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If you’re keen on understanding the concept of price fluctuations, there’s no better place than the stock market. The impact of price fluctuations not only affect companies but also investors and traders who buy these stocks.
Stock options are a type of security in the stock market to protect investors to a certain extent and hedge the risk of losses due to price changes.
What is a stock option?
Stock options trading is also known as equity options trading.
Options in the stock market, are derivative securities which give the holder the right to buy or sell an asset – on a future date, at a pre-agreed price. It is essential to note that the holder has the option to execute the contract but has no obligation to do so.
How do options work?
Options work by giving the holder the option to either execute the contract or cancel it.
If a bullish trader expects a stock’s price to increase, he can enter an options contract to buy the stock at a predetermined price. If the market price increases as expected, the trader can execute the options and buy the stock at a lower price. If the stock’s price falls, the trader can let the options expire and buy the stock directly from the market.
The same concept applies to selling a stock, too.
Features of options
- Option holder – The trader who buys the option to buy or sell assets.
- Option writer – The writer is the seller of the options contract and must execute or cancel the contract, depending on the buyer’s decision.
- Premium – This is the fee paid by the holder to the writer for getting the authority to exercise or cancel the contract. It is a fee paid over and above the contract price to cover the writer from the risk of non-execution.
- Strike price – The pre-agreed upon price in the options contract to trade an asset on a future date.
- Spot price – The current market price of the underlier.
- Settlement date – The future date for exercising the contract or the date that determines the expiry of the options contract.
Types of options
Call options – This is where the option holder has the right to buy the asset on a future date. In a usual scenario, a trader expecting an increase in stock prices enters into call option contracts to buy assets at lower prices.
They are further classified into:
- In-the-money – Strike price < Spot price of the underlier – Indicates a profitable scenario for the option holder.
- At-the-money – Strike price = Spot price (Excluding premium) – Indicates a scenario of no profit, no loss.
- Out-the-money – Strike price > Spot price – Indicates a loss where the holder may decide to cancel the contract.
Put options – This gives the option holder the right to sell the asset on a future date. A trader speculating a decrease in the prices of stocks enters into a put option contract to sell the asset at a higher price.
- In-the-money – Strike price > Spot price of the underlier – Indicates that the option holder will profit by executing the put option.
- At-the-money – Strike price = Spot price (Excluding premium) – A scenario of no profit, no loss.
- Out-the-money – Strike price < Spot price – Suggests a loss where the holder may cancel the put option contract.
Benefits and risks of options trading
Pros of options trading:
- The options contracts are a great way to hedge the risk of price uncertainties and limit losses. It helps traders purchase securities at a price lower than the market price, thereby bringing down their expenses.
- It is a beneficial tool for the holders of the contract as they have the right to execute or cancel the contract based on their profit requirements.
- Various strategies available under option trading, like the iron condor and iron butterfly, help traders earn additional profits in the form of premiums.
Cons of options trading:
- Options are complex securities. Since it involves multiple aspects, it requires thorough market knowledge before entering into options contracts.
- The sellers do not benefit much from the option contracts. Though it is a hedging tool for holders, it is quite risky for option writers as they do not have any control over the execution and cancellation of option contracts.
Bottomline
Options are hence, useful derivative contracts that help in managing price uncertainties in the stock market. Despite its ability to hedge risks, it is not suitable for all traders.
The power of option contracts depends on determining the strike price and expiry date, which requires competence and a strong grip on the market.
FAQs
The current price of Company A’s stock is ₹ 100. You speculate the price to increase above ₹150 in a few months and enter an options contract to buy the stock at ₹100 after three months.
Price goes up to ₹140 – Exercise the options contract and buy the stock at ₹100.
Price comes down to ₹90 – Let the options contract expire and buy the stock directly from the market.
Here, stocks refer to buying equities directly from the stock market. Stock options are where stock becomes the underlier of the derivative contract. Both are risky as stock prices fluctuate constantly. However, options give traders the benefit of hedging risks if strategised properly.
Yes, despite being a risk-hedging tool, option contracts are highly risky. While it does help in restricting the losses at times, price movements in the opposite direction can lead to unlimited losses.
The main disadvantage of options is the complexity of determining the contract’s strike price. The benefit of an options contract can be reaped only if the selection of the strike price is accurate. Otherwise, it can lead to unlimited losses.
To be a buyer or a seller of an options contract depends on whether you are bullish or bearish on the stock. A bullish trader holds a call option while a bearish trader holds a put option. Similarly, a bullish trader writes a put option and a bearish trader writes a call option.