Home Beginner Market Structure Fundamentals Of Options & Its Components That You Should Know

Fundamentals Of Options & Its Components That You Should Know

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Introduction

In spite of the awareness and popularity, there are many myths that exist with respect to options in the market. Options are created for the purpose of hedging and protecting one’s portfolio.

But it is true that options are riskier investments than stocks. The risk can be way higher if misused. They need to be considered similar to stock investments. The protection offered by options is such that, if the price of the stock is worth zero, they gave us some reward with suitable positions in stock options. This will be explained in this article in detail. Along with that, other relevant topics with regard to options like the process of buying an option, when to allow them to expire and how to exercise them will be discussed in this article.

What is an Option?

An option is a legally bound contract between a buyer and a seller.

The option contract gives the buyer the right to purchase and sell the stock at a specific price called the strike price. Every strike price needs to be exercised on or before a specific date known as the expiration date.

The contract gives the seller an obligation to sell or buy the stock at a specific price (strike price) once the buyer exercises his or her option.

The option buyer can exercise his option anytime before the expiration. In this case, the option seller must obey the terms of the contract and close his position to the option buyer.

Types of Options

There are two widely used options in the market

  1. Call Option
  2. Put Option

-> The call option gives the buyer the right to buy the stock at a fixed price within a period of time. The call option seller, also known as, the ‘writer of the option’ is obligated to sell the stock at a fixed price within the specified time frame.

-> The put option gives the buyer the right to sell the stock at a fixed price within a period of time. The put option seller is obligated to buy the stock at a fixed price within the specified time frame.

How are the Options bought?

We are familiar with stock purchases which are bought on a per-share basis but options are different. They are bought in the form of contracts. The contract size varies from country to country. For example in the U.S., 1 option contract is equal to 100 shares of stock.

Why use Options?

There are a number of reasons why we should use options as trading instruments. Below are some of the main advantages of options.

  • More leverage
  • Reduced risk
  • Have a position in a stock without physically owning it
  • Generate more interest in the same investment

Options give us significant returns on a small investment and little movement in the underlying stock.

Instruments in Options trading

There are four major ways of creating and maintaining positions in options.

  • Long Call
  • Short Call
  • Long Put
  • Short Put

Long Call 

When we buy a call option we open a long position in the call. A call is purchased when we expect the price of the underlying stock to rise. It gives us the right to buy the stock at a fixed price within a set time frame. We have the following three choices when we go long in call option.

  1. Sell the option at a profit
  2. Exercise the option at a loss
  3. Let the option expire

You need to keep in mind that you can let the option expire worthlessly rather than lose all of your investments. But most probably you would have bought the call option since you are bullish on the stock. If the stock moves in your favour, you have to resell the option to capture the profit.

Short Call 

A call can also be sold to open a short position. The call is sold expecting the stock to decrease in value. Since we are giving someone the right to buy the stock from us before the expiration, we receive a premium. A premium or a credit is given to us for providing them with this right. Selling a call option without combining them with other trades is known as a naked call.

Brokerages and exchanges have strict margin requirements when it comes to selling naked calls. The reason is that we are exposed to unlimited risk if the stock was to soar above the strike price. Hence it is always recommended to sell them in combination with some other countertrade.

The intention of selling a call is to eat the premium by allowing the option to expire worthlessly.

Long Put & Short Put

 

 

 

 

 

Similar trade positions are created in case of a long put and short put but the major difference is that the put buyer uses them when he is bearish on the stock. The Put Seller uses them as a way to get returns while the stock is retracing. A seller expects the option to expire worthless.

Important Option terminologies

Strike Price – It is the specific price at which a stock can be bought or sold if the option is exercised.

Expiration date – The last trading day on which the option can be exercised.

In-The-Money (ITM) – An option of call is In-the-Money when the market price of the underlying security is higher than the option’s strike price.

At-The-Money (ATM )– When the stock price is the same as that of the strike price then the option is said to be In-The-Money.

Out-of-The-Money (OTM) – An option of call is Out-of-The-Money if the strike price of the option is higher than the underlying security.

Open Interest – The number of outstanding contracts is open interest.

Intrinsic Value – The difference between an in-the-money option strike price and the current market price of the stock is its intrinsic value.

Extrinsic Value – The value of the option that is over and above the intrinsic value is known as its extrinsic value.

Volume – The number of contracts traded in a particular time period which may be a day or a week.

Implied Volatility – Implied volatility is the measure of stock fluctuation that also determines the option prices.

Hope you understood the concept of Options and their significance. In upcoming articles, we are going to discuss more on the various components of Options like Spreads, Exotic Options and respective combinations, which will help you in gaining more knowledge in this regard and making better investment decisions. Stay tuned!

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