Let us start by defining what derivatives are as Options and Futures are certain types of derivatives.
A derivative is a financial instrument whose price is derived from any other instrument and is not limited to financial instrument. For instance price of Future is derived from price of underlying stock and similarly price of Option is derived from price of the underlying stock. The price of a derivative can be derived from current weather condition, sports score or various other factors.
There are multiple types of derivatives, but the most common among them are: Options, Futures, Forward and Swap.
We will be trying to understand Options here. Options is a special type of derivative instrument where the buyer of the Option has the option (right but not obligation) to buy/sell a specified amount of underlying asset at a specified price on or before a specified date.
Option instruments have different characteristics
- Strike: Price of the underlying at which the option can be exercised
- Expiry Date: The date at which the option can be exercised
- Premium: Upfront payment made by the buyer of the option to the seller
Say you have $1000 to invest and today is 1-Jan-201X. You are bullish on stock A.
Scenario 1: You are interested in a stock A, which costs $100 per share. You bought 10 shares of stock A with $1000.
Scenario 2: Call Option of stock A is priced at $5 (premium) with a strike price of $100 and expiry at month end (31-Jan). Each option is a contract to buy or sell 100 shares. You can choose buy 10 call options with $500 and invest remaining $500 in fixed deposit.
Case 1: On 20-Jan-201X, the price of stock A increases to $120
Profits in Scenario 1: You gain $20 for each share. For 10 shares you made, $200.
Profits in Scenario 2: You can exercise your option to buy 10*100 i.e. 1000 shares at a profit of $20 each. Hence you made $20000 – $1000 (initial investment) = $19000 profit on your option contracts. Plus, you earned some interest on the remaining $500. Your total profit would be greater than $19000.
Case 2: On 20-Jan-201X, the price of stock A decreases to $20
Losses in Scenario 1: You lost $80 for each share. For 10 shares you lost $800.
Losses in Scenario 2: You can choose not to exercise your option. Hence you lose $500. But you have your remaining $500 plus some interest on it. Your losses are capped at $500.
Now that we have understood what options are, let us talk about two types of options:
- Call Options: Buyer has the right but not the obligation to buy the underlying stock
- Put Options: Buyer has the right but not the obligation to sell the underlying stock
Call & Put Option from a buyer’s and a seller’s perspective
|CALL OPTION||PUT OPTION|
|BUYER||The right (but not the obligation) To buy||The right (but not the obligation) To sell|
|SELLER||The potential obligation to sell||The potential obligation To buy|
Different styles of options
European Style – Can be exercised only on a expiry date
American Style – Can be exercised any time prior to expiry date
Exotic – Bermudan, Asian, Binary, Barrier etc. The exoticness of the Option can depend on price or time. Bermudan is a fine example of time dependant Exotic Style. You can exercise it on a fixed set of expiry date. In case of binary if the price crosses a barrier you either get a 0 or 1; the pay-off is either 1 if the price crosses a particular value and zero if it doesn’t cross a particular value, this is price dependent exoticness.
So the amount of exoticness that you can have in Options depends on the creativeness of the trader. While European & American are exchange traded, exotic are Over the Counter (OTC).
While buyer has no obligation to buy or sell the underlying if he has a call or put option respectively, the seller has an obligation to fulfil the contract as per the buyer’s decision. Hence, if a buyer of a put option exercises his right to sell, the seller of this option would have no choice but to buy the underlying stock.
Financial payoff for different types of options
Incase of call option, consider a Call option on XYZ Stock with strike = 30, expiry date = 30th Aug 201X
The buyer has the right to buy at 30 and will invoke this right only when the underlying is at a price higher than 30.
For instance if the underlying price is at 36 at the time of expiry, the buyer of the option can still buy the underlying at 30 with a payoff of 6.
Similarly if the underlying is at 40 the buyer gets to buy it at 30 and the profit is 10. However, there are no free lunches in the world! The option premium usually balances the payoff. So, if the stock price is expected to go up till 36, a call option with strike price of 30 would have a high premium charge to nullify the arbitrage.
Likewise in case of a Put Option, the buyer of the option has the right to sell the underlying; so going by the above example the buyer will sell the underlying only when the underlying price is less than 30, the strike price. If the underlying is at 23 the buyer gets to sell at 30 so he makes a payoff of 7.
Why are options attractive?
Options are attractive instruments to trade in because of the higher returns and fewer risks involved. An option gives the right to the holder to do something, with the ‘option’ of not to exercise that right. This way, the holder can restrict his losses and multiply his returns. However in reality, options are very complex instrument to trade. That is because options pricing models are quite mathematical and complex.
Watch out this space in the coming weeks to understand options pricing methods and Greeks.
Revise your basis by watching the video below: