What are Options in Trading?
The option is a type of derivative instrument that allows its holder to buy or sell an asset at a future date and at a certain price. What makes it different from other derivative instruments is that it provides the holder the right to acquire or sell an underlying asset. There is no obligation for the holder to exercise this right. If the holder does not exercise options until maturity, then it becomes worthless and the holder’s right gets lapse.
There are two parties involved in an option transaction. One is the option holder (having the option to buy or sell). The other one is option writer (having obligation to buy or sell the option if the holder exercises his option).
- What are Options in Trading?
- Example of Options
- Options Terminology Used in Trading
- Types of Options
- How do Options Work?
- Determinants of Option Pricing
- Advantages of Options
- Disadvantages of Options
An option creates a right (not an obligation) to buy or sell a certain asset at a predetermined price, on or before a predetermined date.
Let us try to decode this with a simple example.
Example of Options
Imagine your favorite mango season is around the corner, and you can’t wait to eat them! However, due to the uncertainty of rain this season, it isn’t easy to estimate the price at which mangoes will be available this season. In case of good rainfall, they may be appropriately priced. However, a bad monsoon may jack up the prices, and you may have to wait for a whole another year before you can get the taste of it.
You go to the market wondering what to do. One of the fruit sellers senses your dilemma and calls out to you. You explain your worry to him regarding the monsoon and mango prices. He comes up with an innovative solution to your situation. He offers to sell the mangoes to you (when they arrive) at a pre-fixed price of $5 per dozen. This offer will prevail no matter what the actual prices in the markets are. You contemplate that $5 for a dozen is the fair price of mangoes, and it is a good deal. But there lies a twist to the situation. To book the price of $5, you will have to pay $1 upfront. This amount of $1 is called the option price.
Also Read: Put and Call Options
Options Terminology Used in Trading
Now, that you have understood what are options, it is also crucial that one is aware of the common terms used in the options market. Following are the terms that a trader needs to know before he starts trading in options:
The buyer of options needs to pay a certain amount to get the right to buy or sell an asset. This amount is the option premium. The holder needs to pay the premium whether or not he exercises the option. In the above example, the upfront payment of $1 to the fruit seller for buying the option to purchase mangoes is the option premium or option price.
It is the rate at which the holder wants to acquire or sell the asset if they exercise the option. A point to note is that the strike price does not change. One must not confuse it with the market price, which changes regularly. In the above situation, $5 is called the exercise price.
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 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 on or before the expiry.
It is the value of the option contract at the time of exercising the contract. It is the difference between the strike price and the market price of the security under the contract.
The settlement of the options contract takes place when the buyer exercises the option. If the holder does not exercise the option until maturity, the option will automatically expire, and there will not be any need for settlement.
The parties involved in an option contract are – the holder and the seller of the option (also known as the writer of the option). The holder is the buyer of the option and has a right to exercise it. The writer has an obligation to buy or sell the underlying asset if the holder exercises his right.
Types of Options
Primarily, options are of two types:
The call option gives the holder the right to buy (not obligation) the underlying security at a specific rate in the future. But, for the writer, it will be an obligation to sell the security 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.
The put option gives the holder the right to sell the underlying asset at a certain price 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 put 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 that in the open market.
Both put options and call options can be further classified as American and European Options. An American option can be exercised on or before the expiry date while a European option can be exercised only on the date of expiry.
How do Options Work?
Continuing with the above example, consider the following situations to understand how do options work and when does a trader exercises the option.
Out of the Money
Assume that the actual price of the mangoes is $4. Thus, the option held, in this case, is rendered worthless. (Why would you pay $5 for mangoes currently worth $4?) However, the maximum loss is capped at $1 (option price). In such a scenario, the option is said to be out of money.
At the Money
The actual price of mangoes is $5. In this situation, you end up in a break-even or indifferent position since the contract price is also $5. Here, the option is at the money.
In the Money
The actual price turns out to be $8. In this situation, exercising the option makes complete sense. You would be able to purchase the mangoes at a price point of $5 ($6 in total considering the option price) in a market where the prevailing price is $8. Therefore, you will be in a position of obvious advantage compared to the rest of the buyers. This situation is called in the money.
In-the-money (ITM) is when the holder will gain by exercising 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 nor a loss by exercising options.
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. There are various other factors that play a crucial role in determining option pricing.
Determinants of Option Pricing
This concept needs to be crystal clear before understanding an option pricing model is “factors determining the price of an option”.
- Value of Underlying Asset
- Strike Price
- Time Period
- Interest Rates
Refer to our article “What are the Factors Affecting Option Pricing? How and Why?” for a detailed explanation.
Advantages of Options
The following are the advantages of the options:
- It enables traders to hedge the risk arising from the unfavorable movement in the prices.
- It allows traders to earn a profit by using certain strategies.
- Investors can get protection from adverse price movements by just paying a small premium.
- Options give a trader the flexibility to trade any price movement they want.
Disadvantages of Options
The following are the disadvantages of the options:
- Options could be tricky to comprehend for some traders. So, investors may need to pay extra money to hire someone to trade options.
- 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.
- Call Options – Meaning, How it Works, Uses, and More
- What are the Factors Affecting Option Pricing? How and Why?
- American vs European Option – All You Need to Know
- In the Money and Out of the Money – All You Need to Know
- Types of Derivatives Instruments – All You Need to Know
- Put Options – Meaning, How it Works, Strategies, and More