WHAT IS AN OPTION TRADE?

 

Introduction to options trading

 

   An option trade is a type of financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset—such as stocks, commodities, or currencies—at a predetermined price, on or before a specified date. This type of financial instrument is commonly used by investors for hedging, speculation, or generating income.

 

  In essence, an option is a derivative because its value is based on the value of another asset. There are two types of options: call options and put options. Call options give the holder the right to buy the asset, while put options give the holder the right to sell the asset. In this discussion, we will explore what options are, the mechanics of option trading, the key elements of an options contract, and common strategies used in options trading.

 

1. Understanding the basic structure of an option

 

Every option contract has certain critical elements:

 

Underlying asset:  This is the financial asset on which the option is based. It can be individual stocks, indices, bonds, commodities, or even currencies.

 

Strike price:  The price at which the underlying asset can be bought or sold if the option is exercised. It is a fixed price stated in the contract.

 

Expiration date:  Options contracts have a limited lifespan. The expiration date is the last day on which the option can be exercised.

 

Premium:  The price that the buyer pays to purchase the option. This is a non-refundable payment made to the seller (writer) of the option, and it represents the cost of the opportunity or right to buy or sell the asset.

 

1.1. Call option

   A call option gives the buyer the right to purchase the underlying asset at the strike price before or on the expiration date. Investors who buy call options are generally bullish—they believe the price of the underlying asset will rise. If the price of the asset exceeds the strike price, the buyer can exercise the option and buy the asset at a lower price, potentially earning a profit.

 

1.2. Put option

 

   A put option gives the buyer the right to sell the underlying asset at the strike price. Investors buy put options when they expect the price of the asset to decline. If the market price falls below the strike price, the buyer can sell the asset at the higher strike price, profiting from the difference.

 

2. Option trading in action

 

When you trade options, you are essentially placing bets on how the price of the underlying asset will move in the future. You can either buy or sell options. Let’s break down the four primary types of option trades:

 

2.1. Buying call options

 

   This is one of the simplest and most common options strategies. When you buy a call option, you expect the price of the underlying asset to rise. If the asset’s price goes above the strike price before the option expires, the option becomes "in the money" and you can exercise the option to buy the asset at the lower price.

 

   For example, assume you buy a call option for ABC stock with a strike price of Rs.50 and an expiration date in one month. If the stock price rises to Rs.60, you can buy the stock for Rs.50 and sell it at Rs.60, pocketing the Rs.10 difference. However, if the stock price remains below Rs.50, you lose the premium you paid for the option.

 

2.2. Buying put options

 

   When you buy a put option, you anticipate that the price of the underlying asset will decline. If the asset’s price drops below the strike price before expiration, the option becomes profitable.

 

   For instance, suppose you buy a put option on XYZ stock with a strike price of Rs.100. If the stock price falls to Rs.80, you can sell the stock at the higher price of Rs.100 and repurchase it at Rs.80, making a Rs.20 profit per share. However, if the price remains above Rs.100, the option expires worthless, and you lose the premium paid.

 

2.3. Writing (Selling) call options

 

   When you sell a call option, you are obligated to sell the underlying asset at the strike price if the buyer exercises the option. Investors often use this strategy when they believe the asset price will not rise above the strike price before expiration. Writing call options can be risky because if the price of the asset increases significantly, the seller could face significant losses.

 

2.4. Writing (Selling) put options

 

   When you write a put option, you are obligated to buy the underlying asset at the strike price if the option buyer exercises it. This strategy is used when the seller expects the asset’s price to remain stable or rise above the strike price. If the asset price drops significantly, the seller may be forced to buy the asset at a higher price than its market value, leading to potential losses.

 

3. Key elements that affect option pricing

 

The value of an option is determined by several factors:

 

Intrinsic value:  This represents the difference between the current price of the underlying asset and the option’s strike price. For a call option, if the asset price is higher than the strike price, the option has intrinsic value.

 

Time value:  Options lose value as they approach their expiration date, which is known as time decay. Longer-dated options tend to have higher premiums because they provide more time for the underlying asset to move in the trader’s favor.

 

Volatility:  Higher volatility increases the chance of significant price movements, which can affect the premium of the option. More volatile assets often have more expensive options.

 

Interest Rates and Dividends: Changes in interest rates and expected dividends also influence the pricing of options.

 

4. Common options trading strategies

 

4.1. Covered call

 

   This is a strategy where the investor holds a long position in a stock and sells call options on the same stock. It allows the investor to generate income from the option premium while holding the stock.

 

4.2. Protective put

 

   A protective put is used as a risk management tool. Here, an investor buys a put option on a stock they already own, limiting downside risk if the stock’s price declines. The premium paid for the put acts as an insurance cost.

 

4.3. Straddle

 

   A straddle involves buying both a call and a put option with the same strike price and expiration date. This strategy is used when the trader expects significant volatility in the price of the underlying asset but is unsure of the direction.

 

4.4. Iron condor

 

   An iron condor involves selling an out-of-the-money call and put, while simultaneously buying a further out-of-the-money call and put. This strategy profits from low volatility when the price of the underlying asset stays within a certain range.

 

5. Advantages and risks of options trading

 

5.1. Advantages

Leverage:  Options allow traders to control larger positions in the market with less capital compared to directly buying the underlying asset.

 

Flexibility:  Options offer a variety of strategies to profit in different market conditions—whether bullish, bearish, or neutral.

 

Hedging:  Options can be used to hedge against potential losses in an existing portfolio.

 

5.2. Risks

 

Potential for losses:  While the maximum loss for an option buyer is limited to the premium paid, option writers (sellers) can face unlimited losses.

 

Complexity:  Options require a deep understanding of market dynamics, pricing factors, and risk management.

 

Conclusion

 

   Options trading provides investors with versatile financial instruments that offer the potential for both high rewards and significant risks. By understanding how options work, how they are priced, and the strategies that can be used, traders can make informed decisions. However, due to the complexities and risks involved, options trading is often considered more suitable for experienced investors. Beginners should approach with caution, ideally under the guidance of a financial advisor or through simulated trading platforms.