Options are financial instruments whose value is derived from the value of an underlying (aka involved) asset like security or an asset. An options deal offers the buyer the opportunity to buy or sell depending on one’s view on the value of involved security. Owning a call option gives the right to buy shares on expiration at strike price and owning a put option gives right to sell at strike price at expiry.
The options when bought or sold need not necessarily be exercised at the Expiry and at strike price. They can be exercised anytime until the options expiry. So if used judiciously the options are considered less risky than stocks or futures contract. Because of this system, options are considered derivative securities – which means their price is derived from involved assets. However, options, do not represent ownership in the company.
Let’s understand with an example
Imaging Mohan has a wedding in his house after four months and wants to buy gold for the same. However, he is fearful of the fact that the gold price might go up in the future. Therefore, to protect himself from the risk of price fluctuations, he goes to a Jewelry shop, and enters into an agreement with the shop owner whereby he fixes the price for jewelry for buying four months down the line, at the current price of Gold.
But, you must be wondering as to, what is the incentive here for the Jewelry shop owner to fix the price because he is potentially taking a big price risk. If the price goes up after four months, still he’ll have to sell the jewelry at the pre-determined price. Here, his incentive is a small fee (i.e. Premium/Token) that he will be charging to Mr. Mohan for fixing the price of gold. And this fee here is non-refundable.
Say, four months down the line if the price of gold goes up then Mr. Mohan has the right to buy gold at the pre-decided price. On the other hand, if for some reason if the price of gold comes down then he does not have to exercise his right, i.e. he may choose to buy jewelry from some other shop at the discounted current price. He merely stands to lose his premium/token.
Why would an investor use options?
When an investor or trader is buying an options contract, he/she is betting on the stock price to go in his favour (up for call option and down for pit option). The price at which one agrees to buy the involved asset via the option is called the “strike price,” and the price paid for having this right is called the “options premium.”
Benefits of Options Contract
Here are a few key benefits of Options contracts:
- As the name would suggest, the Options contract gives the right to option buyer to exercise his contract if he wishes to. If the Spot price doesn’t go in favor of the buyer of the contract he does not have to exercise his right, he stands to lose just the premium.
- One time premium is the only fee that option buyer has to pay to ride the momentum of underlying price and be a part of a bigger game.
- If an option seller is of the opposite view to that of option buyer, he can just sell the option contract and pocket premium income.
- The options are less risky than equities. Say for example if a trader wants to buy 1000 shares of Reliance, then at CMP (Rs 1400 per share), one has to shed out Rs 14,00,000 (fourteen lakhs). But one can express the same view by buying 2 Call option contracts (500 shares each). Say if he buys At the Money contract of 1410 CE by paying a premium of 35 per lot. Then, his total cost would be = (500*35*2)= Rs. 35000 only. So, now If option were to expire Out of Money for option buyer, he just stands to lose premium only. But, if the share price of Reliance Industries comes down to Rs. 1300, then total loss of equity shareholders will be Rs. 1,00,000 (1000*100).
- Return on investment for an option buyer is very high because the cost paid is just the premium and the potential return is unlimited.
Call and Put Options
The Call/Put options are financial derivative instrument, meaning that their movement is dependent on the price movement of the involved asset or security. The real purpose of buying a call option is that the trader/investor is expecting the price of the involved security to move up in the near future and vice versa for the call option seller.
A Put option is bought by the trader or investor when he expects the price of an involved asset to fall in near future and vice versa for put option seller or writer. The option writer although earns premium while selling but runs the risk of giving up the involved asset in case the options goes in favor of option buyer.
Breaking down Call Options
For U.S. style options, a call option buying contract gives the buyer to buy the involved asset at strike price anytime till the expiry date of contract. In case of an European style option, the call option owner has the power to exercise only on the expiry date.
It is beneficial for the call buyer to power his right to sell his call option if the spot price moves above strike price before expiry and call option writer to bind by his promise.
The premium paid by the option buyer gives him the right to buy the involved stock or security at strike price until the expiry of options agreement. If the price of the asset moves beyond the strike price, the option will be In the money
Breaking down Put Options
Options contract duration can vary from very short term (weekly) to long term (monthly contracts). It is profitable for the put option buyer to exercise or sell his option if the spot price of the involved security comes below the strike price.
The premium paid by the put option buyer gives him the right to sell the involved stock or security at strike price until the expiry of options agreement.
The options writer receives the premium. The premium received is the way of generating income for the option writer or seller. But the put option writers income is limited to the money received as premium and runs the unlimited risk of paying up the option buyer in case the involved security going below the strike price.