Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T10:59:11+05:30

What are the different types of Options?

Investors consistently seek ways to diversify their portfolios and hedge against potential losses in other asset classes. One of the most widely used financial instruments in this regard is Options. An Options contract is a financial instrument that gives buyers the right but not the obligation to buy the underlying assets at a predetermined price on a future date. 

As these underlying assets can be any tradable instrument such as stocks, bonds, ETFs, commodities etc., options contracts are ideal to diversify and make profits. Two types of options provide various advantages: Call Options and Put Options. 

Call Options

A call option is a type of options contract that gives the contract holder the right but not the obligation to buy the attached underlying asset at the strike price before or on the expiry date. Investors and traders buy a call option in stocks when they feel that the price of the underlying shares will increase before the expiry date. In such cases, investors use a long call option to profit from the increase in the price of the shares. 

For example, if you think that the price of XYZ stock will reach Rs 500 from the current Rs 300 within a month, you can buy an options contract at the strike price of 300. If the stock price reaches INR 500 before the specified date, you make a profit. But, if the stock price does not reach the intended level, you lose the money paid to buy the options contract, called the premium. 

In general, there are two types of call options: 

Long Call Option: In a long call option, the buyer has the right but not the obligation to purchase the underlying asset at a predetermined price on a future date. 

Short Call Option: In a short call option, the seller promises the buyer of the call option to sell the underlying asset at a predetermined price on a future date. 
 

Put Options

A put option is a type of options contract that gives the contract holder the right but not the obligation to sell the attached underlying asset at the strike price before or on the expiry date. Investors enter put options when they feel that the price of the underlying asset will decrease from the current levels before or on the expiry date. 

For example, if you think that the price of XYZ stock will reach INR 300 from INR 500 within a month, you can buy a put option contract at the strike price of 300. If the stock price reaches INR 300 before the specified date, you make a profit. If the price goes higher than 300, then you make a loss. 

There are two types of put options: 

Long Put Option: In a long put option, the buyer has the right but not the obligation to purchase the underlying asset at a predetermined price on a future date believing that the underlying asset’s price will decrease. 

Short Call Option: In a short call option, the seller promises the buyer of the put option to sell the underlying asset at a predetermined price on a future date, thinking that the underlying asset’s price will increase. 
 

Payoffs for Options: Calls and Puts

The payoffs for a call and put option varies as the main aim of buying and selling the different type of options differs. Here are the payoffs for a call and a put option: 

Call Option

When a call option is created, it is quoted with the premium amount. When buyers buy option contracts, they are liable to pay the premium amount upfront to the writer of the call option contract. This premium amount is the constant charge the buyer pays to the seller for writing the call option and providing the right but not the obligation to purchase the underlying asset at a predetermined price on a future date. 

Once the buyer pays the premium to the seller of the call option, the wait time starts for the underlying asset to increase in price beyond the strike price of the call options contract. If the underlying asset’s price increases beyond the strike price on or before the expiry date, the buyers can exercise the right to buy the underlying asset and make a profit. Here, the profit potential is unlimited for the buyer as long as the underlying asset’s price keeps increasing beyond the call option's strike price. 

However, if the underlying asset enters a bearish trend and decreases in price beyond the strike price of the call option on or before the expiration date, the buyer may lose money by exercising the contract. Hence, it is ideal for the buyers not to exercise the call option contract to limit the losses. In such a case, when the buyer decides against exercising the call option, the highest payoff is to the seller which equals the premium amount.

Put Option

Similar to call options, put options are also quoted with the premium amount. When buyers purchase a put option, they have the right to sell the underlying asset at the strike price of the put option. Here too, the buyers are liable to pay the premium amount upfront to the writer of the put option contract. The buyer of the put option is always of the view that the underlying asset’s price will decrease in the future and go below the put option's strike price. 
If the spot price of the put option goes below the strike price, the put option is called ‘in-the-money’. However, it is ‘out-of-the-money’ for the put option’s seller as they wish to have the underlying asset’s price go higher than the strike price of the put option. Here, the profit potential is unlimited for the buyer as long as the underlying asset’s price keeps decreasing beyond the put option's strike price. 

However, if the underlying asset’s price increases over the strike price of the contract, it is not exercised by the buyer of the put option as it will result in losses. In such a case, the loss potential is limited to the premium amount which is paid to the seller. If the buyer exercises the put option, the loss for the seller is unlimited.
 

Applications of Options: Calls and Puts

Generally, investors and traders utilise options contracts to hedge against potential losses or risks in their current investments. For example, if you own 1000 shares of a listed company, you can buy or sell options with the shares as the underlying asset to hedge against the losses in the direct investment. However, investors or traders can also use an options contract for the following applications: 

Investment Hedging 
When you trade in an options contract, you set a predetermined price for the underlying asset. This exercise price can ensure that you get the underlying asset at a price that can square off your losses in the direct equity investment in case the share price falls. Investors buy put options for such a situation to ensure they limit their losses in the actual stock investment, typically around earning calls, dividend announcements etc. 

Production Hedging
The main reason behind entering different types of options trades is to ensure they get a predetermined price for their produced assets without incurring any losses if the price of the underlying asset goes down in the coming future. Such hedging sees manufacturers and producers creating an options contract to set a price for their produce and exercising it if the price of the underlying asset goes beyond the strike price. 

Bullish Speculation 
Investors buy a call option or sell a put option in a bullish market when they believe that the price of the underlying asset will rise in the future. When buying call options, the total risk is limited to the premium amount as the buyer has to pay if the contract is not exercised, while the profit potential is unlimited. However, for the sellers, the potential profit is limited to the premium amount paid by the buyers, while the loss potential is unlimited. 

Bearish Speculation 
Investors can also use types of options contracts in a bearish market when they feel the price of the underlying asset will fall in the future. In such a case, they can either sell a call option or purchase a put option. If the price of the underlying asset falls, the buyer of the put option makes a profit equal to the difference between the decline in the market price of the underlying asset and its strike price. If the price doesn’t fall, the loss potential is limited to the option premium. 

Types of Options Based on Underlying Security 

Since investors can buy both types of options with different underlying assets, the options contracts can take different forms. Here are the types of options based on underlying securities: 

Stock Options: They have shares of a listed company as their underlying asset. Stock options are one of the most common and widely used options. 

Index Options: Index options are types of options that have a stock market index such as NIFTY50, Sensex etc., as their underlying asset. These index options mirror the performance of the securities that are included in the specific indices. 

Currency Options: These types of options allow the holders the right but not the obligation to buy or sell specific currency pairs at a predetermined price on a future date.

Futures Options: They have futures contracts as their underlying asset and allow the holders to exercise the futures contract. Investors use these types of options to hedge against their investments in futures contracts. 

Commodity Options: This type of options includes physical commodities such as metals, agriculture products etc., as the underlying assets. Furthermore, such options can also have commodity futures contracts as the underlying asset. These options contracts allow investors to buy or sell specific quantities of commodities at a predetermined price on a future date.

Types of options based on Expiration Cycle

Options contracts may have different expiration dates. If the buyers do not exercise the options contract by this date, the contract expires worthless. Hence, it is vital to buy or sell options contracts with an ideal expiration date as it directly affects the time value of the contracts along with how they are priced. 

Here are the types of options based on their expiration cycle to let you understand the time horizon for the options contracts: 

Regular Options: These are one of the most widely invested options contracts that have standard expiration dates. Investors can choose among four different expiration dates, which stretch from one to several months. Regular options allow investors the flexibility to choose various expiration dates based on their goals, preferences and chosen options trading strategy. 

Weekly Options: Weekly options come with the shortest expiration date among all other options contracts and are also known as weeklies. Such contracts have an expiration date of one week and have to be exercised within that week, or else they become worthless. Furthermore, these options work similarly to regular options by providing the right but not the obligation to the holders to buy or sell the underlying asset. 

Quarterly Options: These options allow the holders the right but not the obligation to buy or sell the underlying asset with an expiration date of the nearest quarter. Such options contracts are also called quarterlies and allow the investors and traders to enter into options contracts during the four quarters of the year. However, the expiration dates are set and reduced depending on the nearing quarter ending date.

Long-Term Options: Long-term options are types of options that allow the holders the right but not the obligation to buy or sell the underlying asset with an expiration date of up to one to three years. Investors and traders who have a long-term horizon for their options investment choose such types of options trades. Such contracts are more expensive than other options as they have a greater time value. 

FAQs:

Q.1: What are the different types of options contracts?
Ans: Options contracts are of two types; Call options and Put options. However, they can differ based on their underlying assets and expiration date. 

Q.2: What is a put and call option?
Ans: A put option allows the holders the right but not the obligation to buy or sell the underlying asset with an expiration date of the nearest quarter. A call option allows the contract holder the right but not the obligation to buy the attached underlying asset at the strike price before or on the expiry date.

Q.3: How do the call and put options work?
Ans: Call and put options work on the principle of premium, where the buyers have to pay the premium to the seller to get the right to exercise the contract on or before the expiration date. If they exercise the right, they have to buy the underlying assets; if not, they have to pay the premium amount, which is the buyer’s maximum loss. 

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