Let us begin by understanding what a stock option is.
A stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stock at a predetermined price and within a specified time period.
Types of options:
Options are primarily of two types: Calls and puts.
An investor buys calls when he/she thinks that the share price of the underlying security will rise or sell a call if they think it will fall. On the other hand, he/she will buy a put if he/she thinks the underlying will fall and sell a put when the price of the underlying is expected to rise.
In short, Call options give the holder the right to buy the underlying at a specified price, while Put options give the holder the right to sell an underlying asset at a specified price (the strike price).
The seller of the stock option is called an option writer, and he is paid a certain sum called premium by the buyer of the stock.
How do options work?
Suppose an Infosys call option is available at Rs75with an expiry of 3 months. Infosys is currently trading at Rs700. Then, the buyer of the stock option will have the right but not the obligation to purchase 100 shares of Infosys at Rs750 within 3 months. Hence, the one who buys a call option presumes that the stock price will go up and vice versa for a person who buys a put.
How are options different from stocks?
The Option contract has an expiration date unlike stocks.
Unlike Stocks, Options derive their value from that of the underlying asset and that is why, they fall under the derivatives category.
Option owners have no rights (voting or dividend) in a company unlike stock owners.
Moneyness is the relationship between the strike price of an option and the current price of the underlying asset.
An in-the-money option
Call Option – when the underlying stock price is higher than the strike price
Put Option – when the underlying stock price is lower than the strike price
An out-of-the-money option
Call Option – when the underlying stock price is lower than the strike price
Put Option – when the underlying stock price is higher than the strike price
An at-the-money option
When the underlying stock price is equal to the strike price
Pros of using options
- As the name suggests, options give one the right to buy/sell the underlying without an obligation to do so. Hence, one can exercise the right to sell or buy an underlying asset but one doesn’t need to.
- Options help in earning additional income as well as hedge risks from stock price movements if you understand how to use them.
Cons of using options
- The less time there is until expiry, the less value an option will have. Hence, the value of an option keeps declining as the expiry date moves closer.
- You stand the risk of unlimited losses if you use options without knowing the right strategies. For example, an unhedged short call can lead to unlimited losses as the price of the underlying may keep on rising.