HOW DO OPTIONS WORK?

 

How Do Options Work?

 

    Options are one of the most versatile and complex financial instruments available in the markets today. They provide investors and traders with unique opportunities for profit, hedging, and leveraging market positions. Understanding how options work is crucial for both novice and experienced market participants because, while options offer considerable profit potential, they can also be risky if not fully understood.

 

   In this comprehensive guide, we will break down how options work, the key concepts involved, types of options, and various strategies used by investors to manage risk and generate returns.

 

What are Options?

 

   Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset (such as stocks, commodities, or indexes) at a specific price (called the strike price) on or before a particular expiration date. The underlying asset can vary, but in most cases, options are used on stocks. Options are classified as derivatives because their value is derived from the value of an underlying asset.

 

   Unlike stocks, where you own a share of a company, owning an option does not give you ownership of the underlying asset. Instead, it gives you the right to decide whether to buy or sell that asset at a specified price before the expiration date.

 

Key Concepts in Options Trading

 

Understanding some basic terminologies is crucial to grasp how options work:

 

Strike price:  The agreed price at which the option buyer can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.

 

Expiration date:  The date on which the option contract expires. After this date, the option ceases to exist and becomes worthless.

 

Premium:  The price paid by the buyer to acquire the option. This is the amount the option seller (or writer) receives in exchange for taking on the obligation to fulfill the contract.

 

Call Option:  A call option gives the buyer the right to buy an underlying asset at the strike price before the expiration date.

 

Put Option:  A put option gives the buyer the right to sell an underlying asset at the strike price before the expiration date.

 

Exercise:  The act of the buyer of the option choosing to buy (call) or sell (put) the underlying asset at the strike price.

 

In the money (ITM):  An option that has intrinsic value. For a call, the underlying asset price is higher than the strike price. For a put, the underlying asset price is lower than the strike price.

 

Out of the money (OTM):  An option that has no intrinsic value. A call is OTM when the underlying asset's price is below the strike price, and a put is OTM when the underlying asset's price is above the strike price.

 

Types of Options: Call and Put

 

There are two main types of options:  call options and put options.

 

Call options

 

    A call option gives the buyer the right to purchase the underlying asset at a predetermined strike price before or on the expiration date. Investors typically buy call options when they believe the price of the underlying asset will rise in the future. If the market price of the asset exceeds the strike price, the call option can be exercised for a profit.

 

   For example, suppose a stock is currently trading at Rs.50, and an investor buys a call option with a strike price of Rs.55 and an expiration date one month away. If the stock price rises to Rs.60 before expiration, the investor can exercise the option to buy the stock at Rs.55, even though the stock is now worth Rs.60, realizing a Rs.5 profit per share (ignoring the premium paid).

 

Put options

 

   A put option gives the buyer the right to sell the underlying asset at a predetermined strike price before the expiration date. Investors buy put options when they believe the price of the underlying asset will fall in the future. If the price drops below the strike price, the put option can be exercised for a profit.

 

   For example, if an investor buys a put option on a stock with a strike price of Rs.50 and the stock price falls to Rs.40, they can sell the stock at the Rs.50 strike price, even though it is worth only Rs.40 in the market, realizing a profit of Rs.10 per share (ignoring the premium paid).

 

Pricing of options

 

    The price of an option, called the premium, is determined by various factors, including the current price of the underlying asset, the strike price, the time remaining until expiration, volatility, and interest rates. Option premiums consist of two parts: intrinsic value and time value.

 

Intrinsic value:  The amount by which the option is in the money. If an option is out of the money, the intrinsic value is zero. For example, if a call option has a strike price of Rs.50 and the stock is trading at Rs.60, the intrinsic value is Rs.10.

 

Time value:  The portion of the premium that reflects the amount of time left until the option expires. As the expiration date approaches, the time value decreases, a phenomenon known as time decay. The more time remaining, the higher the time value because there's a greater chance for the underlying asset's price to move favorably.

 

   Volatility also plays a significant role in option pricing. The more volatile an asset, the higher the premium will be, as the potential for price movement increases.

 

Option Strategies

 

Options can be used in a variety of strategies, depending on an investor’s goals and market expectations. Below are some common strategies:

 

1. Covered call

 

   A covered call strategy involves holding a long position in an asset (such as a stock) and simultaneously selling a call option on the same asset. The investor collects the premium from selling the option, which generates income but limits potential upside gains if the stock rises above the strike price. This strategy is often used when the investor expects little to moderate movement in the asset's price and is willing to sell the asset if it rises above the strike price.

 

2. Protective put

 

   A protective put strategy involves buying a put option on an asset that the investor already owns. This acts as insurance against a decline in the asset's price. If the asset price falls below the strike price, the investor can sell the asset at the higher strike price, thus limiting their loss.

 

3. Straddle

 

   A straddle involves buying both a call option and a put option with the same strike price and expiration date on the same underlying asset. This strategy profits from large price movements in either direction. It’s typically used when the investor expects significant volatility but is unsure whether the price will rise or fall.

 

4. Iron condor

 

   An iron condor is an advanced strategy that involves selling one out-of-the-money call option, buying a further out-of-the-money call option, selling one out-of-the-money put option, and buying a further out-of-the-money put option. This strategy is used when the investor expects low volatility and wants to profit from the price staying within a certain range.

 

Risks of options

 

   While options offer significant profit potential, they also carry substantial risks, especially for beginners or those unfamiliar with the intricacies of options trading.

 

Limited time frame:  Options have expiration dates, which means they have a limited lifespan. If the anticipated price movement does not occur before expiration, the option can expire worthless, resulting in the loss of the premium.

 

Leverage:  Options allow for leverage, which can magnify both gains and losses. While it’s possible to make large profits with small investments, the reverse is also true, and losses can add up quickly.

 

Complexity:  Options can be more complex than other financial instruments like stocks or bonds. Understanding how factors like volatility, time decay, and the Greeks (Delta, Gamma, Theta, and Vega) influence options pricing is crucial for successful options trading.

 

Conclusion

 

   Options are highly flexible financial instruments that can be used for various purposes, including speculation, income generation, and risk management. They offer the potential for significant returns but also carry risks that must be understood before entering the market. Whether used for hedging an existing position or speculating on future price movements, options give traders and investors a powerful set of tools to navigate the markets. However, due to their complexity, options require careful consideration, education, and experience to use effectively.