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What Are Stock Options?

In Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price - the Strike or Exercise price, until or at specified future date - the expiry date. The price is called Premium and is paid by buyer of the option to the seller or writer of the option.

An option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option. Since it is a right and not an obligation, the holder can choose not to exercise the right and allow the option to expire.

An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price.

In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the “premium” or price of the option. The right to buy or sell is held by the “option buyer” (also called the option holder); the party granting the right is the “option seller” or “option writer”. Unlike forwards and futures contracts, options require a cash payment (called the premium) upfront from the option buyer to the option seller. This payment is called option premium or option price.

Options can be traded either on the stock exchange or in over the counter (OTC) markets. Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved. Options traded in the OTC market however are not backed by the Clearing Corporation.

Terms to know for options:
Strike Price: - The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by option holder upon exercise of the option contract.

Moneyness of an Option: - “Moneyness” of an option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not. “Moneyness” of an option at any given time depends on where the spot price of the underlying is at that point of time relative to the strike price.

The premium paid is not taken into consideration while calculating moneyness of an Option, since the premium once paid is a sunk cost and the profitability from exercising the option does not depend on the size of the premium. Therefore, the decision (of the buyer of the option) whether to exercise the option or not is not affected by the size of the premium. The following three terms are used to define the moneyness of an option.
  • In the money, ITM: It is an option that would lead to positive cash flows to the holder if it was exercised immediately. A call option is ITM when spot price is greater than strike price. If the difference is huge it is called deep in the money
  • At the money, ATM: It will lead to zero cash flow if exercised immediately. Option is at the money if strike price is equal to spot price.
  • Out the money, OTM: It will lead no cash flow if exercised immediately. In case of call option if strike price is greater than spot price than it is OTM. Whereas in case of put option if strike price is less than spot price it is OTM
Contract Expiration Date: - The date on which option contract expires is expiration date or the maturity date. It is the last day on which option can be exercised. Active Options normally have a monthly or quarterly expiration cycle.

Option Price: - Option price is the price, which the option buyer pays to the option seller. It is also referred to as option premium. The premium depends on various factors like Strike price, Stock price, Expiration date, Volatility, Interest rate. The buyer pays premium to seller, seller has the obligation to fulfil the option terms when assigned to him.

There are two types of options:
  • Call Option: A call option gives the buyer of the option the right to buy the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. The value of a call increases as the value of the underlying asset increases and decreases as the value of the underlying asset decreases.
  • Put Option: A put option gives the buyer of the option the right to sell the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. The value of a PUT decreases as the value of the underlying asset increases and the value of a put increases as the value of the underlying asset decreases.

The Image below shows, the briefing why we should not sell an option.

Similarly is for Put Option:

Factors impacting option prices

The supply and demand of options and hence their prices are influenced by the following factors:
  • The underlying price,
  • The strike price,
  • The time to expiration,
  • The underlying asset’s volatility, and
  • Risk free rate
Each of the five parameters has a different impact on the option pricing of a Call and a Put.

The underlying price: Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases. Thus, in the case of a Call option, the higher the price of the underlying asset from strike price, the higher is the value (premium) of the call option. On the other hand, in case of a put option, the higher the price of the underlying asset, the lower is the value of the put option.

The strike price: The strike price is specified in the option contract and does not change over time. The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option. Everything else remaining constant, as the strike price increases, the value of a call option decreases and the value of a put option increases. Similarly, as the strike price decreases, the price of the call option increases while that of a put option decreases.

Time to expiration: Time to expiration is the time remaining for the option to expire. Obviously, the time remaining in an option’s life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing. The time value of both call as well as put option decreases to zero (and hence, the price of the option falls to its intrinsic value) as the time to expiration approaches zero. As time passes and a call option approaches maturity, its value declines, all other parameters remaining constant. Similarly, the value of a put option also decreases as we approach maturity. This is called “time-decay”.

Volatility: Volatility is an important factor in the price of an option. Volatility is defined as the uncertainty of returns. The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same. Risk free rate: Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government. Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally. It may however be noted that option prices do not change much with changes in the risk free rate.

First strategy to make money is to save on your brokerage first because your brokerage charges eat up your profit amount and increase loss amount alot. Lets say you make a profit of 2,000/- but your brokerage is 500/- for that trade what you made 1500/- only and if you make a loss of 2000 and brokerage is constant so your Loss is of 2500/-. And people make more loss by themselves than profit. So saving on brokerage is a must as that is a constant expense or loss that cannot be escaped. If you have a good brokerage plan you have win half of the Battle already.

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