agreed upon when the option contract is created.
4. Expiration Date: The expiration date is the last day the option can be exercised. After this date, the option becomes void and worthless if not exercised.
5. Premium: The premium is the price paid by the buyer to the seller (writer) of the option. It is influenced by factors such as the underlying asset’s current price, time to expiration, volatility, and interest rates.

How American Options Work:

When an investor buys an American call option, they have the flexibility to exercise the option to buy the underlying asset at the strike price at any time before or on the expiration date. If the asset’s price rises above the strike price, the holder can buy the asset at the lower strike price and potentially sell it at the higher market price for a profit. Similarly, an investor who buys an American put option can exercise it to sell the underlying asset at the strike price if the asset’s price falls below the strike price.

Benefits and Drawbacks of American Options:

Benefits:

1. Flexibility: The ability to exercise the option at any time before or on the expiration date provides greater flexibility to capitalize on favourable price movements and strategic opportunities.
2. Strategic Uses: American options are suitable for various trading strategies, including those that require early exercise, such as covered calls, protective puts, and options spreads.

Drawbacks:

1. Higher Premiums: Due to the increased flexibility and potential for early exercise, American options often have higher premiums compared to European options. This higher cost can be a consideration for investors.
2. Complexity: Managing American options can be more complex due to the potential for early exercise. Investors need to be vigilant and make timely decisions to maximize their benefits.

Applications of American Options:

Equity Options: American options are widely used in equity options trading. For example, options on individual stocks like Apple, Microsoft, or Tesla are typically American options. These options allow investors to hedge, speculate, or generate income from stock positions with the added flexibility of early exercise.

Hedging Strategies: American options are commonly used in hedging strategies to protect against adverse price movements. For instance, an investor holding a stock portfolio might buy American put options on individual stocks to hedge against potential declines in stock prices.

Speculation: Traders can use American options to speculate on the future price movements of underlying assets. By purchasing call or put options, traders can potentially profit from price changes without owning the actual asset and with the ability to exercise early if needed.

Example Scenario:

Imagine an investor buys an American call option on 100 shares of Company Y with a strike price of ₹50, expiring in three months. The premium paid for the option is ₹4 per share, so the total cost is ₹400 (100 shares x ₹4). If the stock price rises to ₹60 two months before the expiration date, the investor can exercise the option to buy the shares at ₹50 each and sell them at ₹60 each, making a profit of ₹10 per share. After accounting for the premium paid, the net profit is ₹6 per share, or ₹600 in total.

If the stock price does not rise above ₹50 by the expiration date, the investor may choose not to exercise the option, resulting in a loss limited to the premium paid, which is ₹400.

American Option Strategies:

• Covered Calls: A covered call strategy involves holding the underlying asset and selling call options on that asset to generate income. The call options sold are American options, and the seller must be prepared for the possibility of early exercise.
• Protective Puts: A protective put strategy involves holding the underlying asset and buying put options to protect against potential price declines. The put options bought are American options, providing flexibility to exercise early if needed.
• Options Spreads: Various options spread strategies, such as bull spreads, bear spreads, and butterfly spreads, can involve American options. These strategies allow investors to create specific risk/reward profiles and take advantage of market opportunities.

6.5 Asian Options

Asian options, also known as average options, are a type of exotic financial derivative. Unlike standard options (American and European), where the payoff depends on the price of the underlying asset at a specific point in time (maturity), the payoff for Asian options depends on the average price of the underlying asset over a certain period.

Key Features of Asian Options:

1. Average Price Calculation: The payoff is determined by the average price of the underlying asset over a specified period. This average can be calculated using either arithmetic or geometric means.
2. Lower Volatility: Due to the averaging mechanism, Asian options tend to have lower volatility compared to standard options.
3. Hedging Tool: They are particularly useful for hedging against price volatility over time, making them attractive to traders exposed to the underlying asset for an extended period.
4. Cost-Effective: Asian options are generally less expensive than their standard counterparts due to the reduced volatility.

Types of Asian Options:

1. Average Strike Options: The strike price is determined based on the average price of the underlying asset over a specified period.
2. Average Price Options: The exercise price is known, but the payoff depends on the average price of the underlying asset over the period.

Example:

Imagine a trader buys a 90-day arithmetic call option on stock XYZ with an exercise price of ₹22, where the averaging is based on the value of the stock every 30 days. If the stock prices after 30, 60, and 90 days are ₹21.00, ₹22.00, and ₹24.00, the arithmetic average would be (21.00 + 22.00 + 24.00) / 3 = ₹22.332. The payoff would be based on this average price.

Asian options are particularly useful in markets with high volatility or where price manipulation is a concern. They help in reducing the risk associated with price fluctuations over time.

6.6 Barrier Options

Barrier options are a type of exotic option that is activated or deactivated if the price of the underlying asset reaches a certain level, known as the “barrier.” They offer a more complex and flexible structure compared to standard options, making them popular among sophisticated investors for hedging and speculative purposes.

Key Features of Barrier Options:

1. Activation/Deactivation: The option is either activated (knock-in) or deactivated (knock-out) when the underlying asset price hits the barrier level.
2. Cost-Effectiveness: Barrier options are generally less expensive than standard options due to their conditional nature.
3. Types of Barrier Options:

Knock-In Options: These options only come into existence or become active if the underlying asset price hits a specific barrier level.

• Up-and-In: The option is activated when the underlying asset price rises above a certain level.
• Down-and-In: The option is activated when the underlying asset price falls below a certain level.

Knock-Out Options: These options are terminated or rendered inactive if the underlying asset price hits a specific barrier level.

• Up-and-Out: The option is deactivated when the underlying asset price rises above a certain level.
• Down-and-Out: The option is deactivated when the underlying asset price falls below a certain level.

Example:

Let’s say you purchase an Up-and-Out call option on stock ABC with a strike price of ₹50 and a barrier level of ₹60. If the stock price rises to ₹60 at any point during the option’s life, the option is deactivated and becomes worthless. If the stock price stays below ₹60 and rises above ₹50, you can exercise the option for a profit.

Benefits and Risks:

• Benefits:
  • Lower Premiums: Due to the conditional nature, barrier options often have lower premiums.
  • Tailored Strategies: They offer more strategic flexibility for specific market views or hedging needs.
• Risks:
• Complexity: The complexity of barrier options can make them harder to value and understand.
• Trigger Risk: If the barrier is hit, the option may deactivate or activate, potentially leading to unexpected outcomes.

Barrier options are highly versatile financial instruments that cater to a range of strategic needs. They are particularly useful in managing risk and implementing complex trading strategies.

6.7 Binary Options

Binary options are a type of financial derivative that allow traders to speculate on the price movement of an underlying asset. The key feature of binary options is their simplicity, as they offer two possible outcomes: a fixed payoff or nothing at all. This is why they’re also known as “all-or-nothing options” or “digital options.”

Key Features of Binary Options:

1. Fixed Payoff: The payoff is predetermined and fixed. If the option expires “in the money,” the trader receives a fixed amount. If it expires “out of the money,” the trader loses the initial investment.
2. Simplicity: Binary options are straightforward and easy to understand, making them accessible to novice traders.
3. Short-Term Expirations: They typically have short expiration times, ranging from minutes to hours, though longer expiration times are also available.
4. Wide Range of Assets: Traders can speculate on a variety of underlying assets, including stocks, commodities, currencies, and indices.

Types of Binary Options:

1. Call/Put Options: The most common type of binary options. A “call” option is bought if the trader believes the price of the underlying asset will rise, while a “put” option is bought if the trader believes the price will fall.
2. One-Touch Options: These options pay out if the price of the underlying asset touches a predetermined level at any time before expiration.
3. No-Touch Options: These options pay out if the price of the underlying asset does not touch a predetermined level before expiration.
4. Boundary Options: Also known as “range” options, these pay out if the price of the underlying asset stays within a predetermined range until expiration.

Example:

Let’s say a trader buys a binary call option on stock XYZ with a strike price of ₹100 and an expiration time of one hour. If the stock price is above ₹100 at the time of expiration, the trader receives the fixed payoff. If the stock price is below ₹100, the trader loses the initial investment.

Benefits and Risks:

Benefits:

• Simplicity: The all-or-nothing nature makes binary options easy to understand and trade.
• Short-Term Opportunities: Traders can take advantage of short-term price movements.

Risks:

• High Risk: The all-or-nothing nature means traders can lose their entire investment.
• Lack of Regulation: Binary options have been associated with fraud and scams, so it’s important to trade through regulated brokers.

Binary options can be a useful tool for traders looking to speculate on short-term price movements, but they come with significant risks. It’s essential to understand these risks and trade through reputable brokers.