OPTIONS
What Are Options?
Options are versatile financial instruments that derive their value from an underlying security, such as stocks, indexes, and exchange-traded funds (ETFs). Unlike futures contracts, options offer buyers the right—but not the obligation—to buy or sell the underlying asset at a predetermined strike price within a specific time frame. This flexibility allows investors to leverage positions without committing to purchase or sell, providing a strategic tool for speculation and hedging against market fluctuations.
Options are commonly traded through online platforms or retail brokers, with each contract having a predetermined expiration date that dictates when the options must be exercised
Key Takeaways
Options are financial instruments that provide the right, but not the obligation, to buy or sell an underlying asset at a set strike price, offering investors a way to leverage their positions or hedge against risks.
The two main types of options are call options, which benefit from an increase in the underlying asset's price, and put options, which profit from a decline in the asset's price.
Options are categorized as American or European based on their exercise timings, not geography; American options can be exercised anytime before expiration, while European options can only be exercised at expiration.
"The Greeks" are crucial risk metrics in options trading, helping traders manage risks—with delta measuring price sensitivity, theta representing time decay, gamma showing delta fluctuation, and vega indicating volatility sensitivity.
Options strategies, such as spreads, use combinations of buying and selling different options to achieve specific risk-return profiles, enabling traders to capitalize on various market scenarios, including volatility and price movements.
How Options Work
Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset at a stated price within a specific time frame. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific time frame. Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.
U.S. Securities and Exchange Commission. "Investor Bulletin: An Introduction to Options."
Traders and investors buy and sell options for several reasons. Options allow traders to leverage a position in an asset for less cost than buying the shares directly. Investors use options to hedge or reduce the risk exposure of their portfolios.
In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option's daily trading volume and open interest are the two key numbers to watch to make the most well-informed investment decisions.
American options can be exercised any time before expiration, whereas European options can only be exercised at expiration.
Exercising means utilizing the right to buy or sell the underlying security.
Options Terminology to Know
Options trading involves a lot of lingo. Here are just some of the key terminology to know the meanings of:
At-the-money (ATM): An option whose strike price is exactly that of where the underlying is trading. ATM options have a delta of 0.50.
In-the-money (ITM): An option with intrinsic value and a delta greater than 0.50. For a call, the strike price of an ITM option will be below the current price of the underlying; for a put, it'll be above the current price.
Out-of-the-money (OTM): An option with only extrinsic (time) value and a delta a less than 0.50. For a call, the strike price of an OTM option will be above the current price of the underlying; for a put, it'll be below the current price
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Premium: The price paid for an option in the market.
Strike price: The price at which you can buy or sell the underlying, also known as the exercise price.
Underlying: The security upon which the option is based.
Implied volatility (IV): The volatility of the underlying (how quickly and severely it moves) as revealed by market prices.
Exercise: When an options contract owner exercises the right to buy or sell at the strike price. The seller is then said to be assigned.
Expiration: The date at which the options contract expires, or ceases to exist. OTM options will expire worthless.
Exploring the Types of Options: Calls and Puts
Calls
A call option gives the holder the right, but not the obligation, to buy the underlying stock at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).
The Options Industry Council. "Delta."
A long call can be used to speculate on the price of the underlying rising, as it has unlimited upside potential but the maximum loss is the premium (price) paid for the option.
Puts
Opposite to call options, a put gives the holder the right, but not the obligation, to sell the underlying stock at the strike price on or before expiration. A long put, therefore, is a short position in the underlying security, as the put gains value as the underlying's price falls (puts have a negative delta).
Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
Understanding American and European Option Styles
American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date.
The difference between American and European options is about early exercise, not geography. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
Key Considerations for Trading Options
Each options contract usually represents 100 shares of the underlying asset. The buyer pays a premium fee for each contract.
For example, if an option has a premium of 35 cents per contract, buying one option costs $35 ($0.35 x 100). The premium is partially based on the strike price or the price for buying or selling the security until the expiration date.
Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will influence the use-by date and some options will expire daily, weekly, monthly, and even quarterly. For monthly contracts, it's usually the third Friday.
CME Group Education. "What is Expiration Date (Expiry)?"
Strategies With Options Spreads
Options spreads combine buying and selling different options to achieve a specific risk-return profile. Spreads are constructed using vanilla options and can take advantage of various scenarios, such as high- or low-volatility environments, up- or down-moves, or anything in-between.
Important
Decoding the Greeks: Key Metrics for Options Risk Management
The options market uses the term the "Greeks" to describe the different dimensions of risk involved in taking an options position, either in a particular option or a portfolio. These variables are called Greeks because they're typically associated with Greek symbols.
Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Traders use different Greek values to assess options risk and manage option portfolios.
Delta
Delta (Δ) represents the rate of change between the option's price and a $1 change in the underlying asset's price. In other words, the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by 50 cents.
Delta also indicates the hedge ratio needed for a delta-neutral position.
So if you purchase a standard American call option with a 0.40 delta, you need to sell 40 shares of stock to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio's hedge ratio.
A less common usage of an option's delta is the current probability that it'll expire ITM. For instance, a 0.40 delta call option today has an implied 40% probability of finishing ITM.
Theta
Theta (Θ) represents the rate of change between the option price and time, or time sensitivity—sometimes known as an option's time decay. Theta indicates the amount an option's price would decrease as the time to expiration decreases, all else equal. For example, assume an investor is long an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option's value would theoretically decrease by $1.50.
Theta is higher for ATM options and lower for ITM or OTM options. Options closer to expiration also have accelerating time decay.
Long calls and long puts usually have negative Theta. Short calls and short puts, on the other hand, have positive Theta. By comparison, an instrument whose value isn't eroded by time has zero Theta.
Gamma
Gamma (Γ) represents the rate of change between an option's delta and the underlying asset's price. This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. Let's assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or decrease by 0.10.
Gamma is used to determine the stability of an option's delta. Higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying's price.
Gamma is higher for ATM options and lower for ITM or OTM options, increasing as expiration nears. Gamma values are generally smaller the further away from the date of expiration. This means that options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.
Options traders may opt to not only hedge delta but also gamma in order to be delta-gamma neutral, meaning that as the underlying price moves, the delta will remain close to zero.
Vega
Vega (V) represents the rate of change between an option's value and the underlying asset's IV. This is the option's sensitivity to volatility. Vega indicates the amount an option's price changes given a 1% change in IV. For example, an option with a vega of 0.10 indicates the option's value is expected to change by 10 cents if the IV changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience extreme values, a rise in volatility correspondingly increases the value of an option. Conversely, a decrease in volatility negatively affects the value of the option.
Vega is at its maximum for ATM options that have longer times until expiration.
Those familiar with the Greek alphabet will point out that there's no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.
Rho
Rho (p) represents the rate of change between an option's value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for ATM options with long times until expiration.
Minor Greeks
Some other Greeks, which aren't discussed as often, are lambda, epsilon, vomma, vera, speed, zomma, color, ultima.
These Greeks are second- or third-derivatives of the pricing model and affect things like the change in delta with a change in volatility. They're increasingly used in options trading strategies, as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.
Weighing the Pros and Cons of Options Trading
Buying Call Options
As mentioned earlier, call options allow the holder to buy an underlying security at the stated strike price by the expiration date, also called the expiry. The holder has no obligation to buy the asset if they don't want to purchase the asset. The risk to the buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.
Suppose buyers are bullish on a stock and believe the share price will rise above the strike price before the option expires. If the investor's bullish outlook is realized and the price increases above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the current market price for a profit.
Their profit on this trade is the market share price less the strike share price plus the expense of the option—the premium and any brokerage commission to place the orders. The result is multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
If the underlying stock price doesn't move above the strike price by the expiration date, the option expires worthlessly. The holder isn't required to buy the shares but will lose the premium paid for the call.
Selling Call Options
Selling call options is known as writing a contract. The writer receives the premium fee. In other words, a buyer pays the premium to the writer (or seller) of an option. The maximum profit is the premium received when selling the option. A seller of a call option expects the stock price to fall or stay near the strike price.
If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The option seller pockets the premium as their profit. The option isn't exercised because the buyer wouldn't buy the stock at the strike price higher than or equal to the prevailing market price.
However, if the market share price is more than the strike price at expiry, the seller of the option must sell the shares to an option buyer at that lower strike price. In other words, the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order, plus any brokerage order expenses, but less any premium they received.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise, increasing losses significantly.
Buying Put Options
Put options are investments where the buyer believes the underlying stock's market price will fall below the strike price on or before the expiration date of the option. Once again, the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock's price is below the strike price. If the prevailing market price is less than the strike price at expiry, the investor can exercise the put. They'll sell shares at the option's higher strike price. Should they wish to replace their holding of these shares, they may buy them on the open market.
Their profit on this trade is the strike price less the current market price, plus expenses—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.
Selling Put Options
Selling put options is also known as writing a contract. A put option writer believes the underlying stock's price will stay the same or increase over the life of the option, making them bullish on the shares. Here, the option buyer has the right to make the seller buy shares of the underlying asset at the strike price on expiry.
If the underlying stock's price closes above the strike price by the expiration date, the put option expires worthlessly. The writer's maximum profit is the premium. The option isn't exercised because the option buyer wouldn't sell the stock at the lower strike share price when the market price is higher.
If the stock's market value falls below the option strike price, the writer is obligated to buy shares of the underlying stock at the strike price. In other words, the put option will be exercised by the option buyer who sells their shares at the strike price because it's higher than the stock's market value.
A put option writer risks losing when the market price drops below the strike price. The seller is forced to purchase shares at the strike price at expiration. The writer's loss can be significant depending on how much the shares depreciate.
The writer (or seller) can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss. Any loss is offset by the premium received.
An investor may write put options at a strike price where they see the shares being a good value and would be willing to buy at that price. When the price falls and the buyer exercises their option, they get the stock at the price they want with the added benefit of receiving the option premium.
Market Position
The company is among India’s top 5 gold jewellery retailers, accounting for about 6% of the total organised market share. [1]