The Banking Tutor’s Lessons
BTL 707 24-09-2024
Options
The term option refers to a financial instrument that is based on the value
of underlying securities, such as stocks, indexes, and exchange-traded
funds (ETFs).
Each options contract will have a specific expiration date by which the
holder must exercise their option. The stated price on an option is known
as the strike price.
Options are financial derivatives that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price and
date.
Options trading can be used for both hedging and speculation, with
strategies ranging from simple to complex.
Although there are many opportunities to profit with options, investors
should carefully weigh the risks.
These contracts involve a buyer and seller, where the buyer pays a
premium for the rights granted by the contract.
Call options allow the holder to buy the asset at a stated price within a
specific time frame.
Put options, on the other hand, allow the holder to sell the asset at a
stated price within a specific time frame.
Each call option has a bullish buyer and a bearish seller while put options
have a bearish buyer and a bullish seller.
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Traders and investors buy and sell options for several reasons. Investors
use options to hedge or reduce the risk exposure of their portfolios.
In some cases, the option holder can generate income when they buy call
options or become an options writer.
For options traders, an option's daily trading volume and open interest
are the two key numbers to watch to make the most well-informed
investment decisions.
Exercising means utilizing the right to buy or sell the underlying security.
Types of Options
Calls
A call option gives the holder the right, but not the obligation, to buy the
underlying security at the strike price on or before expiration. A call
option will therefore become more valuable as the underlying security
rises in price (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising,
since it has unlimited upside potential but the maximum loss is the
premium (price) paid for the option.
Puts
Opposite to call options, a put gives the holder the right, but not the
obligation, to instead sell the underlying stock at the strike price on or
before expiration. A long put, therefore, is a short position in the
underlying security, since the put gains value as the underlying's price
falls (they have a negative delta).
Protective puts can be purchased as a sort of insurance, providing a price
floor for investors to hedge their positions.
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American vs. European Options
American options can be exercised at any time between the date of
purchase and the expiration date. European options are different from
American options in that they can only be exercised at the end of their
lives on their expiration date.
The distinction between American and European options has nothing to
do with geography, only with early exercise. Many options on stock
indexes are of the European type. Because the right to exercise early has
some value, an American option typically carries a higher premium than
an otherwise identical European option. This is because the early exercise
feature is desirable and commands a premium.
In the U.S., most single stock options are American while index options
are European.
A vanilla option is a financial instrument that gives the holder the right,
but not the obligation, to buy or sell an underlying asset at a
predetermined price within a given timeframe. A vanilla option is a call
option or put option that has no special or unusual features.
Options contracts usually represent 100 shares of the underlying security.
The buyer pays a premium fee for each contract.
For example, if an option has a premium of 35 paise per contract, buying
one option costs Rs 35 (Rs 0.35 x 100 = Rs 35). The premium is partially
based on the strike price or the price for buying or selling the security
until the expiration date.
Another factor in the premium price is the expiration date. Just like with
that carton of milk in the refrigerator, the expiration date indicates the
day the option contract must be used.
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The underlying asset will influence the use-by date and some options will
expire daily, weekly, monthly, and even quarterly. For monthly contracts,
it is usually the third Friday.
Options Spreads
Options spreads are strategies that use various combinations of buying
and selling different options for the desired risk-return profile.
Advantages of Options
A call option buyer has the right to buy assets at a lower price than the
market when the stock's price rises
The put option buyer profits by selling stock at the strike price when the
market price is below the strike price
Option sellers receive a premium fee from the buyer for writing an option
Disadvantages of Options
The put option seller may have to buy the asset at the higher strike price
than they would normally pay if the market falls
The call option writer faces infinite risk if the stock's price rises and are
forced to buy shares at a high price
Option buyers must pay an upfront premium to the writers of the option
Example of an Option
Suppose that Microsoft (MFST) shares trade at Rs 108 per share and you
believe they will increase in value.
You decide to buy a call option to benefit from an increase in the stock's
price.
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You purchase one call option with a strike price of Rs. 115 for one month
in the future for 37 paise per contract. Your total cash outlay is Rs 37 for
the position plus fees and commissions (0.37 x 100 = Rs 37).
If the stock rises to Rs 116, your option will be worth Re 1, since you could
exercise the option to acquire the stock for Rs. 115 per share and
immediately resell it for Rs. 116 per share. The profit on the option
position would be 170.3% since you paid 37 paise and earned Re.1—
that's much higher than the 7.4% increase in the underlying stock price
from Rs. 108 to Rs. 116 at the time of expiry.
In other words, the profit in Rupee terms would be a net of 63 paise or
Rs 63 since one option contract represents 100 shares [(Re. 1 - 0.37) x 100
= Rs. 63].
If the stock fell to Rs.100, your option would expire worthlessly, and you
would be out Rs. 37 premium. The upside is that you didn't buy 100
shares at Rs. 108, which would have resulted in an Rs. 8 per share, or Rs.
800, total loss. As you can see, options can help limit your downside risk.
Risks Associated with Options:
Price Fluctuation Risk: Options are highly sensitive to changes in the price
of the underlying asset. If the asset's price moves unfavourably, the
option could expire worthless, resulting in the loss of the premium paid.
Time Decay Risk: Options have expiration dates, which means their value
declines as they get closer to expiration. If the anticipated price move
doesn't occur before the option expires, its value diminishes.
Volatility Risk: Options prices are influenced by market volatility. If the
market becomes very volatile, the value of options can change rapidly
and unpredictably, potentially leading to losses.
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Lack of Ownership Risk: Unlike stocks or bonds, owning an option doesn't
mean owning a piece of the underlying asset. This lack of ownership
limits the benefits one can gain from dividends or interest payments
associated with the asset.
Premium Loss Risk: When purchasing an option, a premium is paid
upfront. If the anticipated price move doesn't happen, the premium is
lost.
Tail Notes
Implied volatility (IV) - the volatility of the underlying (how quickly and
severely it moves), as revealed by market prices
Naked Option - A naked option is created when the option seller does
not currently own any, or enough, of the underlying security to meet
their potential obligation.
Chooser Option - A chooser option allows the holder to decide whether
it is a call or put after buying the option. It provides greater flexibility
than a vanilla option.
Stock Options - A stock option gives an investor the right, but not the
obligation, to buy or sell a stock at an agreed-upon price and date.
Intrinsic value is the difference between the strike price of the options
contract and the spot price of the security. After calculating the intrinsic
value, we can know the moneyness of an options contract.
The moneyness is classified into three categories namely, In-The-Money
(ITM), At-The-Money (ATM) and Out-of-The-Money (OTM). You have to
keep in mind that this intrinsic value will change as the spot price
fluctuates.
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The calculation for intrinsic value differs for call option contract and put
option contract.
For call option contract, Intrinsic Value is Spot Price minus Strike Price.
For put option contract, Intrinsic Value is Strike Price minus Spot Price.
The intrinsic value cannot be negative and if the intrinsic value is negative
after calculation, then we must consider the intrinsic value as zero for all
practical purposes.
ATM (At-The-Money), ITM (In-The-Money), and OTM (Out-Of-The-
Money) are different terms used in options trading. These terms describe
the relationship between - The current price of the underlying asset, and
The strike price of the option
ATM - An option is considered an ATM when the current price of the
underlying asset is equal to the strike price of the option. This situation
usually happens as there's no intrinsic value of the option.
ITM - An option is considered an ITM when the current price of the
underlying asset is favourable in comparison to the strike price of the
option. Now, this favourable situation happens differently under both
call options and put options.
For a call option, if the underlying asset price is higher than the strike
price, it is ITM.
For a put option, if the underlying asset price is lower than the strike
price, it is ITM.
ITM options have intrinsic value because they can be exercised for profit.
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OTM - An option is considered out-of-the-money when the current price
of the underlying asset is unfavourable in comparison to the strike price
of the option. This unfavourable situation happens differently for both
call options and put options.
For a call option, if the price of the underlying asset is less than the strike
price, it is OTM.
For a put option, if the underlying asset price is higher than the strike
price, it is OTM.
Sekhar Pariti
+91 9440641014
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