An Option is a financial contract that provides the buyer with a right, but not the obligation, to either buy (call option) or sell (put option) an underlying asset. This right can be exercised at an agreed-upon price, known as the Exercise Price or Strike Price, within a certain period or on a specific date, regardless of changes in the underlying asset’s market price during that period.
An option transaction involves two parties: the buyer or holder who acquires the right, and the seller or writer (also known as the grantor) who sells the privilege and takes on a potential commitment if the buyer exercises their right. To obtain this right, the buyer pays a price to the seller, which is called the option price or the premium. The writer keeps the premium whether or not the option is exercised.
Options are considered a type of financial derivative because their value is derived from the value of an underlying asset. The underlying assets can include stocks, foreign exchange (forex), commodities, indexes, or interest rates.
Purpose and Uses
Options are primarily used by investors for two main objectives: speculation and hedging.
- Speculation: Investors may purchase call or put options in anticipation of changes in stock prices, essentially betting on the overall movement of the underlying asset or market. For instance, an option trader buys a put option when they expect the price of the underlying asset to decrease in the future.
- Hedging: Portfolio managers, for example, can use index options to limit their downside risk. Options are considered useful hedging instruments that can be efficiently used to protect against loss. This includes hedging transaction risk using currency options. Interest rate options are often used as hedges to protect against adverse interest rate movements.
Investing in options can provide limited risk, high potential reward, and requires a smaller amount of capital to control the same number of shares compared to the cash market. Options help companies develop a risk mitigation strategy.
Types of Options
Options can be classified in several ways:
- Based on Nature:
- Call Option: Gives the buyer the right, but not the obligation, to buy the underlying asset at a pre-determined price.
- Put Option: Gives the buyer the right, but not the obligation, to sell the underlying asset at a pre-determined price.
- Based on Exercise Timing (Styles):
- European Option: Can only be exercised on the expiry date. Most options in the Indian market are European style.
- American Option: Can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options and all stock options are American style. A Bermuda Option is a compromise, exercisable only on certain dates or on expiration.
- Based on Underlying Assets:
- Stock Options: The underlying is an individual stock. Various kinds exist, including put and call options.
- Stock Index Option: A call or put option on a financial index, where investors bet on the overall movement of a basket of stocks.
- Currency Options: The underlying is foreign exchange. These give the holder the right to buy or sell a currency at a predetermined rate on or before a specified maturity date. Specific types include foreign currency call and put options. Standardized currency option contracts are traded on exchanges like the Philadelphia Stock Exchange (PHLX).
- Interest Rate Options (IRO): The underlying is one or more interest rates, prices of interest rate instruments, or interest rate indices. Also known as Interest Rate Guarantees, they allow protection against adverse interest rate movements while benefiting from favourable ones. Call options profit from rising interest rates, while put options profit from falling rates. In India, IROs are traded on NSE based on underlying G-Sec bonds.
- Exotic Options: These are options with structures and features different from traditional American and European options (“plain vanilla options”). They are typically more complex and often traded in the OTC market. Types mentioned include:
- Chooser Options: Buyer decides whether it’s a call or put after a specified period.
- Compound Options: An option on an option; gives the right to buy another option.
- Barrier Options: Become active only if the underlying price reaches a certain level.
- Binary Options (Digital Options): Payoff is a pre-decided amount based on a specific event occurring.
- Asian Options: Payoff determined by the average price of the underlying over a period.
- Bermuda Option: Exercisable only on certain dates or at expiration.
- Basket Options: Value depends on a portfolio (basket) of underlying assets.
- Spread Options: Payoff depends on the difference between two underlying prices.
- Look back Options: Holder chooses the most favourable strike price on maturity based on historical prices.
- Real Options: These are options embedded within capital budgeting projects, representing flexibility in investment decisions. Examples include the right to invest (long call), expand (long call), sell (long put), or abandon a project (long put). Valuation methods for real options are similar to financial options.
- Options related to Bonds:
- Put options (on bonds): Give the holder the right to sell bonds back to the issuer at a predetermined price and date. Euro-convertible bonds may include this option.
- Call options (on bonds): Give the company the right to convert bonds into equity before maturity. Euro-convertible bonds may include this option.
- Double Option Bonds: Have two parts (principal and interest certificates) that can be sold separately.
Option Mechanism and Concepts
- Exercise: The act of the option buyer choosing to implement their right to buy or sell the underlying asset at the strike price. It’s usually exercised only if it’s advantageous.
- Premium Determinants: The option premium depends on various factors including the Exercise Price, Expiry Date, price of the underlying in the spot market, time value of money (interest rates), and future volatility. Higher exercise prices generally lead to lower call option premiums and higher put option premiums. Greater interest rates mean the present value of the future exercise price is less, affecting the option value.
- Value of an Option: The price or premium is comprised of Intrinsic Value and Time Value.
- Intrinsic Value: The gain to the holder from immediate exercise; the amount by which the option is “in-the-money”. Out-of-the-money and at-the-money options have no intrinsic value.
- Time Value: The portion of the premium exceeding the intrinsic value. It erodes as the option approaches expiration. Time is generally the enemy of the options buyer, as the value declines if the stock price doesn’t change significantly.
- Maximum and Minimum Value: The sources provide formulas for the maximum and minimum values of both American and European call and put options based on the spot price (ST), exercise price (X), risk-free rate (r), and time to maturity (t). For American options, the buyer can exercise before expiration, which affects their minimum value compared to European options.
- Option Valuation Techniques: Mathematical models compute the fair value. Major methods include:
- Binomial Model: Breaks time into intervals and uses probability to project future prices. It assumes the underlying asset can have only two values at maturity. This model calculates the option premium to provide a risk-free rate of return. The “Option Delta” is used in this model.
- Black-Scholes Model: A well-known formula used for option pricing. It calculates measures related to changes in factors affecting option value. A by-product is the calculation of Delta.
- Option Greeks: These are statistical measures related to how sensitive an option’s price is to changes in factors like the underlying price, time, volatility, and interest rates.
- Delta (Δ): Measures the degree to which an option price moves given a small change in the underlying stock price. It also represents the hedge ratio of shares to options for a hedged position. Delta of a Call is generally positive, and Delta of a Put is generally negative. The Put Delta equals (Call Delta – 1). Delta helps traders understand the relationship between the option premium and the underlying price.
- Rho: Indicates the change in option value for a one percentage change in the interest rate. Increasing interest rates increase call values and decrease put values; decreasing rates do the opposite. Long calls and short puts have positive Rho, while short calls and long puts have negative Rho. (Other Greeks like Gamma, Theta, Vega are mentioned as part of the syllabus content but not explicitly defined or explained in detail in the provided excerpts.)
Profitability and Payoffs
The profitability of an option contract depends on the relationship between the Spot Price (ST) on expiry and the Exercise Price (X). Options can be:
- In-the-Money (ITM): Exercising the option is advantageous and profitable. For a Call: ST > X. For a Put: ST < X.
- At-the-Money (ATM): Exercising the option results in neither profit nor loss from the price difference (before considering premium). For both Call and Put: ST = X.
- Out-of-the-Money (OTM): Exercising the option would result in a loss from the price difference. For a Call: ST < X. For a Put: ST > X.
The Break-even Price for a Call Option is X + Premium, and for a Put Option is X – Premium.
The maximum possible loss for an option buyer (call or put) is limited to the premium paid for the contract. When exercising is not advantageous, the buyer simply loses the premium.
The profit potential for an option seller (writer) is generally limited to the premium received, especially if the option expires out-of-the-money. However, the seller’s potential loss can be unlimited, especially if it is an uncovered (naked) option where they do not own the underlying asset.
Payoff profiles graphically illustrate the profit or loss for option buyers (long call, long put) and sellers (short call, short put) at various underlying asset prices on expiry.
Option Strategies
Options can be combined with the underlying asset or with other options to create various strategies for risk management and speculation. Elementary strategies include buying/selling single call or put options. More complex strategies involve combinations like:
- Stock and Option Combinations: e.g., Covered Call (Long Stock + Short Call) or Protective Put (Long Stock + Long Put).
- Option and Option Combinations: Spreads (Vertical, Horizontal, Diagonal, Butterfly, Condor) and Combinations (Straddle, Strangle, Strap, Strip). For example, a Strangle involves buying a call and a put with the same expiry date and underlying but different strike prices. A Strap involves buying two calls and one put, while a Strip involves buying one call and two puts.
Comparison with Futures
Options differ from futures in key ways:
- Nature: Option buyers have the right, but not the obligation, while futures buyers are obligated to the contract.
- Price Movement: Futures prices much more closely follow the underlying asset price, while option values can fluctuate somewhat independently, related to the option premium and its determinants.
- Cost: Option buyers pay a premium (a sunk cost), which is lost if the option expires worthless. Futures contracts require an initial margin deposit and maintenance margin.
Options in India
In the Indian market, most options are European style. Options trading in equities started in India in June 2000 [Source not provided in this set, but was in previous notes]. Popular interest rate options are traded at NSE. Standard Chartered PLC issued Indian Depository Receipts (IDR) in 2010 [Source not provided in this set, but was in previous notes]. While IDRs are not options, they illustrate mechanisms for accessing foreign assets or markets.