An option is a derivative, a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date (expiration date) at a specified price (strike price). There are two types of options: calls and puts. Additionally- there are two variety in which they are traded- American-style options can be exercised at any time prior to their expiration & European-style options can only be exercised on the expiration date.
Types of Options
To enter into an option contract, the buyer must pay an option premium. The two most common types of options are calls and puts:
A call option- is a type of options contract that gives the holder the right, but not the obligation to buy the asset at the agreed upon strike price before the expiration date. The call option can be bought by the investor by paying a premium upfront to the seller. The option holder therefore, makes a profit if the value of the asset rises in the future. This is because the call option allows him to buy the asset at a much lower price and then sell in the market for its current higher price.
Example- Say, you purchase a call option for a stock at a strike price of Rs 200 and the expiration date is in two months. If within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40.
A put option- is a type of options contract that gives the holder the right, but not the obligation to sell the asset at the agreed upon strike price any time before the expiration date. If the value of the asset falls in the future, the call option gives him the choices to sell the asset at the agreed upon higher price and thereby minimize his risks.
Example- Let’s assume you purchase a put option for a stock at a strike price of Rs 200 and the expiration date is in a month. If within that period, the stock price falls to Rs 180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of the stock rises above Rs 200, you still have no obligation to sell it or can still sell it at the current market price.
Terms in Options
Some of the essential terms that are often used in options trading are:
Lot Size: This refers to the standard quantity or units of the underlying asset that is included in the options contact.
Strike Prize: Also known as exercise price, this is the price of the asset at which the two parties agree to buy or sell the underlying asset, in an options contract.
Premium: This refers to the amount that the buyer pays to the seller of the asset in order to avail the benefits of the options contract. It is essentially the market price of the options contract itself.
Expiration Date: This refers to the future date by which an options contract must be exercised by the investor. Beyond the expiration date, the options contract will expire worthless.
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, and 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
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.
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
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 rights can be tough.
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.