Option is a specific type of financial instrument that allows traders to acquire and sell an asset at a future date and at a certain price. It will not be wrong to call them a type of derivatives. What makes it different from other instruments is that it accords the holder the right to acquire or sell a security. Or, it does not make it an obligation for the holder to exercise options. If the holder does not exercise options until maturity, then it becomes worthless and automatically cancels or becomes zero.
We can say that such contracts work like insurance policies as they do not come with obligations. The underlying asset for options could be shares, commodity, currency, or bonds.
- Option Terminology
- How Option Works?
- Determinants of Option Pricing
- Types of Option
- Advantages and Disadvantages of Option
Options could be In-the-money, Out-of-the-money, or At-the-money. In-the-money (ITM) is when the holder will gain by using options. Out-of-the-money (OTM) is when the trader will incur a loss by exercising options. And, At-the-money (ATM) is when a trader will neither make a profit or a loss by exercising options.
To understand options, it is crucial that we are aware of the common terms used in the options market. Following are the terms that you need to know before you start to trade options:
The buyer of options needs to pay a certain amount to get the right to buy or sell an asset. This premium is the option premium. The holder needs to pay the premium whether or not they exercise options at the expiry. Again, it is like insurance; you need to make a premium payment to buy. And if no contingency occurs, then the insurance period is over and the premium paid is lost.
It is the rate at which the holder wants to acquire or sell the security if they exercise options. A point to note is that the strike price does not change. One must not confuse it with the market price, which changes regularly.
The contract size is the minimum quantity of the underlying asset that a trader can buy or sell using options. For instance, if a contract is for 100 shares, then to buy 500 shares, the trader will need to buy five such contracts.
It is the date when the option contract comes to an end/expires, or all the rights and obligations of the parties under that contract are over. And effectively, the financial value of that contract becomes zero or useless. So, a trader needs to exercise the option at or before the expiry. This date does not change until the period of the contract.
It is the value of the option contract that still remains even after the expiry of the contract. And it is the difference between the strike price and the market price of the security under the contract.
The settlement of the options contract is when the buyer uses the option. If the holder does not exercise the option until maturity, the option will automatically cancel, and there will not be any need for settlement.
How Option Works?
Suppose you have one stock currently, and you plan to sell it in the future at a higher price. But, the future is unpredictable, and so there are chances that the price of security will drop. This is where options come in. You can buy an option (put) to ensure that you do not incur a loss in the future.
Buying an option (put) gives you the right to sell the security at a predetermined rate. This way, you will be able to sell your security at a higher price even if the price drops in the future. And, if the price of that security rises in the future (even more than the strike rate), then you can sell the security at the spot price at the time without exercising the put option. Or allow the option contract to expire by efflux of time. This is because an option is a right, not an obligation. In this case, the trader will only lose the option premium or the cost of buying the option.
An important point to note is that the use of options depends upon in which direction a trader expects the prices of security to move. For instance, if more traders expect the price to rise, then the option representing this would be more expensive. Other factors also play a crucial role in determining the option premium (we will discuss it later).
Determinants of Option Pricing
The following factors determine the price of an option:
Value of Underlying Asset
If the price of the asset goes up, then the option premium to buy that asset also goes up. Similarly, the price of the options to sell that asset loses value if the asset price rises.
If the consensus among traders is that the price of the underlying would witness wild swings, then options would be more expensive. The more volatility, the more is the risk. This is why traders want more return or price for the riskier options.
Usually, the call options lose value as they move closer to the ex-dividend date. This is because the value of the stock may reduce by the dividend amount. The opposite is true for the put option, meaning they gain value as they near the ex-dividend date.
The strike price is the rate at which a trader wants to buy or sell the underlying asset at a future date. So, the wider the strike price is to the current price of the underlying, the more valuable the options are. Because in this situation, the option contract buyer gets the maximum benefit to buy or sell the security or asset at a much higher price than the current market price of that security.
This is simple to understand. The more time options have until the expiry, the more valuable it is. It is because the traders have to bear the risk for more time. As the expiry period comes close, the value of the contract reduces.
Usually, the call option premium increases with the rise in the interest rate. In contrast, the put option premium drops with the rise in the interest rates and vice versa.
Types of Option
Primarily, options are of two types:
This option gives the buyer the right to buy the underlying security at a specific rate in the future. The call option gives the holder the right (not obligation) to buy the security at a particular price. But, for the seller of the security, it will be an obligation to sell if the holder exercises the call option.
For example, Mr. A buys a call option for shares of Company X at a strike price of $50 and expiry one month later. Now, if at the expiry, the share price goes above $50, says $60, Mr. A will still be able to buy it at $50 using the call option.
This option gives the holder the right to sell the underlying asset at a certain price in the future. Usually, with a put option, a trader locks a minimum price at which they want to sell the security in the future. The trader will exercise the put option if the strike rate is higher than the market rate of the security at the expiration period.
For example, Mr. A buys a call option for Company X shares at a strike price of $50 and expiry one month later. If, at the expiry, Company X shares drop below $50, then also Mr. A will be able to sell his shares at $50. And, if the share price rises above $50, then Mr. A will not exercise the option but rather sell at the current market price.
Options are also classified as American and European Options.
Advantages and Disadvantages of Option
These are the advantages of options:
- It enables traders to hedge risk arising from the unfavorable movement in the prices.
- It allows traders to hedge risk and earn a profit by using certain strategies.
- Investors can get protection from adverse price movement by just paying a small premium.
- Options give a trader the flexibility to trade any price movement they want.
Following are its disadvantages:
- Options could be tricky to comprehend for some traders. So, investors may need to pay extra money to hire someone to trade option.
- Options are less liquid than other markets. So, it is possible that traders may not always get the trade they want.
- If an investor does not fully understand the risks, it could result in massive losses.
Also read – Futures vs. Options.