What are Options? And, what should you know about Option Trading? A bit more complex terminology than stock trading, the option trading strategies can be a whole new ball game for amateur traders. Don’t worry!! We’ll discuss the intricacies of these financial derivatives one by one.
Investing is like hunting. You have to look out for the prey, strike at it at the right moment, and hope the result, the meat, is not spoiled. The only difference is there is no ethical debate of whether you should invest, but a fundamental responsibility towards your future self to invest today. The good news is, there is an avenue for every kind of investor need, equities, bonds, derivatives like options, future contracts, etc. Yes! Options are also an option. And yes, that entire introduction was to build-up that one pun. With that, let’s get into it.
What are Options? Meaning
Options are contracts giving the buyer the right, but not the obligation, to buy or sell a particular asset on or before a specified date.
Let’s clarify something. Yes, options are securities like stocks and bonds, and yes options can be traded just like stocks and bonds. But what makes options different as a security is the fact that they are dependent on the value of other securities for which the option is created, which means there is an underlying security, like shares on whose value also affects the value of the option.
Think of it this way. Options are like movie-tickets. You remember movie halls, right? Where people all used to gather, physically, to watch a movie on a giant screen, because it’s cool. I know right, getting out of the house to a gathering of people, and knowingly committing to sit beside strangers whom always seem to have a crying baby, all without wearing a mask. Wild, wild country.
Anyway, options are like movie tickets. When you buy a movie ticket, what you’re actually doing is buying a right to go the hall during the duration of the movie, before it ends. But, in no way can a movie hall authorities can force you to sit through or even attend the movie. But if you want to, you can because you have the ticket. That’s exactly what an option does.
See options are the rights to buy or sell an asset, but not the obligation. You can buy an option and choose not to exercise it, when the deadline comes, but since you have the option, you have the right to exercise it in case you wanted to. Now what does exercising an option mean? Good question. Let me explain that through explaining the types of options.
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Types of Options
There are two kinds of options, let’s discuss them in detail.
Humor me in a hypothetical. You’re a farmer. Last year, you had the best produce in your town. So now, shop-keepers know that this year the price for your produce might increase because there would be higher demand. So a shop-keeper comes to you, before you even start planting the seeds, to sell this season’s produce to only him, at rate much lower than what he expects would be, in case there is a higher demand.
You’re a smart person, and an economics student, for some reason, I don’t know, farms use economics.
You figure out why we want to do make that contract, but the price that he is offering is higher than what you sold for last year, and there is a chance that this year’s produce might not turn out great. So what you do is sell that right to him at a premium, an amount you think would offset the losses if the produce didn’t turn out as good as last year, and he wouldn’t exercise that contract.
Now what any rational shop keeper would do at that point is think in terms of cost and revenue. If the shop-keeper thinks that his profit, after deducting the cost of actually purchasing the produce and the cost of the right to buy would be high enough, he would buy that option by paying a an option premium.
And that is exactly how call options work.
A call option is basically a contract of buying. It works something like this. When you buy a call option, what you’re doing is buying the right to buy an asset, mainly shares, at a specific price before a specific date.
The issuer of the option sells the stock and the buyer of the option buys the stock.
If the holder of the option sees that the strike price,i.e. the price at which the call option can be exercised, is lower than current market price, and even after deducting the option premium, there is enough difference to make a profit, they would exercise the option.
This basically means they would use their right to buy at the strike price. The seller of the option will have to sell the shares at that strike price, even and especially when the strike price is lower than current market price, because he has a contractual obligation to do so.
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How does Call Option Trading work ?
Let’s understand it even better, consider a simple hypothetical.
You expect the price of a share XYZ ltd. to go Rs.150 at the end of the week, which is now trading at Rs.100 only. But for whatever reason, which could be liquidity or just general doubt, you don’t buy the shares. However, you buy an option worth Rs.10 to buy the share at Rs.100 at the end of the week. In this case, if the stock does go Rs.150, you can exercise the option and still get a profit of Rs.40. (Rs.150 – Cost of Shares Rs.100 – Option Premium of Rs 10).
But here’s how options benefit you. Say you were wrong, and the share goes down to Rs.50 at the end of the week. Here, if you’d bought the shares, you’d have made a loss of Rs.50. But since you bought an option, your loss is capped at Rs 10, which is the option premium and you don’t exercise the option.
Call option buyers usually expect a bullish market.
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Put option is the opposite of call option, It is the right to sell at a specified strike price. It is the right to sell an underlying asset at a specific strike price on or before a specific date. Here, the main difference is that the issuer of the option buys the stock and the buyer of the option sells the stock.
Here, you would make money if the strike price is higher than the market price, because you have the right to sell (and the issuer will have to buy) the stock at a higher rate than the market price. Of course, rationally, one would ascertain the option premium in costs.
Put option buyers generally expect a bearish market.
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How does Put Option Trading work ?
This can be either a hedge for your current stock holding, or a hedge for your short position.
Consider you hold a stock in XYZ ltd. bought at Rs.100. You expect the stock might go down to Rs.50. So you buy a put option at Rs.10 to sell the stock at Rs.100. In this case, even if the stock does fall, you have capped your loss at Rs.10, because you still recover Rs.90 (Rs.100 Strike Price of the option – Rs.10 Option Premium). This is instead of making a loss of Rs 50.
Here are a few terms that are often associated with options:
1. In the Money:
An option is ‘in the money’ basically when the exercising of the option would result in profit. For a call option, it would be when strike price is lower than spot price i.e the market price, and for a put option, it would be when the strike price if higher than the market price. This is basically because you could exercise the option and instantly make money.
2. Out of the Money:
It is when exercising the option would result in losing money. For a call option, it is when the strike price is greater than market price. For a put option, it is when strike price is less than the market price.
3. At the Money:
This means exercising the option would make no difference, because the strike price and market price are the same. However, the seller of the option makes a profit if the option is exercised because of the cost of option premium.
Option Trading: The Bottom Line
The thing is, options can be a great way to hedge your bets. If you think price of a stock might go down, but it has a fair chance of going up, you could sell a call option, providing you a cushy landing even if the stock goes down hard. But options also require multi-dimensional thinking, so be careful!
Disclaimer: There is a high degree of risk involved in stock trading and investing in any risky asset classes. The details given on this website are for informational purpose only and cannot be constituted as professional advice in any regard. Please follow due diligence while investing your money.
Now, that you know what are options and how do they work, option trading can offer a unique path to participate in the stock market with limited risk. Of course, act with extreme caution! Stock market is highly volatile, pay attention to the associated risks and then take your first steps. If you wish to gather more information on derivatives, don’t miss to explore the Types of Futures: Stock, Index, Currency and Commodity.