Options are a type of financial instrument whose value is derived from the value of another asset: the underlying, such as a stock, index, crude oil, bond, natural gas, ETF, commodities, futures, currencies, and other assets.
Traders choose options as a financial instrument for trading because it requires less capital to trade with potential of high return. With a smaller amount of money traders have control over a large asset.
What are the components of an option?
As said earlier, Options are financial instruments whose value is derived from the value of another asset.
An option contract gives the owner (buyer) the right, but not the obligation, to buy or sell the underlying asset at a fixed price on or before a predetermined date.
You have four components to the option contract;
- The right, not the obligation
- To buy or sell an asset
- At a fixed price, known as strike price
- On or before a predetermined date, known as expiration date
We will be discussing these components in detail. Let us first understand exercise styles and types of options.
Also read: What is the future market and how does it work?
Exercise style: American style vs European style
Option contract can be either American style or European style. We don’t have much difference between the two.
In European style, the option contract does not allow the buyer (owner) to exercise the option before the expiry date. Which means they can only be exercised at expiration and not beforehand.
The American style option allows the buyer (owner) to exercise the option at any time before the expiry date.
In simpler words, options that can be exercised at any point on or before the expiry date are American style. Options that can be exercised only on the day of expiration are European style.
If in a definition of call or put option, you find that the contract can be exercised before a specific date, then its American style. If it’s written as expiry is on a specific date, then its European style.
In India, we follow the European style. You will find letters “CE” and “PE” in option contracts. CE means “Call European style” and PE means “Put European style”.
In the US, they follow American styles. These option contracts can be exercised at any time before the expiration date.
We have two types of options: call and put.
You can buy or sell either type based on your strategy.
What is a Call option?
In a call option, the owner (buyer) has the right, not the obligation, to buy an asset at a predetermined price before a specific date.
When someone buys the call option, they are not obliged to buy the underlying asset. They only have the right to do so at a price and on a date mentioned in the contract. Risk of buying a call option is limited only to the price paid for it, known as premium. Reward of a call option is unlimited based on how the price of the underlying asset moves.
When you buy a call, there is someone on the other side of the trade. The seller of a call option is known as an “option writer”. The maximum loss for a call writer is unlimited and profit is limited to the call premium received.
The seller of the call option obliges to deliver the underlying asset to the option buyer.
Call option own value only when the price of underlying asset is more than the strike price. Which means the price of the asset minus the strike price is the value of the call option.
If you buy a call, you have the right to buy the underlying asset at the strike price on the expiry date. In case of an American style option, you can exercise your right on or before the expiration date.
When to buy a call option?
You buy a call option when you think the price of the underlying asset will be higher than the strike price.
For instance, if you are thinking that the stock of XYZ will move from 100 to 120, then you buy a call option in order to benefit from the price move of the underlying asset instead of buying its stock. Same thing applies to index options.
If your expectation is correct, you will receive a positive return.
Purchasing a call means you are bullish on the underlying asset.
Call writing
We have two types of call writing: naked and covered.
When you write a covered call, it means you own the stock. For instance, suppose you have purchased 1200 shares of XYZ stock at Rs 100 per share. You write a 110 call on the XYZ stock, and receive a 8 rupees premium for each share covered by this contract.
If the price does not go up and the call option expires unexercised, you keep the premium as profit. Writing a covered call is preferred by many investors to receive additional income from stocks they already own.
In naked calls, you are writing naked call options on stocks that you don’t own. Naked call is more risky compared to a covered call.
In both the cases, if the market moves in your favour you will receive a premium as profit. But in case, if it goes against you and the call option is exercised, then you will not be in a position to sell the stock in naked calls, whereas in covered calls you can sell those shares as you already own it.
When you sell or write a call option, you are obligated to sell the underlying asset at the strike price, if you are assigned.
What is a Put option?
Put option is the exact opposite of a call option.
In a put option, the owner (buyer) has the right, not the obligation, to sell an asset at a predetermined price before a specific date. Which means the buyer is not obligated but they have the right to sell the underlying asset.
The risk of the buyer is limited to the premium paid while buying a put option. However, the reward potential is unlimited based on how the underlying asset price moves.
For every put option you buy, you have a seller on the other side of the trade. Sellers have a different risk profile than a buyer.
A seller of the put option has an obligation to buy the underlying asset from the buyer at a fixed price on the date of expiry. In case of american style, the put option can be exercised before the expiration date.
If you buy a put, you have the right to sell the underlying asset at the strike price on expiry date. In case of an american style, you can exercise your right on or before expiration.
Both call and put options can be sold by the option holder to another buyer during its term or to let it expire worthless.
Buying put
Buying puts can help you to profit in a bear market.
If traders think that the market or underlying asset will decline, they buy puts. As the value of underlying asset decreases in a decline market, the put premium increases,
The other way to make money in a declining market is by selling the stock short through a margin account.
If you buy shares of the underlying stock at the time of purchasing put, it’s referred to as married put. Instead of purchasing stocks now, if you are already holding equity for some time, then purchasing a put for the same stock is referred to as a protective put.
Put writing
Traders with a bullish or neutral view on the underlying asset can sell a put option on the asset. They will be paid a premium.
If the price of the underlying asset does not drop below the strike price, the put option will most likely expire unexercised. In this case, the premium received will be the profit for the put writer.
In put, the writer is obligated to buy the underlying asset, if assigned.
Suppose you think that stock of XYZ limited will not drop below 400 rupees for a few days until expiry. You write XYZ put with a strike price of 380 rupees or for any amount below 400.
A writer can purchase an offsetting contract to end an obligation to meet the terms of the contract.
What is the option premium?
As a buyer, when you buy a call or put option, the purchase price paid is called the premium. When someone sells, the premium is the amount they receive.
Premium is paid to the writer to gain the right.
In exchange, the premium is not fixed. Both call and put option premium changes constantly depending on what buyers are willing to pay and what sellers are willing to accept for the option. Price is the point at which both agree.
You must subtract the cost of the premium from money you realised to find out net profit before brokerage and other charges.
Option premium has two parts: time value and intrinsic value.
Premium = intrinsic value + time value
Intrinsic value is the amount by which the option is in-the-money.
Time value is the difference between whatever the intrinsic value is and what the premium is.
Time value depends on the time until expiration.
Contracts that are at-the-money or out-of-the-money have no intrinsic value. The entire premium of an out-of-the-money or at-the-money option as its time value as its intrinsic value is zero.
Option buyers pay the premium, while option sellers receive the premium.
In-At-Out-of-the-Money
In the money (ITM), at the money (ATM), and out of the money (OTM) are terms that options traders use to express where the option strike price is in relation to the price of the underlying assets.
What is ITM, OTM and ATM in call option?
When the underlying asset’s current market price is greater than the strike price, the call is in-the-money (ITM).
A call option will be out of the money (OTM) when the underlying asset’s current market value is less than the strike price.
When the underlying asset value is equal to the strike price, the call option will be considered as at the money (ATM).
What is ITM, OTM and ATM in Put option?
Put option is the exact opposite of the call option.
A put option value is strike price minus price of the underlying asset.
A put option will be In-the-money (ITM), when the underlying asset’s current market price is less than the strike price.
In an out of the money (OTM) put option, the underlying asset’s current market price will be greater than the strike price.
If the underlying asset price is equal to the strike price, then the put option is considered as at the money (ATM).
| ITM/ATM/OTM | Call option | Put Option |
| In the money (ITM) | strike price less than price of underlying asset | strike price greater than the underlying asset’s price |
| At the money (ATM) | strike price same as price of underlying asset | strike price same as the price of underlying assets. |
| Out of the money (OTM) | strike price greater than the price of the underlying asset. | strike price less than the price of the underlying asset. |
What is the strike or exercise price?
Strike price is a price at which the contract may be exercised. Strike or exercise price is a predetermined fixed price at which option can be exercised.
In an equity option, if you have bought a call option with an exercise or strike price of Rs 600, then you have the right to buy the stock at a price of Rs 600 on the date of expiry.
If the option is an american style, then you have the right to exercise the option before the expiry date.
What is the expiration date?
Every option has an expiration date. Expiration date is a date when an option expires or it no longer has any value or no longer exists.
In european style, options can be exercised on a specific date mentioned in the contract.
Whereas, in american style, options can be exercised before the specific date mentioned in the contract.
The date mentioned in the contract before or on which the option can be exercised is known as expiration date.
Equity options generally have monthly expiry. Index options have both monthly and weekly expiry.
Let us understand What is the meaning of “right, not the obligation”?
Buyer obligation in option contract
Buying an option (call or put) gives the right, not the obligation, to buy (call) or sell (put) an underlying asset.
Underlying assets can be shares, index, commodities like crude oil, silver, natural gas, agricultural products and gold.
When you buy an option contract, you have the right but not the obligation to buy or sell the underlying asset. Which means, you have the right to exercise your option contract at the predetermined price.
The risk that you take to buy an option contract is the price you paid for it, known as premium.
While buying an option contract, the owner (buyer) pays the seller a payment called the option premium. It’s also known as the value of the option.
Seller obligation in option contract
As a seller of option contract (call or put), you are obliged to buy from (in case of put) or deliver (in case of call) to the option buyer if he or she exercises the option.
| Type of option | Right and obligation of Buyer | Right and obligation of Seller |
| Call option | Call buyer has the right, not the obligation to buy underlying asset from call seller. | Call seller obliged to sell the underlying asset to call buyer if he/she exercised his/her rights. |
| Put option | Put buyer has the right but not the obligation to sell the underlying asset to put seller. | Put seller is obliged to buy the underlying asset from the put buyer if he/she has exercised his/her rights. |
Where option contracts are traded?
Option transactions occur through the exchange on which an option has been listed. The major option exchanges in India are followings;
- National stock exchange (NSE)
- BSE (formerly Bombay stock Exchange)
- Multi Commodity Exchange of India Limited (MCX)
Equity, currency and index options are traded in both NSE and BSE. Commodity related options are traded in Multi Commodity Exchange of India Limited (MCX).
In the US, we have bigger exchanges such as New York Stock Exchange (NYSE), Chicago Mercantile Exchange and American Stock Exchange (AMEX) where option contracts are traded.
In the US market, both European and American style options are traded. All equity options are American style.
What factors can impact option premium?
Here are the factors that affect an option’s premium:
- Underlying asset price,
- Strike price,
- Expiry date,
- Volatility of the underlying asset, and
- Interest rate.
What is Delta, Gamma, Theta, Vega and Rho in option?
Delta, Gamma, Theta, Vega and Rho is known as option Greek
Sensitivity to the change in option price relative to change in underlying asset price is measured by Delta. Which means its the rate of change of the option price compared with the price movement of the underlying asset price.
Delta = rate of change in option price / rate of change in underlying asset price
A positive delta means when the underlying asset’s price rises, the option will be more valuable. Negative Delta means the option value will increase as the underlying asset’s value decreases.
As a thumb rule, ATM call options have deltas of 0.5. Which means for every one point move in the price of underlying asset, the call will move at approximately 0.50
Change in option delta relative to change in underlying asset price is known as Gamma.
Theta measures the sensitivity to change in option price relative to change in time left for expiration.
Change in option price relative to the change in the underlying asset’s volatility is measured by Vega.
Sensitivity of option price to risk free interest rate is measured by Rho.
Why are options considered as wasting assets?
The value of the option diminishes as the expiration date approaches, which is known as time decay. After the expiration date, they have no value. For this reason, options are considered as wasting assets.
In stocks, if you have unrealised loss, you can hold onto it over the long term. As long as the company exists, you have chances of regaining value. Whereas, in options, after expiration date, it will not have any value even if the underlying asset moves in your favour after expiry.
Another biggest problem with options is the direction of the underlying asset within the time limit. If prie of the underlying asset moves against your anticipated direction, then you will not have much time to wait for the underlying assets to come back. Once the option is out-of-the-money, it becomes worthless. As a holder of the out of the money option, you will lose the entire premium paid.
Key Takeaways
- Options are traded on all types of securities such as stocks, commodities, bonds, ETFs, currencies and crude oil, through multiple exchanges around the world.
- Call and Put options contracts give traders more leverage than buying the underlying asset on its own.
- Option pricing depends on many factors such as performance of the underlying asset, implied volatility, strike price, time period, interest rates, dividends and terms of the contract.
- Option trading can be very risky no matter which strategy you use. Traders require extensive knowledge and expertise to begin trading these financial instruments.
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
