Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date.
The underlying asset can be a stock, an index, a commodity, or a currency. Since the value of an option is derived from the price of another asset, options are classified as derivatives.
Unlike futures contracts, which require both parties to fulfil the contract, options give the buyer a choice. Depending on market conditions, the buyer can either exercise the option, sell it before expiry, or allow it to expire. To obtain this right, the buyer pays a premium to the seller of the option. For buyers, the premium represents the maximum amount that can be lost on the trade.
How do options work?
When traders buy an option, they pay a premium for the right to buy or sell an underlying asset at a predetermined price, known as the strike price.
If the market moves in their favour, they may choose to exercise the option or sell it before expiry. If the market moves against them, they can simply let the option expire worthless. The seller, also known as the option writer, receives the premium in exchange for taking on the obligation to fulfil the contract if the buyer chooses to exercise the option.
Example
Suppose a trader buys a call option on a stock with a strike price of ₹1,000 by paying a premium of ₹20.
- If the stock price rises above ₹1,000, the option may gain value, and the trader can profit by exercising or selling it.
- If the stock price remains below ₹1,000, the trader may let the option expire. In this case, the maximum loss is limited to the ₹20 premium paid.
Types of options
There are two types of options contracts:
- Call options: A call option gives the buyer the right to buy the underlying asset at the strike price.
- Put options: A put option gives the buyer the right to sell the underlying asset at the strike price.
What is the underlying asset?
The underlying asset is the asset from which an option derives its value.
Common underlying assets include:
- Stocks such as Reliance Industries and Infosys.
- Indices such as Nifty 50 and Sensex.
- Commodities such as gold and crude oil.
- Currencies such as USD/INR.
Changes in the price of the underlying asset influence the value of the option contract.
What is expiry?
Every options contract has an expiry date, which is the last day on which the contract can be traded or exercised. Once an option expires, it ceases to exist and can no longer be traded.
The time remaining until expiry is an important factor in determining an option's value. In general, options lose value as they move closer to expiry because there is less time for the underlying asset to move in the buyer's favour. This phenomenon is known as time decay. Options contracts can have different expiry cycles, such as weekly and monthly expiries. In India, expiry schedules vary across exchanges and contract types.
| Exchange | Contract type | Weekly expiry | Monthly expiry |
|---|---|---|---|
| NSE | Index options | Tuesday of the expiry week | Last Tuesday of the expiry month |
| NSE | Stock options | No weekly contracts | Last Tuesday of the expiry month |
| BSE | Index options | Thursday of the expiry week | Last Thursday of the expiry month |
| BSE | Stock options | No weekly contracts | Last Thursday of the expiry month |
If the scheduled expiry day falls on a trading holiday, the contract expires on the previous trading day.
At expiry, an option contract is settled according to the exchange's settlement mechanism. If the option has value at expiry, it is settled as per exchange regulations. If it has no value, it expires worthless.
Expiry is important because it affects both the value and behaviour of an option contract. As expiry approaches:
- Option premiums tend to decline due to time decay.
- Volatility often increases as traders adjust or close positions.
- Small movements in the underlying asset can have a larger impact on option prices.
- Liquidity is usually concentrated in near-expiry contracts.
Because of these factors, expiry days are often among the most actively traded sessions in the derivatives market.
Options vs futures
Although both options and futures are derivative contracts, they differ in important ways.
| Feature | Options | Futures |
|---|---|---|
| Obligation | Buyer has a right, not an obligation | Both parties are obligated to fulfil the contract |
| Upfront cost | Buyer pays a premium | No premium is paid |
| Maximum loss for the buyer | Limited to the premium paid | Can be substantial depending on price movement |
| Flexibility | Can be exercised, sold, or allowed to expire | Contract must be squared off or settled |
What are the advantages of trading options?
Some advantages of options trading include:
- Limited risk for option buyers, as losses are restricted to the premium paid.
- Lower capital requirement compared to purchasing the underlying asset directly.
- Exposure to stocks, indices, commodities, and currencies through a single product type.
- Flexibility to implement a wide range of trading and hedging strategies.
- Ability to potentially benefit from both rising and falling markets.
What are the risks of trading options?
Some of the risks associated with options trading include:
- Options can lose value rapidly as they approach expiry.
- Leverage can magnify losses as well as gains.
- Option sellers can face substantial, and in some cases theoretically unlimited, losses if the market moves sharply against their position.
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Option pricing is influenced by multiple factors such as volatility, time to expiry, and interest rates, making options more complex than stocks.
Options are derivative contracts that give buyers the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified date. They are widely used for trading, speculation, and hedging.
While options offer flexibility, leverage, and limited risk for buyers, they also involve complexities and risks that traders should fully understand before using them. To learn more about options, visit the Options Theory module on Varsity.