Options are financial derivative instruments that derive their value from the underlying assets. The underlying assets can be stocks, bonds, commodities, etc. Since underlying asset value fluctuates continuously, option prices also keep changing.
What are Options?
Options are financial instruments that give the buyer or the seller the right but not the obligation to buy or sell the underlying asset at a specified price and date. The key feature of options instruments includes the premium, contract size, strike price, intrinsic value, and expiration date of the option.
- Premium: The premium for options is the amount the buyer needs to pay to have the right to exercise options. The premium equals the sum of the option’s intrinsic value and time value.
- Strike price: The strike price, also known as the exercise price, is the predefined price at which the trader can buy or sell underlying assets when exercising options.
- Contract size: The deliverable quantity of underlying assets in an options contract is known as contract size.
- Intrinsic value: The intrinsic value of an option is the difference between the strike price and the underlying security’s current price.
- Expiration date: It is the last date on which the option contract for that particular series expires. The series can be weekly or monthly. The option expires if not exercised by this date.
Types of Options
Following are the types:
- Call Option: A call is an option that gives the buyer the right but not the obligation to buy the underlying asset at a specified price on or before the expiration.
- Put Option: A put option is an option that gives the buyer the right but not the obligation to sell the underlying asset at a specified price on or before expiration.
Options can be American or European. All exchange-traded options traded on the stock exchanges in India are European. American options generally trade over the counter in India.
How Do Options Work?
Here is an example showing how options work.
For instance, by paying the premium, Pranav purchased a long call option for 200 shares of XYZ Limited at ₹120 per share with an expiration date of November 30. It gives him the right to purchase 200 shares of XYZ Limited at ₹120 per share on expiry, irrespective of the actual price. On November 30, if shares are trading at ₹130 per share, Pranav can buy them at ₹120 per share and make profits.
On November 30, if shares are trading at ₹100 per share, Pranav can opt not to exercise the option as the shares are available at a lower price. In this case, Pranav’s loss would be the premium he paid while buying options.
How are Options Priced?
The price of the option to be paid by the buyer is also known as the premium of the option traded. The option premium comprises the sum of the intrinsic value and time value. The intrinsic value of an option can be calculated either by the binomial tree model or the Black Scholes Merton model.
The extrinsic value or the time value of the option is the value of the premium that is above the intrinsic value. The time value of an options contract is the additional money a buyer is willing to pay above the intrinsic value. This would be for the additional time an options contract has until the expiration date. At expiration, the time value of the option is only its intrinsic value as the theta decay makes the time value of the same option go to zero. Time value essentially means that the option possibly has the potential to be “in-the-money” or rather reach the preferred price for the buyer if it is given more time until the expiration date.
Use Cases of Options
Two of the most important uses of options are hedging and speculation.
- Hedging: Traders and investors can hedge their position in any stock or the portfolio as a whole by using several options strategies. By employing hedging strategies, a trader can reduce the risk of the portfolio.
- Speculation: Traders may attempt to predict the price movements and use options for gaining. They may buy calls or sell puts if they expect the underlying assets’ price to rise. They may sell calls or buy puts if they expect the underlying assets’ price to fall.
Advantages and Disadvantages of Options
- There is immense potential in the instruments to deliver extremely high returns.
- The maximum loss of an option buyer is limited to the premium paid.
- The cost efficiency of these instruments may increase since they provide high leverage and use lesser capital.
- Due to its nature of high leverage, options can also magnify the losses. If not careful, these instruments can wipe off entire portfolios.
- Using it as a speculative instrument can be a two-edged sword. High taxes and commissions for speculation can eat into any profits.
- An option writer faces unlimited price risk, whereas an option buyer has the risk of time decay. Time works against the buyer in these instruments.
Risk Metrics in Options
There are a few standard risk metrics used to measure the riskiness of an option. It can either be measured in absolute terms or relative terms. A few of the risk metrics are as follows.
- Delta: Delta represents the rate of change in the option’s value due to a change in the underlying security. Call options have positive delta ranges between 0 and 1, whereas put options have negative delta ranges between -1 and 0.
- Theta: Theta calculates the price change of an option as a result of a reduction of one day into its expiry. In other words, theta indicates the theoretical reduction in the option’s price when the expiry is near.
- Gamma: Gamma measures the rate of change in an option’s delta with a unit change in the underlying asset’s price. It indicates how much the delta should change as a result of an increase or decrease in the underlying asset’s price.
- Vega: Vega represents the changes in options price as a result of an increase or decrease in volatility.
- Rho: Rho represents the changes in options price as a result of an increase or decrease in interest rates.
Frequently Asked Questions
Premium: It is the amount the buyer needs to pay to have the right to exercise options. The premium is the sum of the intrinsic value and time value.
Strike price: The strike price, also known as the exercise price, is the predefined price at which the trader can buy or sell underlying assets when exercising options.
Lot size: Refers to the total number of contracts in one derivative.
Expiration date: The last date on which the option contract for that particular series expires. The series can be weekly or monthly.
There is no definitive answer to this question. One may start trading with as little as INR 5,000 by buying naked options. However, a higher sum enables the execution of multiple hedging strategies in a portfolio.
Theoretically, the answer to this question is yes. But in the actual world, the odds are stacked against you. Unless strategies are executed with absolute precision and with a strict risk management framework, options can be quite risky.
The answer to this question is an absolute NO. Options are extremely complicated instruments, and it takes years to master the art of executing option contracts.
Options give the right but have no obligation for the buyer to purchase a contract at a particular date. A futures contract gives the buyer the right and also the obligation to fulfil the terms of the contract at a future date.