Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T10:56:34+05:30

Introduction

The Indian financial market includes numerous asset classes such as stocks, bonds, commodities, and more. However, derivatives are one of the most widely utilised asset classes by investors. Within derivatives, options are financial instruments that give a buyer the right but not the obligation to sell an underlying asset at a predetermined price in the future. 

Options contracts derive their value based on the underlying asset, which can be any tradable instrument such as stocks, bonds, commodities etc. Options differ from futures contracts as the former does not bind the investors and traders to exercise the contract. Hence, in an options contract, the holder does not need to buy or sell the underlying asset if the price direction is not favourable.

All options in the stock market have a specific expiry date by which the holder can exercise the contract. If the contract is not exercised on or before the expiration date, the buyer does not pay anything but the premium amount. 

How do Options Work?

Options in the stock market create a financial contract between the buyer and seller to purchase or sell the underlying asset at a predetermined date in the future. Every options contract comes with an underlying asset attached that influences the price of the options contract. 

The underlying assets can be stocks, bonds, currencies, commodities or another category that give the investor the right to buy or sell a specific quantity at a predetermined price. However, they are not obligated to exercise the options contract and can decide against it if they feel they will incur a loss based on the price direction of the underlying asset. 

To better understand what are options and options definition, here are some of the basic terms associated with options in the stock market: 

  • Strike Price: Also known as the exercise price, this is the amount at which the buyers and sellers agree to execute the options contract on a future date. It constitutes the set price of the underlying asset and selling price if the options contract is exercised before the expiration date. 
  • Expiration Date: The expiration date for an options contract is the future date by which the buyers can exercise the right to buy the underlying asset. If the buyers do not exercise the options contract by the expiration date, the contract expires worthless. 
  • Premium: This is the amount the buyers of an options contract must pay to the sellers for the right to exercise the contract on or before the expiration date. Every options contract is quoted with the premium amount, which is essentially the market price of the contract. In case the buyers do not exercise the contract, they have to pay the premium amount to the sellers. 
  • Spot Price: It is the current price of the underlying asset at any given time in the stock market. This is the price that the buyers analyse to calculate their potential profit and loss amount. The spot price of the underlying asset directly affects the buyers' decision for the contract. 

Investors can enter an options contract to ensure they get the underlying asset at a specific price in the future. Even if the spot price of the underlying asset decreases, the buyers can exercise the contract to buy the underlying asset at the predetermined price to make profits. 
 

Features of an Options Contract

Investors and traders who want to buy securities such as stocks can buy stocks from the secondary market directly. However, as the stock market is volatile and the prices fluctuate, they may incur a loss if the stock price decreases after the purchase. 

Hence, they buy options in the stock market to purchase or sell stocks or any other underlying asset at a predetermined price without any obligation to exercise the contract. Here are some of the features that make options an ideal financial instrument: 

  • No Obligation - An options contract is a financial instrument that gives the buyers the right but not the obligation to exercise the contract. It means that the investor does not have to pay and buy the underlying asset if they don’t want to but can hold the contract and wait for a preferable price direction. They can exercise the contract on or before the expiration date or let the contract expire worthless. 
  • Settlement - Unlike buying securities such as stocks from the secondary market where the trade is settled immediately, options contracts do not result in buying, selling or exchanging the underlying assets when entering the contract. It is only settled if the holder exercises the right to buy the underlying assets on or before the expiration date. 
  • Contract Size - Every options contract comes with a contract size (lot size) which is the volume of the underlying assets attached to the contract. For example, options in the stock market may have a lot size of 100 shares of a company. If a buyer enters the contract with the same lot size, they will buy those shares if the contract is exercised. 
  • Implied Volatility - Implied volatility (IV) refers to a market term to calculate the change in the price of a given security. In options contracts, investors use implied volatility to assume the future price movement of the underlying asset, which also affects the price of the contract. 

Types of Options

Options contracts are of two types: Call Options and Put Options. Investors choose the appropriate type depending on their assumption of the price direction of the underlying asset. Here is a detailed understanding of both types of options: 

Call Option:

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 buy a call option when they feel that the price of the underlying asset 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. 

Put Option:

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 attached underlying asset will decrease from the current levels before or on the expiry date. Here, they use a long put, which is a short position in the underlying shares, to benefit from the share price decrease. 
 

Understanding how options are priced

In the financial market, two factors affect the pricing of an options contract: the intrinsic value and the time value. 

An options contract's intrinsic value is essentially its current value in the derivatives market. The intrinsic value of the options contract defines how much the options contract is “in-the-money” (when the underlying asset’s price is higher than the options contract’s strike price). For example, if you have a call option with a strike price of Rs 300 on a share that is currently trading at Rs 500 in the equity market, the intrinsic value of the options contract will be Rs 200 (500-300). 

The time value of an options contract is the extra money the buyer is willing to pay over the intrinsic value for the additional time an options contract has until the expiration date. Time value suggests that an options contract has more potential to be “in-the-money” or reach the preferred price for the buyer if it has more time until the expiration date. 

Applications of Options

Generally, investors and traders utilise options contracts to hedge against potential losses or risks in their current investments. For example, if you own 500 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
Traders or investors can use an options contract to hedge against their current investments, especially in the stock market. When you trade in an options contract, you set a predetermined price for the underlying asset. 

This exercise price ensures 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 and traders buy put options to ensure they limit their losses in the actual stock investment. 

Production Hedging
Manufacturers and producers of the underlying asset such as commodities also use derivative contracts like options to protect themselves against risk exposure. The main reason behind entering into an options contract 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. 

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 coming future. When buying call options, the total risk is limited to the premium amount as 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
Options contracts are also useful in a bearish market when they feel the price of the underlying asset can fall in the coming future. In such a case, investors and traders 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. 

Options Risk Metrics

In essence, options in the stock market are considered more complex than other types of financial instruments. Within the literature on options, successful options investors and traders deeply analyse Options Greeks. 

Options greeks are financial measures included in the risk metrics of an options contract and are based on mathematical formulas aimed at calculating the sensitivity of an options contract's price. For example, if you hold an options contract and want to decide if you should exercise it, you can look at options greeks to calculate the risks and predict if the underlying asset price will fall or rise. 

Delta: Delta risk metric calculates the change in the price of the options contract to a unit change in the underlying asset’s price. For example, if the delta of an options contract is 0.7, it shows that for each unit of increase or decrease in the attached underlying asset, the price of the contract will also increase or decrease by 0.7 points. 

Gamma: Gamma as an options risk metric calculates the change in the underlying asset for the contract’s delta value. For example, if the gamma value for an options contract is 0.05, it means that the delta value will change by 0.05 points in the case of the underlying asset changes by 1 point. 

Vega: Vega helps calculate the price change of the options contract per unit change in the market volatility. Vega is directly related to the values of implied volatility; the higher it is, the higher the options price. 

Theta: Theta measures the rate of an options contract at which it loses the time value as the expiration date nears. For example, if the theta value is -2 with everything else remaining constant, the contract’s price will decline by 3 points on a particular day. 

Rho: Rho is a risk metric that calculates the change in the price of the options contract for a unit change in the interest rate. For example, if the rho of an options contract is -5, it indicates that for each unit increase in the interest rate, the option price will decrease by 3 points. 

Advantages of Options

  • Low Entry Cost 

Investors and traders prefer options because of their low cost of entry. When compared to other asset classes such as equities, where the buyers have to pay the whole transaction amount upfront, options buyers only have to pay the contract amount if they exercise the contract. They can also immediately sell the underlying assets to make profits. 

  • Hedging

One of the best advantages of buying options is their ability to protect against any potential losses in other asset classes. Investors and buyers can enter into an options contract with the same underlying asset they have purchased directly to ensure they can mitigate their losses if the direct investment does not follow the preferred price direction. 

  • Flexibility

Options in the stock market are considered to be one of the most flexible financial instruments as they allow investors and traders to make profits based on any potential movement in the underlying security’s price. If investors feel that the underlying security’s price will rise, they can buy a call option to make profits. However, if they feel the underlying security’s price will fall, they can make profits by buying a put option. 

  • Upside Potential 

Investors and traders utilise options in the stock market as they come with unlimited upside potential. For example, if buyers believe that the price of the shares of a company will increase in the coming future, which are currently Rs 150, they can buy a call option with a lot size of 100 at a strike price of Rs 150. If the shares increase in price above Rs 150, the buyers make a profit. However, the profit potential is unlimited as long as the share price keeps increasing. 

  • Limited Loss 

One more advantage of options is their ability to limit the loss potential in certain types of options. For example, suppose buyers buy an options contract thinking that the underlying security’s price will increase, but it falls further from the strike price, the buyers are not obligated to exercise the contract. Hence, their loss becomes limited to the premium amount at which they entered the contract. 

Example of an Option

Options in the stock market are better understood with real market examples, which the buyers or sellers can apply to execute options trading. However, as options are of two types and differ in their aim and working, it is important to understand both of them through an example. 

Call Options

Suppose, there’s a call option for 500 shares of ABC company with the strike price of Rs 50. The buyer pays Rs 100 as a premium for the options contract, which gives the buyer the right to buy 500 shares of ABC company at Rs 50 until the expiration date. However, at the time of the expiration date, the shares of ABC company are trading at Rs 80. 

Since the price is higher, the buyer exercises the call option and immediately sells the shares in the market at Rs 80. With this transaction, the buyer had to pay Rs 25,000 to buy 500 shares and sold the shares to make Rs 40,000. After subtracting the Rs 100 premium amount, the net profit of the buyer, excluding transaction costs, came to Rs 14,900. If the price had come down, the buyer wouldn’t have exercised the contract and would have only the premium amount of Rs 100. 

Put Options 

A put options contract for 300 shares is trading at a strike price of Rs 30. The buyer pays Rs 100 as a premium for the options contract, which gives the buyer the right to sell 300 shares of ABC company at Rs 30 until the expiration date. However, at the time of the expiration date, the shares of ABC company are trading at Rs 10. 

Since the price of the shares has fallen as per the prediction of the buyer, they exercised the put option and immediately sold the shares in the market at the predetermined price of Rs 30. Thus, by selling the shares at Rs 30 and not 10, the buyer cut the loss by Rs 20 per share, making a profit of Rs Rs 5,900 (9,000-3,000-100). 
 

FAQs:

Q:1: What are the four types of options?
Ans: You can trade the two types of options in four ways; buying a call option, selling a call option, buying a put option and selling a put option. 

Q.2: Are options good for beginners? 
Ans: Yes, options trading is good for beginners, especially for hedging purposes. However, it is important to gain prior knowledge of options trading before holding a position. 

Q.3: How do I learn Options?
Ans: You can learn options by reading 5paisa blogs on options trading or watching 5paisa videos to understand how to trade options. 

Q.4: How do options work?
Ans: Options work by creating a financial agreement between two parties where the buyer has the right but not the obligation to buy the underlying asset at a predetermined price on a future date. 
 

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