What are Options and How it Works?

Options, in the derivative market, are a type of financial instrument that helps to purchase high-valued underlying assets at a comparatively lower price, potentially generating considerable profits. The underlying assets refer to stocks, indexes, exchange-traded funds (ETFs), or commodities. The options are contracts bought and sold by the ‘buyer’ based on the type of contract, i.e., the underlying asset. These contracts have a particular expiration date within which the holder of the contract must exercise their option. In options trading, the buyer is called the ‘holder’ of the contract. The mentioned price of an option is termed the strike price or the exercise price. The options are usually bought and sold via retail or online brokers. In addition to this, options contracts are not obligated to exercise the contract, unlike other derivative products (forwards or futures).

Geeky Takeaways:

• Definition: Options are a type of derivative contract that provides the ‘holder’ the right to buy or sell, but not the obligation, an underlying asset or a financial instrument at an agreed-upon exercise price on or before a specified date based on the type of option (index, stock, commodities or ETFs).
• History: Initially, options were used for olive harvest speculation in ancient Greece. Current options (used for investment) were first published in the Chicago Exchange. Later in 1973, the European Options Exchange was formed in Amsterdam.
• Types: Basically, there are two types – call and put options, which form the basis for a broad range of option strategies developed for generating income, hedging, or speculating.
• Benefit: Options have multiple opportunities to earn profit, but by carefully weighing their risks. It is a complicated derivative product that provides multiple advantages compared to stocks or ETFs.

How does Options Work?

1. Option is another form of derivative instrument where investors are allowed to speculate or hedge against the uncertainty of an underlying asset. It is an interesting investment technique for advanced investors.

2. One type of option trading is the Call option that allows holders to profit if the price of the underlying asset increases. On the other hand, another type of option is the Put option where the holder earns a profit only if the price of the underlying asset decreases. The call option is the right to hold a stock, while the put option is the right to sell the stock.

3. Investors can short an option, i.e., to sell the option to other investors. By shorting (i.e. selling) a call option, profit is earned only if the underlying asset value declines. Whereas by shorting a put option, if the underlying asset price increases, profit is earned.

4. The options contract has an expiry date, a pre-determined price at which the contract is exercised (strike price), a holder (buyer) of the contract, and a seller of the contract. Apart from these, a premium amount is attached along with the contract. The investors hedge these contracts and generate income using these premiums.

Features of an Option Contract

The features of an options contract are listed below:

1. Holder (Buyer) of an Option: To enter the contract, a premium price needs to be paid initially. If the value of the asset increases, the call option holder earns a profit. While if the value decreases, the maximum loss will be only the premium amount (loss is limited). In the case of a put option, if the price decreases, the holder earns profit while limiting the loss if the price increases, i.e., only the premium amount is lost.

2. Writer (Seller) of an Option: In this case, the seller receives the premium amount at the beginning of the contract to limit the risk. If the price of the value decreases, call option writers benefit while facing an unlimited loss if the price increases. Along similar lines, the put option writers benefit if the price of the asset increases and would incur losses if the price declines.

3. Strike (or Exercise) Price: Both the holder and the writer agree to a pre-determined price, at which the option contract will be exercised only if the price of the underlying asset moves in the anticipated direction.

4. Expiration Date: The option contract mentions a specified date (expiration date) within which the option should be exercised. The holder of the contract must exercise on or before this pre-determined date. Beyond this date, the option contract becomes invalid.

5. Contract Size (Lot Size): These contracts are usually standardized in terms of the lot size which mentions the quantity of the underlying asset under a single contract. For instance, an option contract might address 100 shares as the underlying asset.

6. Premium Price: A premium amount is paid at the beginning of the contract by the holder of an option. This is done to provide the right to execute the trading of the contract. Usually, this premium amount is subtracted from the overall payoff amount before disbursement to the investor.

6. Hedging: Options can be used for hedging against uncertainty where these contracts as insurance to cover potential losses in the underlying assets.

How Options are Priced?

The options are priced based on a ‘premium’ amount. This ‘premium’ amount is calculated based on intrinsic and time value. Intrinsic value depicts the difference between the strike price and the spot price (the current price of the underlying asset). Whereas time value depicts factors such as time remaining until expiration, interest rates, and market volatility calculated in addition to the intrinsic value. Time value is also termed as the Extrinsic value of the option contract.

Types of Options

Primarily two types of options are available in the derivatives market:

1. Call Option

In a Call option contract, the holder (buyer) has the right to buy the underlying asset at a pre-determined agreed-upon price, known as the strike price (exercise price). The holder needs to exercise the option contract on or before the expiration date mentioned in the contract. Investors exercise the call option if they anticipate that the price of the underlying asset will increase in the future. Hence, the option will be valid if the investor can buy the asset at the strike price which is lower than the market price of the asset at the date of exercising the agreement. On the other hand, if the market price (spot price) falls below the strike price, the contract is not exercised and it becomes invalid. In addition to this, call options can be either short (sell) or long (buy) depending on the investor’s agreement.

2. Put Option

In the Put option, the holder has the right to sell the underlying asset, but no obligation, on or before the expiration date at the pre-specified strike price. A put contract allows investors to anticipate a decline in the future price of the underlying asset. It allows them to sell the asset at a higher price than the market price.

Apart from the above two, based on the expiration date, two forms of options are designed. American Option and European Option. In the American option, the holder can exercise the option at any time before the expiration date. While the European Option can only be exercised at the time of expiry. Early exercise is not possible in the European option before the specified date. Hence, the American option has a greater advantage as investors can look for strategic opportunities based on the market price movements between the date of purchase and the date of expiry. Nonetheless, most of the stock index options are designed under the European type because the early exercise option (American option) carries a larger premium than the later type (European option).

Options Risk Metrics

Some Greek terms are used by the options market to describe the different forms of risk associated with the options based on their position, size, and types. The Greek symbols are used to describe the risk and hence, the risk metrics of options are termed the “Greeks”. A few of these Greek letters are mentioned below:

1. Delta (Δ)

• The delta represents the sensitivity in the price of the option, i.e., the rate of change of the option’s price with respect to the underlying asset’s price change.
• For the call option, the delta ranges between 0 and 1, whereas, for the put option, the delta ranges between 0 and -1.
• For option traders, a delta-neutral position is created by representing a hedge ratio using the delta.
• A typical feature of the delta is the probability of the option getting expired in-the-money (ITM).

2. Theta (Θ)

• Theta is the rate of change of the price of the option with respect to time. Also known as the time sensitivity or option’s time decay. Theta represents the amount of price decrease with a decrease in expiration time, ceteris paribus.
• Theta declines when options are in-the-money (ITM) and out-of-the-money (OTM), while increases when options are at-the-money (ATM).
• Long calls and puts have negative theta. Whereas short calls and puts have positive theta. Hence, an instrument that does not get affected by time, has a 0 theta (eg.: stock).

3. Gamma (Γ)

• Gamma represents the rate of change of the option’s delta with respect to the price of the underlying asset. Hence, known as second-order or second-derivative price sensitivity.
• Gamma is used to measure the stability of the delta. Higher gamma indicates delta changes drastically concerning the price of the underlying asset.
• Higher Gamma means options are ATM while lower Gamma means options are ITM and OTM. The value accelerates when the expiration date approaches.

4. Vega (V)

• The rate of change of option’s value with respect to the volatility of the underlying asset is the Vega. It is the option’s sensitivity to volatility.
• A rise in volatility simultaneously increase the price of the option. On the other hand, decline in volatility, increases the value of the option.
• Vega is maximum for ATM as they have longer expiration time.

4. Rho (ρ)

• Rho is the rate of change of option’s value with respect to interest rate. in other terms, sensitivity to interest rate.
• Rho is highest for ATM options as longer expiration times.

Advantages of Options

The advantages of options can be listed as:

1. Provide Insurance: Option contracts are used by investors for protecting themselves against uncertainty in the price movements by providing the benefit during favorable price movements. This can also be termed as hedging against the risk of market fluctuations.

2. Lower Capital Requirement: A minimal premium is required to pay for entering the options contract while enjoying the benefits of the stock price. Unlike stock transactions, investors can take any position in the options market by paying a small amount. Therefore, options are said to have high leverage.

3. Reward/Risk Ratio: In option strategies, the investors are liable to unlimited profits and limited loss. The flexibility nature of the options market helps investors to take any position with the underlying asset.

Disadvantages of Options

On the other hand, the disadvantages of the options are as follows:

1. Time Delay: In options contract, the time value decreases as the expiration date approaches. The options market is sensitive to time as the investors have to accurately predict the time and price movements to benefit from the position.

2. Complicated: The delicate and complex nature of this investment requires a good understanding of the options market. Investors need to predict both the time and price movements at the same time which requires a good analytical understanding in the options market.

3. Reduced Liquidity: Very few investors invest in the options market, thus the availability is less when required. Often it might happen buying an option at a higher premium and selling at a lower rate compared to other liquid investment opportunites.

How do Options Differ from Futures?

In the derivative market, three forms of investment takes place: Forwards, Futures and Options. Both Futures and Options are traded in the exchanges. Their values are obtained from an underlying asset or security. In Options, contracts grant to the right to exercise but not obligated to exercise the option unlike in Futures, investors have to exercise the contract irrespective of whether they want to or not.

How to Use Options in Trading?

There are two ways through which options can be used in trading:

1. Holding the Options till Expiry: An investor can hold on the Option position till expiry and depending on the favourable conditions of the investors, the options can be exercised or make it invalid.

2. Trade the Option: Before the expiry date, the holder can sell its option to other investors to gain profit as price of the option might increase in the market compared to the time the holder bought it.

For making profit in the derivative market, one have to predict the time and price accordingly for reaping the benefits from it.

FAQs

1. Why are Options Used?

Answer:

Options are used to avoid risks and gain profits by either holding (buying) an in-the-money (ITM) option till expiry or by shorting (selling) the option at a higher price. Options can be used to hedge the position, speculate the market and arbitrage the position.

2. List some common strategies for using Option contracts.

Answer:

A variety of strategies are used in Options contracts. Some of them are:

• Covered Call: Sell the call option while long the underlying asset to generate profit.
• Protective Put: Long a put option to hedge against the potential losses in the current position.
• Straddle: Simultaneourlsy buying a call option and a put option with the same strike price and expiry date in order to gain from the price fluctuations.

3. What is ATM, ITM and OTM?

Answer:

• ATM (at-the-money): It is an option whose strike price is same as that of the underlying asset price. ATM options have a delta of 0.50.
• ITM (in-the-money): It is an option with an intrinsic value, and a delta which is greater than 0.50. For a call, the strike price of an ITM option will be below the spot price of the underlying asset; for a put, above the market price.
• OTM (out-of-the-money): It is an option with only the extrinsic value or the time value, having a delta of less than 0.50. For a call, the strike price of an OTM option will be above the spot price of the underlying asset. While, for put option, the strike price will be below the market price.

4. Are Options better than Stocks?

Answer:

Both Options and Stocks are better, based on the context, for example the market trends, investor’s risk profile, etc. For example, if one wants to avoid high risk and have a longer investment horizon than 1 or 3 months, then it is better to invest in stocks than to trade Options.