Beginners in the stock market often start their journey with stocks, mutual funds, and ETFs. They might pay less attention to other financial instruments that might lead to portfolio diversification. Derivatives are popular among experienced investors for hedging, price speculation, good returns, diversification, and other reasons. You can also combat rising prices of financial instruments by investing in options contracts. Read on to understand what are options contracts in detail.
Exploring Options Trading
Options are a type of derivatives or financial contracts for investors. A contract is based on or derived from an underlying security. The underlying security could be a currency, stock, commodity , or any other asset. When you purchase a contract, you get the right to sell/buy the underlying asset on the expiration date in the future. The price for buying or selling the underlying asset is predetermined in a contract, also called the strike price. When the contract expires, you can exercise or choose to ignore it. In short, it gives investors the right but not the obligation to sell/buy the underlying asset on the expiration date. Investors usually rely on this to hedge against rising prices and combating uncertainty in the market.
Understanding Options with Example
Let us take an options example
for further understanding. Let us say you come across a contract named ‘Voltas 20-Jan-24 900 CE’. It is based on the stock of Voltas, a popular company in India. It is a European-type call option, as mentioned through ‘CE’. A call gives the holder the right to buy the underlying asset at the strike price on the expiration date. The date ’20-Jan-24’ in the contract is the expiration date. You can take action (buy the asset) or ignore the contract on this date.
After the underlying asset’s name and date, you witness ‘900’ in the contract. It is the strike price for buying the shares of Voltas on 20-Jan-24, also called the expiration date. Let us say the market price (spot price) on 20-Jan-24 for Voltas stock is Rs 950. It means you will get Voltas stocks at a lower price through the contract. You can exercise the call option when the spot price is higher than the strike price. When the spot price is below Rs 900 on the expiration date, you can ignore the call option. In such a case, you will only lose the premium paid for purchasing the above contract.
How Do Options Work?
Since they are financial contracts, they are executed between two parties. They allow two parties to buy/sell the underlying asset on a future date between themselves. The price for them will depend on the underlying asset’s value. The price for purchasing them is also known as a premium. The underlying could be a stock, commodity, currency, bond, or any other financial instrument. It is crucial to note that they are flexible financial contracts that do not obligate the holder to take action on the expiration date. The expiration date for them is predetermined. When the holder does not exercise them on the expiration date, they become worthless. You already know that one can buy/sell the underlying asset at a predetermined price on the expiration date with them. The predetermined price for selling or buying the underlying asset is called the strike price.
Types of Options
Now that you understand the options meaning, let us discuss the types. Beginners in the stock market need to understand how different types of options work. It will allow them to make informed investments and reduce portfolio risks. They are divided into two categories: call and put.
A call gives the holder the right to buy the underlying asset on the expiration date at the given strike price. It is crucial to note that they are only used to purchase the underlying asset at a given strike price. Since they are derivatives, investors are not obligated to take action on the expiration date. They can ignore it on the expiration date when the prices are not in their favour. Usually, investors ignore calls when the strike price is more than or equal to the market price on the expiration date.
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Puts are also popular among derivatives investors. Compared to a call, it allows the holder to sell the underlying asset at a given strike price on the expiration date. Similar to any other derivative, you aren’t obligated to exercise it on the expiration date. Usually, investors ignore puts when the strike price is less than or equal to the market price on the expiration date. When the strike price is more than the spot price, you can sell the underlying asset at a better rate through a put.
Features of Options
Now that you have understood their meaning, let us discuss some features. The basic feature of them is their flexibility. They will not obligate you to buy/sell the underlying asset on the expiration date. You can ignore them on the expiration date when the market prices are not in your favour. In such a case, you will lose the premium paid for acquiring them. However, your losses will only be limited to the premium.
The same flexibility cannot be achieved with other derivatives. For instance, futures obligate the holder to buy/sell the underlying asset at the strike price on the expiration date. You have no choice even when market prices are not in your favour. It is where they are better than other types of derivatives.
You can also choose to buy or sell the underlying asset at a strike price in the future. Investors wanting to purchase an underlying asset in the future can choose call options. On the other hand, puts are available for investors willing to sell an underlying asset on a future date at a strike price. Investors must also be familiar with the contract size. It represents the quantity of the underlying asset. It is the quantity of the underlying asset you are planning to buy or sell with the help of them.
Another feature is their relation with implied volatility. Investors can analyse future price fluctuations for a particular asset with the help of implied volatility. When it is high for an asset, associated contracts will have a high premium. The demand for them will increase as more investors want insurance against price fluctuations. On the other hand, the demand decreases when implied volatility is low.
How to Use Options in Trading?
You can use contracts to make substantial profits. While they are used for hedging , they can also provide high returns. However, you must implement the right strategies to benefit from trading them. The basic strategy for benefiting from them is to hold them till expiry. When the market price on the expiration date is in your favour, you can exercise the option. You also have the right to ignore them when the market price is not in your favour. When you do not exercise the contract on the expiration date, it becomes worthless.
Another way of making a profit is to sell them before the expiration date. Let us say you aren’t sure of the future market price for a particular asset. Let us say you bought a contract at a premium of Rs 500. However, the current premium for the same contract in the market is Rs 800. Since you aren’t sure of future price movements, you can sell the contract to make a profit of Rs 300 on the premium. It is crucial to note that you must sell it before the expiration date.
Trading them can be challenging when the implied volatility is high. Due to increased price fluctuations, the premium for them increases. Also, investors fail to gauge the future market direction. In such a case, investors can use spread strategies to minimise losses.
Advantages of Options Trading
They allow investors with a low point of entry into the market. You only have to pay the premium for them to take a longer position in the market. Let us say you want to purchase 50 shares of a popular company. You can purchase based on the shares by only paying a small premium. On the other hand, you might have to shelve a huge amount for purchasing the 50 shares without any contract. When it expires, you can purchase the 50 shares at a better rate or ignore the contract. Since they do not obligate investors to buy/sell the underlying asset on the expiration date, they offer flexibility. You can hedge the portfolio against inflation, uncertainty, and other risks with their help.
Disadvantages of Options
Beginners often start with stocks, mutual funds , and other liquid instruments. Even though seasoned investors prefer derivatives, the liquidity for them might be low at times. Investors might fail to buy or sell them timely in some markets due to decreased liquidity. Traders also bear the risk of losing the premium paid to acquire the contract. When the market price on the expiration date is not in your favour, you might ignore the contract. In such a case, you will lose the premium paid to acquire it. Beginners in the stock market might face issues understanding how they work, as they are a little more complicated than stocks and mutual funds.
Conclusion
They can help investors hedge their portfolios against rising prices or market disruptions. One can buy/sell the underlying asset on a future date at a predetermined price with a contract. Also, you aren’t obligated to exercise it on the expiration date. The same flexibility cannot be achieved with other derivatives in the market.
