Options are financial instruments that give the buyer/holder the right but not the obligation to buy or sell an underlying asset (such as stocks, commodities, and currencies) at a fixed price over a specific period of time. Options are a category of derivative instruments (instruments that derive their value from an underlying asset). Other categories of derivatives include forwards, futures and swaps.
Options are of two types – Call option and Put option. A Call option is an option contract that allows the holder to buy an underlying asset at an agreed-upon price over a specific time frame while the Put option is an option to sell an underlying asset.
The fixed price at which the underlying asset can be bought or sold under the options contract is called the exercise or strike price. Also, an option can be a European option or an American option. A European option can be exercised only on the expiration day while the American option can be exercised any day through the exercise day.
About options trading
Individuals can trade options in over-the-counter markets or through exchange-traded contracts.
Over-the-counter options
OTC options are not traded on an exchange and are transacted directly between the buyer and seller. The terms of an OTC option are not standardized and are generally defined by the two parties involved. OTC options are preferred by many investors for the flexibility involved in terms of deciding the strike price and expiration date. However, the absence of an exchange or clearinghouse makes these trades risky.
Exchange-traded options
An exchange-traded option is a standardized contract to buy or sell the underlying asset and is listed on exchanges such as the Chicago Board Options Exchange or CBOE. The exchange establishes the terms of the options contracts, including the expiration dates, exercise prices, and the delivery and settlement procedures. In the US, a single option contract on stock covers 100 shares.
Exchange-traded options are regulated by the SEC (Securities and Exchange Commission). They are also guaranteed by clearinghouses such as the Options Clearing Corporation, thus making exchange-listed options effectively free of credit risk.
Basic trades
Long Call
In a long call, the buyer of the option gets the right to buy the underlying instrument from the seller (writer of the option) at the strike price on or before the exercise date. The investor buys a long call option on the expectation that the market price of the underlying asset will rise above the strike price before the option expires.
For example, let us consider a call option (in the US one option represents 100 shares) on stock XYZ at a strike price of $50. The option is priced at $2 (it’s the premium that the option buyer pays to the seller) with an expiration period of one month. If the price of the stock rises to $65 then the buyer can exercise his option to buy the shares at $50. If the price of the stock falls below the strike price then the buyer would not exercise his option.
In a long call option, the profit potential is unlimited as the price of the underlying asset increases, and the maximum risk is limited to the premium paid for the option.
Long Put
A long put gives the option holder the right to sell a security at a fixed strike price within a specific time frame. It is a bearish strategy as the buyer of the option believes that the stock would fall and intends to exercise the option when it does.
For example, Consider the buyer has a put option on stock XYZ with a strike price of $50 at an option premium of $2. When the stock price falls to $40, the option holder can exercise this option to sell his shares at $50. However, if the stock price rises beyond the strike price then he will not exercise his option and the premium paid for the option ($2*100 shares =$200) is his loss in this case.
Therefore, in the case of a long put option, the potential loss is limited to the premium paid for the put while the potential profit increases as the price of the underlying stock decreases.
Short Call
A short call option is a bearish trading strategy that involves selling a call option on a stock that the trader believes will decline. Under this strategy, the option seller (writer) has the obligation to sell the underlying stock at the strike price to the call option buyer if the call is exercised.
For example, a trader writes a short call option on stock A at a strike price of $100 for a price (option premium) of $10. If the option is not exercised by the buyer and expires, then the short call writer realizes a profit of $1000 (the premium on 1 option (or 100 shares) = $10*100), which is the maximum profit under this strategy.
However, if the stock price rises to $125 and the buyer decides to exercise the option, then the short call option writer will be obligated to sell 100 shares at $100. So in the case of an uncovered short call (which implies that the trader writes the call option without owning the underlying security), the net loss for the option writer will be (($125-$100)*100 shares)-option premium = $1500. The potential loss increases with the increase in the price of the underlying stock.
The short call option is risky as it involves limited reward (premium) but unlimited exposure/risk as to the price of the underlying asset rises.
Short Put
A short put option trading strategy involves selling a put option on a stock that the option writer believes will rise (or stay flat). Under this strategy, the option writer has the obligation to buy shares at the strike price if the option buyer decides to exercise the option.
The potential profit in a short put strategy is limited to the premium but the potential loss is substantial and increases as the stock price of the underlying asset decreases.
For example, a trader sells a put option on stock A at a strike price of $100 for an option premium of $10. If the put option is not exercised by the buyer and the option expires, the short put writer realizes a profit of $1000 (the premium on 1 option (100 shares) = $10*100), which is the maximum profit under this strategy.
However, if the option buyer decides to exercise the option when the stock price falls to $70 then the option writer will be obligated to buy shares at $100. So, the loss to the option writer in case of an uncovered short put option will be (($100-$70)*100)-option premium = $2000. The potential loss increases with the decrease in the price of the underlying stock.
What influences price of the options?
There are many variables that impact the price (or premium) of the option including the price of the underlying asset, exercise price, interest rates, implied volatility, and time to expiration. Implied volatility reflects the expected volatility in the underlying stock’s or asset’s price over the life of the option contract. Options with higher levels of implied volatility have a higher premium. Option traders keep an eye on any major events that could impact the implied volatility like news on mergers and acquisitions, key product launches, and earnings announcements.
What are the pros and cons of options trading?
Options have the potential to generate high returns and are also used to hedge against potential losses with a relatively lower cash outlay. Options provide a lot of flexibility for investors as there are a wide variety of option strategies that can be traded on different types of underlying instruments like stocks, bonds, stock indices, and commodities.
However, options trading can be complex and requires a good understanding of certain financial concepts. Also, high risk, lower liquidity, and higher commissions are some other disadvantages associated with options.