An option is a derivative that gives the owner the right to buy or sell securities at an agreed upon price within a certain period of time. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer. There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
There’s three other components that determine the price (premium) of the option. First, is implied volatility. If traders think the price of the underlying asset will swing wildly, therefore be more volatile, it will drive the option price higher. Second, is dividends. If they are paid by the underlying stock, it will drive the options price up slightly. Third, is interest-rates. Here again, if they are high it will drive the options price up a bit because bonds are competing with options for the investment.
Two Major Types of Options
Hedge funds and other traders use options to buy and sell stock or commodities without ever actually owning any.
- Call Option : The ‘Call Option’ gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. Call options are abbreviated as ‘C’ in online quotes.
Example: A call option might be thought of as a deposit for a future purpose. For example, a land developer may want the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws are put into place. The developer can buy a call option from the landowner to buy the lot at say $250,000 at any point in the next 3 years. Of course, the landowner will not grant such an option for free, the developer needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the premium, and is the price of the options contract. In this example, the premium might be $6,000 that the developer pays the landowner. Two years have passed, and now the zoning has been approved; the developer exercises his option and buys the land for $250,000 – even though the market value of that plot has doubled. In an alternative scenario, the zoning approval doesn’t come through until year 4, one year past the expiration of this option. Now the developer must pay market price. In either case, the landowner keeps the $6,000.
- Put Potion : The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls. Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes.
Example : A put option might be thought of as an insurance policy. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more than 10% of its value. If the NSE is currently trading at 2500, he can purchase a put option giving him the right to sell the index at 2250 at any point in the next two years. If in six months time the market crashes by 20%, 500 points in his portfolio, he has made 250 points by being able to sell the index at 2250 when it is trading at 2000 – a combined loss of just 10%. In fact, even if the market drops to zero, he will still only lose 10% given his put option. Again, purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that period the premium is lost.
- Current Price : The current price is the actual selling price of a security trading on an exchange, as well as the most recent price of a security listed in an investment portfolio. The current price, also known as the market value, is the price at which goods are currently being sold in the market. Similar to market price, which is the price determined by buyers and sellers in an open market, the current price of a security is the price at which a security last traded.
- Option Premium: An option premium is the income received by an investor who sells or “writes” an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire. Investors who write calls or puts use option premiums as a source of current income in line with a broader investment strategy to hedge all or a portion of a portfolio. The main factors affecting an option’s price are the underlying security’s price, moneyness, useful life of the option and implied volatility.
- Expiration Date: A future date on or before which the options contract can be executed.
- Lot Size: Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded. E.g. options contracts for Reliance Industries have a lot size of 250 shares per contract.
- Open Interest: It refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.
Example: If trader A buys 100 Nifty options from trader B where, both traders A and B are entering the market for the first time, the open interest would be 100 futures or two contract. The next day, Trader A sells her contract to Trader C. This does not change the open interest, as a reduction in A’s open position is offset by an increase in C’s open position for this particular asset. Now, if trader A buys 100 more Nifty Futures from another trader D, the open interest in the Nifty Futures contract would become 200 futures or 4 contracts.
- In-the-money: You will profit by exercising the option. A Call Option is ‘In-the-money’ when the spot price of the asset is higher than the strike price. Conversely, a Put Option is ‘In-the-money’ when the spot price of the asset is lower than the strike price.
- Out-of-the-money: You will make no money by exercising the option. It is used to describe a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset i.e. revrese of ‘In the money’.
- At-the-money: A no-profit, no-loss scenario if you choose to exercise the option. It is a situation where an option’s strike price is identical to the price of the underlying security. Both call and put options are simultaneously at the money. For example, if XYZ stock is trading at 75, then the XYZ 75 call option is at the money and so is the XYZ 75 put option.
- Intrinsic Value : It is the difference between the cash market spot price and the strike price of an option. It can either be positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). An asset cannot have negative Intrinsic Value.
- Time Value: It basically puts a premium on the time left to exercise an options contract. This means if the time left between the current date and the expiration date of Contract A is longer than that of Contract B, Contract A has higher Time Value.