What are options and their types?
Options are a kind of a derivative security. The price of an option is related to the price of something. Strictly speaking options are contracts which end up giving you the right but does not give the obligation to buy or sell an asset that is underlying at a fixed price, on a specified date.
Options are widely acclaimed for being a highly versatile security. Options are often being used to forecast and speculate the market which can be risky at times. Hedgers take into account options and wisely use them to minimize the risk of holding back an asset.
Options are different from futures contract and forward contracts. Forward contracts are non-standard contract between two parties to buy / sell a particle asset at a predetermined price and a predetermined date. Futures contracts are standard contract available on a stock exchange between two parties to buy / sell a particle asset at a predetermined price and a predetermined date.
But an option is something like a futures contract but in options the buyer gets the right and not the obligation to buy / sell for a predetermined at a predetermined date for a price called premium. Graphically speaking following is the difference.
Here we have the payoff (profit / loss) on the Y axis and the price of the asset or stock on the x axis. If we look at Fig – 2, this is the payoff matrix for a futures contract. The stock was bought at Rs 90 and if the price falls to Rs 80 the buyer suffers a loss of Rs 10 and if the price moves up to Rs 100, the buyer makes a gain of Rs 10. But if we see Fig- 1 the loss is curtailed to Rs 0 and the profits are unlimited. Puzzled – ok, now since it has peaked your interest, let’s learn the types of options to fully understand the graph. There are two types of options – call option and a put option. These are the terminologies that one needs to be conversant with to understand options
Strike price – The price at which option holder exercises his right.
Exercise price – Price at which the buyer of an option buys/ sells.
Assignment – Price which the seller of an option has to buy / sell
Expiration – end of the validity of the contract
A Call option give a person the option to buy the options at certain price. So, a person will buy a call option when he thinks that the price will go up. Here if the price of the stock in the market goes up, the buyer will exercise his right to buy at the strike price which will be less than the market price and then sell the stock in the market price and earn profit. But if the price of the stock is less that the strike price, the buyer of the option can let the option expire and can avoid losses. This is the reason for the graph we saw in FIg- 1 has no payoff line in the loss column. On the other hand the seller of the call option has the obligation and not the right so he believes that the underlying stock’s price will drop and the buyer will not exercise the option and he earns the premium amount.
Put options gives the person the option to sell at a certain price. So if the person is bearish and thinks that the stock will fall then he will buy a put option. Here if the price of the stock in the market goes down, the buyer will exercise his right to sell at the strike price which will be more than the market price. But if the price of the stock is more that the strike price, the buyer of the Put option can let the option expire and can avoid losses.