Options are contractual agreements that grant the holder the right, without imposing an obligation, to buy or sell a specified amount of an underlying asset at a predetermined price before or at the contract’s expiration.
These financial instruments offer diverse advantages for portfolio management, including income generation, protection, and the potential for amplified returns through leverage. Based on an investor’s objectives, options can be tailored to suit various scenarios. For instance, they serve as a valuable tool to safeguard against market downturns, effectively limiting potential losses. Initially devised for hedging purposes, options function akin to insurance policies, mitigating risks associated with investments at a reasonable cost. Similar to how you insure your valuable possessions like a house or car, options provide a safeguard to shield investments from adverse market movements.
Types of Options
- Call options: These give the buyer the right to buy a certain number of shares of a stock at a certain price by a certain date. For instance, if you acquire a call option with a strike price of ₹3,500 and the stock price rises to ₹4,000, you can choose to exercise your option and procure the shares at ₹3,500 each, subsequently selling them at ₹4,000 each. This transaction results in a profit of ₹500 per share.
- Put options: These give the buyer the right to sell a certain number of shares of a stock at a certain price by a certain date. For example, if you obtain a put option with a strike price of ₹3,500 and the stock price declines to ₹3,000, you can opt to exercise your option and sell the shares at ₹3,500 each, despite their reduced market value of ₹3,000. This results in a profit of ₹500 per share.
Important Terminology in Options
- Strike price: This is the price at which an option can be exercised.
- Expiration date: This is the date at which an option expires.
- Option premium: This is the price at which an option is purchased.
- Option Value: Option value is divided into two parts
- Intrinsic Value: This is the portion of an option’s value that is directly related to the difference between the current price of the underlying asset and the option’s strike price. For a call option, the intrinsic value is calculated as the current price of the underlying asset minus the strike price (if positive, otherwise, it’s zero). For a put option, the intrinsic value is calculated as the strike price minus the current price of the underlying asset (if positive, otherwise, it’s zero). Intrinsic value can never be negative. It represents the “real” value an option would have if it were immediately exercised. For example, if a call option has a strike price of 50 and the underlying stock is trading at 60, the intrinsic value of the call option is 10 (60 – 50). Similarly, if a put option has a strike price of 70 and the underlying stock is trading at 60, the intrinsic value of the put option is 10 (70 – 60).
- Extrinsic Value (or Time Value): Also known as time value, extrinsic value is the remaining portion of an option’s premium that is not attributed to its intrinsic value. It represents the value that the option holder is willing to pay, anticipating the possibility that the option’s price may change before expiration. Extrinsic value is affected by factors such as time until expiration, implied volatility, and interest rates. Extrinsic value can be positive or zero but never negative. For example, if an option is trading at 15 and has an intrinsic value of 10 based on the difference between the current stock price and the strike price, the remaining 5 would be the extrinsic value. This extrinsic value reflects the market’s expectations, time decay, and volatility.
- Option Buyers – Option buyers purchase options contracts, gaining the right (but not the obligation) to buy or sell the underlying asset at a specified price (strike price) within a predetermined timeframe.
- Option Sellers or Writers– Option writers sell options contracts to buyers and take on the obligation to sell or buy the underlying asset if the buyer decides to exercise the option.
Options based on Exercise Style
- American Options Exercise Style: American options allow the holder to exercise the option at any time before the expiration date. This flexibility means the option can be exercised (i.e., the right to buy or sell the underlying asset) at any point up to and including the expiration date.
- Flexibility: The key advantage of American options is their flexibility, as holders can choose the most advantageous time to exercise the option based on market conditions.
- European Options Exercise Style: European options differ in that they can only be exercised at expiration. This means the holder of a European option can only exercise their right to buy or sell the underlying asset on the expiration date itself, not before.
- Less Flexibility: Compared to American options, European options offer less flexibility since they limit the exercise to a single specific date.
The key difference between American and European options lies in the exercise style. American options provide the holder with the flexibility to exercise at any time until expiration, while European options only allow exercise at the expiration date itself.
The choice between American and European options might depend on various factors, including the specific trading strategy, market conditions, and the underlying asset being traded. American options often command a slightly higher premium due to their added flexibility compared to European options.
Option Chain
An option chain is a listing of all available options contracts for a particular underlying asset. It provides detailed information about various strike prices, expiration dates, and types of options (calls and puts) available for trading on that asset. Here are the key components of an option chain:
- Underlying Asset: This is the security (stock, index, ETF, etc.) for which the options are available.
- Expiration Dates: Option chains display a range of expiration dates available for the options contracts. Each expiration date will have a separate list of available strike prices.
- Strike Prices: For each expiration date, the option chain lists different strike prices available for both call and put options. The strike prices are the prices at which the underlying asset can be bought or sold if the option is exercised.
- Call Options: The option chain lists call options on the left-hand side, showing various strike prices and associated premiums. Call options give the holder the right to buy the underlying asset at the specified strike price before the expiration date.
- Put Options: Put options are listed on the right-hand side of the option chain, displaying various strike prices and associated premiums. Put options give the holder the right to sell the underlying asset at the specified strike price before the expiration date.
- Bid and Ask Prices: Alongside each option contract, the option chain typically displays bid and ask prices. The bid price is what buyers are willing to pay for the option, while the ask price is what sellers are asking for the option.
- Open Interest and Volume: Some option chains include information about the open interest (the total number of outstanding contracts) and trading volume for each contract. This data provides insights into market activity and liquidity.
- Implied Volatility: Option chains may also display implied volatility levels for different options. Implied volatility represents the market’s expectation of the future volatility of the underlying asset’s price.
Option chains are essential tools for traders and investors to analyze available options contracts, assess their premiums, compare different strike prices and expirations, and make informed decisions about their options trading strategies based on the market conditions and their trading objectives.
Comparative table outlining the benefits and drawbacks for options buyers (holders) and options writers (sellers)
| Aspect | Options Buyers (Holders) | Options Writers (Sellers) |
| Benefits | Potential for unlimited profit if the underlying asset moves favourably. | Receive a premium upfront, which is their maximum potential profit. |
| Limited risk – the maximum loss is the premium paid. | Time decay works in their favour. | |
| Flexibility – the right to exercise the option if profitable. | May profit from stable markets or minor price movements. | |
| Drawbacks | Pay the premium upfront, risking the entire amount paid. | Unlimited risk – potential for significant losses beyond the premium. |
| Time decay can erode the value of the option over time. | Obligation to fulfil the terms of the contract if the holder exercises. | |
| Need a substantial move in the underlying asset’s price to profit. | Limited potential profit to the premium received. | |
| Limited lifespan – options expire, potentially leading to losses. | Margin requirements in some cases can tie up capital. |
Application of Options
Options serve various purposes and are utilized by investors and traders for several reasons:
- Speculation: Traders use options to speculate on the direction of an underlying asset’s price movement without needing to own the asset itself. Buying call options can allow for bullish speculation while purchasing put options enables bearish speculation.
- Hedging: Investors use options to hedge against adverse price movements in their investment portfolios. For instance, buying put options can protect against downside risk in a stock position, acting as insurance against potential losses.
- Income Generation: Option writing, such as selling covered calls or cash-secured puts, can generate income for investors. They receive premiums upfront by selling options and may profit from the time decay of these contracts if the options expire worthless.
- Risk Management: Options are utilized to manage risk exposure. Various strategies involve combinations of buying and selling options to control risk, limit losses, and optimize potential gains.
Factor affecting options price
| Factor | Correlation with Call Price | Correlation with Put Price |
| Strike Price | Negative Correlation: The higher the strike price, the less likely the option will be in the money, lowering its value (call price goes down). Conversely, a lower strike makes it more likely to be profitable, increasing its value. | Positive Correlation: The higher the strike price, the more the option benefits from an increase in the underlying asset price (put price goes up). Conversely, a lower strike makes it less valuable with rising prices. |
| Time to Expiration (Time Value) | Positive Correlation: More time remaining gives the option more chances for the underlying asset to move towards the strike price, increasing its potential value (both call and put prices go up). | Positive Correlation: More time also allows the underlying asset to move away from the strike price, potentially making the put more valuable (the put price goes up). |
| Volatility | Positive Correlation: Higher volatility indicates larger potential price swings, making the option more valuable for both buying (call) and selling (put) as it offers greater potential profit/loss. | Positive Correlation: Similar to calls, higher volatility increases the potential for significant price movements, making the put more valuable. |
| Interest Rate | Positive but Nuanced: A higher rate reduces the present value of the future pay-out, making the call less attractive to buy but more attractive to sell (put price goes up). However, the effect can be smaller for longer-dated options. | Negative but Nuanced: A higher rate increases the present value of the option’s pay-out, making it more attractive to buy (put price goes down). However, the effect can be smaller for longer-dated options. |
| Stock Price | Positive Correlation with Intrinsic Value: A higher stock price makes the call more likely to be in the money, directly increasing its value. However, the time value may decrease if the stock rises rapidly, leaving less time for further gains. | Negative Correlation with Intrinsic Value: A higher stock price makes the put less likely to be in the money, directly decreasing its value. However, the time value may decrease if the stock falls rapidly, leaving less time for further declines. |
Payout for Option Buyers
Payout for Option Writers
The Python code for the payout is accessible within the Python code category.
