What are the different types of Options?

Last Updated: 14 Jan 2025

If you are an investor looking for short-term financial instruments, Option is a great option. It is a derivative contract that gives the owner the right to buy or sell securities at an agreed-upon price within a certain period. Although there are many types of options in the stock market, there are broadly two types of options namely,Call and Put.

Call Option

A call option is a financial contract that provides the buyer the right, but not the obligation, to buy an asset at a specified price (strike price) within a specific time period. It enables traders to gain from a bullish price action or protect against increasing expenses.

For instance, you might purchase a call option on ABC Ltd. with a ₹500 strike price and pay a ₹15 premium. Later, if the price of the stock rises to ₹550, you can exercise the option to buy the stock at ₹500 and sell it at 550, achieving ₹35 in profit (₹550 – ₹500 - ₹15). If the stock quotes below ₹500, your loss is whatever premium you paid, which is ₹15 in this case.

There are two types of put option strategies:

• Long call: You buy the option expecting prices to rise, with limited risk (premium) and high potential gains.
• Short call: You sell the option expecting prices to remain stable or decline, earning a premium but facing unlimited risk if prices rise significantly.

Put Option

A put is a contract that allows the purchaser to sell some asset at a set price (the strike price) before a certain date. It’s often used as a hedge against price drops or to profit from expected declines in an asset’s value.

For instance, you purchased a put option of ABC Ltd, with a strike price of ₹500 after paying ₹20 as a premium when the stock price is ₹500. The stock drops to ₹450, meaning you will be able to sell at ₹500, thereby making a profit of ₹30 per share (₹500 – ₹450 – ₹20 premium). But if the price does remain above ₹500, your maximum loss is the ₹20 premium paid.

There are two types of put option strategies:

• Long put: You buy the option expecting prices to drop.
• Short put: You sell the option expecting prices to remain stable or rise, earning a premium but with higher risk if prices fall.

What happens when the price movement is not favorable to the investor?

In both types of options in the stock market, the loss is limited to the premium of the Options contract. In case one buys a call option and the price falls, they are not obligated to exercise their right to buy. They can simply let the contract expire without exercising it. Similarly for a put-holder, if the market price of the stock were to increase, they can choose not to sell at all.

Types of Options based on an underlying security

The most common type of option is a stock option in which the underlying security is stock in a publicly listed company. Therefore, there are various option types depending based on the assets. Here are a few examples of different types of options based on underlying security:

1. Stock Options: A very popular choice amongst investors, it has the shares of a publicly listed company as its underlying security.
2. Index Options: Quite like the stock options, instead of a particular company’s shares, the Index option is based on an index like NSE, BSE, etc.
3. Forex/Currency Options: This option type gives the owner the right to buy or sell a specific currency at an agreed exchange rate.
4. Futures Options: For this type of option the underlying security is a specified futures contract. A futures option allows the owner to enter into that specified futures contract.
5. Commodity Options: In Commodity Options, the underlying asset can either be a physical commodity or a commodity futures contract.

Types of options based on Expiration Cycle

The expiration cycle refers to the time frame within which the contract-owner can exercise their right to buy or sell the relevant asset. While some option types are available with a fixed expiration cycle, you can choose an expiration cycle for other types of options.

Examples of different types of options based on the expiration cycle are listed below:

1. Regular Options: These options have a standard expiration cycle. You can choose between at least four different expiration months, according to your preference and strategy.
2. Weekly Options: This option type has a much shorter expiration date and they are also known as weeklies. However, they work on the same principles as regular options.
3. Quarterly Options: These are also known as quarterlies. The investor can choose any expiration cycle between the nearest four quarters plus the final quarter of the following year.
4. Long-Term Expiration Anticipation Securities: This type of option, as the name suggests, is for a long term lasting from one to three years before expiry. Regular Options: These options have a standard expiration cycle. You can choose between at least four different expiration months, according to your preference and strategy.

Payoffs for Options: Calls and Puts

The payoffs for call and put options differ because the objectives of buying and selling these contracts vary. Here’s how the payoffs work for each type of option:

Call Option

A call option is initially quoted with a premium amount, which is the cost the buyer pays upfront to the seller (writer) of the option. This premium is a fixed charge, granting the buyer the right, but not the obligation, to purchase the underlying asset at a predetermined strike price before or on the expiry date.

Once the premium is paid, the buyer anticipates that the price of the underlying asset will rise above the strike price. If this happens, the buyer can exercise the option, buy the asset at the lower strike price, and sell it at the higher market price, thereby making a profit. The profit potential for the buyer is theoretically unlimited, as the asset price can continue to increase beyond the strike price.

Conversely, if the price of the underlying asset falls below the strike price, the buyer would incur a loss by exercising the option. In such cases, it is better for the buyer to let the option expire unexercised, limiting their loss to the premium paid. In this scenario, the seller (writer) of the call option retains the premium as their maximum profit.

Put Option

Put options, like call options, are also quoted with a premium, which the buyer pays upfront to the seller. By purchasing a put option, the buyer obtains the right to sell the underlying asset at the strike price. Buyers of put options usually anticipate a decline in the asset’s price.

If the price of the underlying asset drops below the strike price, the put option becomes ‘in-the-money.’ The buyer can exercise the option, sell the asset at the higher strike price, and profit from the difference, less the premium paid. The buyer’s profit potential is significant as long as the asset price continues to fall below the strike price.

However, if the asset price rises above the strike price, the buyer will not exercise the option to avoid losses. In this case, the buyer’s loss is limited to the premium paid, while the seller retains the premium as their maximum profit. If the buyer exercises the put option, the seller’s loss is potentially unlimited as they must purchase the asset at the higher strike price.

Applications of Options: Calls and Puts

Options, specifically call-and-put options, are versatile financial instruments that offer flexibility to investors and traders. Their applications span various strategies, including hedging and speculation. Here are some common uses:

1. Investment Hedging

Options are frequently used to protect investments against adverse price movements. For instance, investors holding a portfolio of stocks may purchase put options to hedge against potential declines in market value. Similarly, call options can be used to lock in a favourable purchase price for an asset in anticipation of future price hikes. This approach provides a safety net, particularly in volatile markets like the Indian equity market.

2. Production Hedging

Businesses, particularly in the agricultural and manufacturing sectors, utilise options to safeguard against price fluctuations of raw materials or commodities. For instance, a farmer anticipating a fall in crop prices may buy put options to secure a minimum selling price. Similarly, a manufacturing company can use call options to fix the cost of a critical raw material, ensuring stable production costs despite market volatility.

3. Bullish Speculation

Investors expecting a rise in the price of a stock or commodity can buy call options to profit from the upward movement. By purchasing a call option, they gain exposure to the potential upside without having to commit the full capital required to purchase the asset. This is particularly appealing in markets like India, where bullish trends in sectors like IT or banking often attract speculative interest.

4. Bearish Speculation

On the flip side, traders anticipating a decline in asset prices can buy put options to benefit from the drop. This allows them to profit without the need to short-sell the asset, which might involve higher risks or costs. For example, an investor can use put options to speculate on falling stock prices during the bearish phases of the Indian economy.

Conclusion

With various types of options contracts available to invest in, it can be tricky to choose the one that is suitable for you. The ideal way to make the best out of your investing journey is to do your research or consult the experts at IIFL Capital Securities Limited to help you choose the right strategy that will suit your financial goals.

Frequently Asked Questions

What are exotic options?

Exotic options are a more complex type of Options. It has a different expiration cycle, strike price, payment structure and underlying asset. These are hybrid securities that can often be customized to the investor’s needs. The advanced and complex nature of these options makes them more profitable and perfect for hedging and risk management.

What is an example of a Put and Call option?

Example of Call option: Stocks of Company X are trading at ₹500. You buy a call contract at a strike price of ₹500 for a premium of ₹10. The trading price of Company X’s stocks starts rising and has reached ₹550. You can exercise your right to buy at the strike price, i.e. ₹500 and sell it at the market price i.e. ₹550. Thus, you have made ₹40 as profit (₹50 – ₹10 paid as premium).

Example of Put option: SImilarly, you expect the price of Company X’s stock to fall and buy a put option for a strike price of ₹500 for a premium of ₹10. The market price of the stock falls and becomes ₹470. You can exercise your right to sell at the strike price i.e. ₹500, making a profit of ₹20 ( ₹30 – ₹10 paid as premium).

How do I know what options to buy?

Your financial goals will determine the best options strategy you should use. There are various strategies like straddle, a bear call spread; bear put spread, bull call spread, bull put spread, etc. that you can use to maximise returns. It is recommended to have a clear exit strategy in mind before trading in Options.

How do options compare to futures?

Options give the buyer the right, but not the obligation, to buy or sell an asset at a specific price, limiting losses to the premium paid. Futures, on the other hand, require both parties to fulfil the contract, exposing traders to potentially unlimited risk and reward.

Are options contracts considered assets?

Yes, options contracts are considered financial assets. They derive value from the underlying asset and can be traded in the market. However, they are classified as derivative instruments, as their value depends on the price movement of the underlying stock, commodity, or index.