Derivatives are touted as one of the riskiest investment options offered by stock markets. They consist majorly of Futures and Options of major stocks and commodities. Among F&O investments, equity options are the most popular. If traded smartly, even small price movements may fetch investors sizable returns.
An equity option is a contract or a derivative instrument. An option gives the buyer the right or the choice, but not the obligation to buy (for a call option) or sell (for a put option) a particular asset at a specific price (strike price/exercise price) in the future. After the said date, the option ceases to exist and is no longer valid. Let us understand this in more detail.
This article covers:
- Basics of equity options
- Two types of equity options
- Who are the participants in Options?
- American option vs European option
Basics of equity options
Premium: Option premium refers to a token price that the option buyer pays to the option seller. The loss of the option holder is limited to the premium paid for the contract. On the other hand, the seller has an unrestricted potential loss, which is offset by the initial premium received for the contract.
You can use put and call option contracts to position a spot in a market with limited capital. Your initial investment is limited to the price of the premium.
Expiry date: The expiry date, also known as the exercise date, refers to the date on which a trader exercises an option on an exchange or with a brokerage, whether bought or written. It also refers to the date specified in an option contract.
In simple terms, the expiration date tells us how long the contract is in effect. After the expiry date, the contract ceases to exist, after which the option’s owner has no right, and the seller has no obligations.
Monthly options usually expire on the final Thursday of the week. Stocks and bank index options expire on the last Thursday of every month. At times when Thursday is an exchange holiday, the preceding business day becomes the last trading day. There are contracts with short-term and long-term expiries. Therefore, you should be aware of the exact contract terms, including expiration dates for all contracts.
Strike price: The strike price is sometimes also called the exercise price. It refers to the price at which the buyer of the contract has the choice to buy or sell the underlying security if he decides to exercise the contract. In other words, it may also be the stated price per share to buy or sell the underlying security (for call or put options, respectively).
Be careful not to confuse strike price with the premium. As opposed to a fixed and specified strike price, premium fluctuates daily and is the price at which the contract trades.
Underlying security: The underlying security is the instrument that an option writer must deliver (for call option) or purchase (for put option) after an option contract holder issues an exercise notice.
Two types of equity options
The two types of equity options are:
This option provides the buyer the right but not the obligation to buy an underlying security at the strike price before the expiration date, i.e. until the contract is valid. The writer of the option, however, has an obligation to sell the shares.
A put option gives its buyer a choice but not the obligation to sell the underlying security at the strike price before the option’s expiration date. The writer of the option has an obligation to buy the shares.
You can also use put and call option contracts to hedge against market risks actively. Furthermore, you can purchase a put as a hedge to protect stockholdings against an unfavourable market move while simultaneously maintaining stock ownership.
|Calls||Right to buy||Obligation to sell|
|Puts||Right to sell||Obligation to buy|
Who are the participants in Options?
One who buys an option pays the premium and acquires the right to exercise his option on the seller/writer on a particular date.
The writer or seller of an option receives the premium of the option. Therefore, the writer is obligated to sell/buy the asset if the buyer of the option chooses to exercise it.
American option vs European option
American options refer to options that can be exercised at any date until the expiry date. For such options, the regulator authorizes the American style of settlement.
European options refer to an option that can be exercised only on the expiry date. In India, all options of stocks and indices such as Nifty options, Bank Nifty options, etc., are authorized only in the European style of settlement. Stocks options are also read as such.
For example, if SBI is trading at Rs. 300 and you wish to buy an option at the strike of Rs. 320, then the SBI call option would appear on the exchange as SBIN 320 CE where SBIN stands for State Bank of India, 320 is the strike and CE stands for Call European.
Option trading is risky, but the potential of returns are good. Traders can use equity options to hedge, evaluate the market’s future direction, arbitrage, or even implement strategies to generate income. Since Muhurat Trading is nearing, you can start planning your strategies. Visit Tickertape to help you in preparing for this trading session. One can employ multiple trading strategies such as long-call options trading strategies, short-call options trading strategies, long-straddle options trading strategies, and short-straddle options trading strategies to gain returns when considering equity options for investments.
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