BTL 707 - Options

 

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.

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.

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.

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.

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.

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.

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.

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

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