Monday 4 February 2008

Options - A beginner's guide

Options - A beginner's guide


    • Introduction
    • What is an option?
    • What is a call option?
    • What is a put option?
    • What is the option premium?
    • What is a strike price?
    • What is an at-the-money option? An in-the-money option? An out-of- the money option?
    • What is a contract size of an equity option?
    • What is open interest?
    • What does it mean to be exercised or assigned on an option transaction?
    • What happens to my option if I do nothing?
    • What is a European-style and American-style option?
    • What is the expiration date?
    • What is a strike price and how are they determined?
    • How options work?
    • Bullish Outlook
    • Bearish Outlook


Introduction

A few weeks back, capital markets regulator, SEBI, decided to introduce options from July 2, 2001. While trading on index-based options has begun, that on scrip- based options would begin from July 2. The introduction of options came in the wake of a concomitant ban on the 135-year old carry forward system, popularly called badla. The introduction of options is yet another milestone in India's march toward globalisation and the adoption of international systems and best practices. Much like stocks, options can be used to take a position on the market in an effort to capitalize on an upward or downward market move. Unlike stocks, however, options can provide an investor the benefits of leverage over a position in an individual stock or basket of stocks reflecting the broad market. Enumerated below are some basics on options:-

What is Options?

A stock option is a contract which gives the buyer the right, but not the obligation, to buy or sell shares of the underlying security or index at a specific price for a specified time. Stock option contracts generally are for 100 shares of the underlying stock. There are two types of options, calls and puts.


What is a call option?

A call option gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy.


What is a put option?

A put option gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell.


What is the option premium?

The premium is the price at which the contract trades. The premium is the price of the option and is paid by the buyer to the writer, or seller, of the option. In return, the writer of the call option is obligated to deliver the underlying security to an option buyer if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.

What is a strike price?

The strike, or exercise, price of an option is the specified share price at which the shares of stock can be bought or sold by the buyer if he exercises the right to buy (in the case of a call) or sell (in the case of a put).


What is an at-the-money option? An in-the-money option? An out-of- the money option?

When the price of the underlying security is equal to the strike price, an option is at-the-money. A call option is in-the-money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security. A call option is out-of- the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the money if the strike price is less than the market price of the underlying security.

What is a contract size of an equity option?

The amount of the underlying asset covered by the options contract. This is 100 shares for one option unless adjusted for a special event, such as a stock split or a stock dividend.

What is open interest?

Open interest refers to the number of outstanding option contracts in the exchange market or in a particular class or series.


What does it mean to be exercised or assigned on an option transaction?

When you buy an option you have the right to either purchase or sell stock at a predetermined price. When and if you choose to purchase or sell stock at that predetermined price you are said to be " exercising your right".When you sell an option you now have the obligation to sell or purchase stock. You have or may not have to fulfill that obligation. You are considered to be "assigned" if you are being required to fulfill that obligation. Typically this occurs when the option is in-the-money.


What happens to my option if I do nothing?

If you bought a call or put you would lose the premium you paid for the option plus whatever commissions and fees incurred on that transaction. If you sold a call or a put and your option is in-the-money you will most likely be assigned and you will have to sell or buy stock.

What is a European-style and American-style option?

American-style is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-style. All stock options are American-style. European-style is an option contract that can only be exercised on the expiration date.

What is the expiration date?

The last day (in the case of American-style) or the only day (in the case of European-style) on which an option may be exercised.

What is a strike price and how are they determined?

A strike price is the actual numeric value of the option. For example, a May option may have strike prices of 45, 50 and 55. Strike prices are determined when the underlying reaches a certain numeric value and trades consistently at or above that value. If, for example, XYZ stock was trading at 49, hit a price of 50 and traded consistently at this level, the next highest strike may be added.

How options work?

If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value. Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential. Buying an XYZ July 50 call option gives you the right to purchase 100 shares of XYZ common stock at a cost of Rs50 per share at any time before the option expires in July. The right to buy stock at a fixed price becomes more valuable as the price of the underlying stock increases. Assume that the price of the underlying shares was Rs50 at the time you bought your option and the premium you paid was 3 1/2 (or Rs350). If the price of XYZ stock climbs to Rs55 before your option expires and the premium rises to 5 1/2, you have two choices in disposing of your in-the-money option:

  • You can exercise your option and buy the underlying XYZ stock for Rs50 a share for a total cost of Rs5,350 (including the Option premium) and simultaneously sell the shares on the stock market for Rs5,500 yielding a net profit of Rs150.
  • You can close out your position by selling the option contract for Rs550, collecting the difference between the premium received and paid, Rs200. In this case, you make a profit of 57% (200/350), whereas your profit on an outright stock purchase, given the same price movement, would be only 10% (55-50/50).

Bullish Outlook

The profitability of similar examples will depend on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date. Also influencing your decision will be your desire to own the stock. If the price of XYZ instead fell to Rs45 and the option premium fell to 7/8, you could sell your option to partially offset the premium you paid. Otherwise, the option would expire worthless and your loss would be the total amount of the premium paid or Rs350. In most cases, the loss on the option would be less than what you would have lost had you bought the underlying shares outright, Rs262.50 versus Rs500 in this example. Put options may provide a more attractive method than shorting stock for profiting on stock price declines, in that, with purchased puts, you have a known and predetermined risk. The most you can lose is the cost of the option. If you short stock, the potential loss, in the event of a price upturn, is unlimited.

Bearish Outlook

Another advantage of buying puts results from your paying the full purchase price in cash at the time the put is bought. Shorting stock requires a margin account, and margin calls on a short sale might force you to cover your position prematurely, even though the position still may have profit potential. As a put buyer, you can hold your position through the option's expiration without incurring any additional risk. Buying an XYZ July 50 put gives you the right to sell 100 shares of XYZ stock at Rs50 per share at any time before the option expires in July. This right to sell stock at a fixed price becomes more valuable as the stock price declines. Assume that the price of the underlying shares was Rs50 at the time you bought your option and the premium you paid was 4 (or Rs400). If the price of XYZ falls to Rs45 before July and the premium rises to 6, you have two choices in disposing of your in-the-money put option:

  • You can buy 100 shares of XYZ stock at Rs45 per share and simultaneously exercise your put option to sell XYZ at Rs50 per share, netting a profit of Rs100 (Rs500 profit on the stock less the Rs400 Option premium).
  • You can sell your put option contract, collecting the difference between the premium paid and the premium received, Rs200 in this case.
If, however, the holder has chosen not to act, his maximum loss using this strategy would be the total cost of the put option or Rs400. The profitability of similar examples depends on how the time remaining until expiration affects the premium. Remember, time value declines sharply as an option nears its expiration date. If XYZ prices instead had climbed to Rs55 prior to expiration and the premium fell to 1 1/2 , your put option would be out-of-the-money . You could still sell your option for Rs150, partially offsetting its original price. In most cases, the cost of this strategy will be less than what you would have lost had you shorted XYZ stock instead of purchasing the put option, Rs250 versus Rs500 in this case. This strategy allows you to benefit from downward price movements while limiting losses to the premium paid if prices increase.