An option is an agreement between a buyer and a seller that allows them to buy or sell an underlying asset on a later date at a predetermined price. However, this agreement may or may not be binding depending on the type of party, i.e. seller or buyer.
Options are different from a futures contract, in the sense that options allow the buyer to not exercise his right if the market situation is not favourable. There are two types of options:
A call option is an agreement that provides the buyer of option with the right to exercise the option and buy the underlying asset but not the obligation to do so. This means that if the price from the spot market seems favourable to the buyer of the option, he or she can break out of the contract and buy from the spot market instead. This is a key feature of options. The same is not applicable for the seller of the option.
A put option provides the buyer of the option with the right to sell the underlying asset under the conditions specified in the contract, but not the obligation to do so. The seller of the put option has an obligation to follow the buyer.
Strike Price refers to the predetermined price mentioned in the contract on which the agreement is made. If the option is exercised, the strike price is the price which the buyer of the asset has to pay to the seller. This price may or may not be different from the spot price prevailing in the physical markets, which is why these options are useful for hedgers and speculators.
Premium refers to the price that has to be paid by the buyer of an option to the seller of the option to lock in the contract. This fee ensures that even if the buyer decides to not exercise his right in the option, the seller has a secured income equal to the premium.
Another important aspect to note is that owing to the price risk in the spot market, the seller of the option is not secure and have a theoretically unlimited loss. However, a premium act as a lower bound beyond which losses cannot be incurred for the buyer.
Option contracts are exchange-traded as well as traded in OTC market. The options traded on exchanges are highly regulated and have less scope of counterparty default. There are clearing houses involved that ensure no error is made on the part of either party involved.
Since these contracts are traded on verified exchanges, they are standardized. This means that the contract is applicable for a specific quantity/amount of the underlying asset, for a particular type of asset and the strike price remains fixed.
The underlying assets mentioned in an options contract can be equity, commodity, bonds or any other financial instrument listed on the exchanges. However, OTC options do not have any regulation and function quite differently.
Hedgers use options to safeguard themselves from price risk prevailing in the spot markets. This means that options can be used by buyers and sellers of assets to safeguard themselves from the impending risk of falling and rising prices. A buyer always has a price risk on the downside, i.e. risk of falling price in the future and a seller has a price risk on the upside, i.e. risk of increasing price in the future.
To reduce this directional risk, both the buyer and seller can make a counter position in the derivatives market to mitigate the risk. For eg
There are many trading strategies that can be used with options. As options provide a more diverse range of opportunities to trade, there are many ways for speculators to make profits using options. Since speculators generally speculate on the direction, these directional bets sometimes can go wrong, and therefore these bets are relatively riskier but at the same time yields more return than a hedged position. Two simple strategies to speculate are:
If a speculator is bullish on the direction of the underlying, he essentially buys a call option so that he can benefit from the upside move.
Put option is bought when the view on the underlying is bearish and a speculator can benefit from the fall in the price or underlying asset. This is o as put option is inversely correlated with the direction of the underlying asset.
These strategies are used by speculators and not hedged. Therefore loss through unfavoured direction would also lead to higher loss than a hedged position. There are many other creative strategies that can be used with options and futures by both hedgers and speculators.
Options have an extrinsic value (time value) and intrinsic value. Time value of options is related to how close the option is to expiry. An option loses its value as it comes closer to its expiry.
Intrinsic value refers to what value an option would have if it were exercised today. To put it simply, intrinsic value is the amount by which an option is In the Money (ITM). Therefore, Out of the Money (OTM) options always have 0 intrinsic value.
A deep OTM option that is far away from the spot price will have lesser value than an option which is ITM. In other words, as the options go from ‘In the Money’ (ITM) to ‘At the Money’ (ATM) to ‘Out of the Money’ (OTM), its intrinsic value keeps on decreasing and eventually reaches 0 as the option becomes OTM.
Volatility also affects the value of an option. If the option is highly volatile, then the value will be higher; however, a less volatile option has a lower value.