What are Options in Derivatives?

Last Updated: 17 Jan 2025

Whether you trade in stocks, commodities or any other financial instrument, it can take place across a number of different platforms and in a number of different ways. However, some commonly employed trading methods have proven useful time and time again for investors looking to make a profit while carefully hedging their risks. One such investing method is an options contract.

But, what are options? What is options trading and how does it work? To understand these concepts better, let us take a closer look:

What Are Derivatives?

To understand options trading, we must first get familiar with the concept of derivatives. Derivatives are essentially a type of financial instrument that derives their value from the changing value of an underlying asset such as stocks, commodities, currencies etc., and are set between two or more parties. Therefore, as the price of the underlying asset changes in the market, the overall value of the derivative contract changes with it.

When trading in derivatives, people essentially trade in agreements or contracts that stipulate the purchase or sale of an asset at an agreed upon price and a specific date. Options trading is essentially a type of derivatives trading, which you will learn about below.

What Are Options?

An Options contract is essentially a type of agreement between two parties, whereby the buyer has the right but not the obligation to buy or sell an underlying asset. The asset must be bought or sold – depending on the type of options contract- on the specific date and at a predetermined asset price.

Some of the essential terms that are often used in options trading are:

• Lot Size: This refers to the standard quantity or units of the underlying asset that is included in the options contract.
• Strike Prize: Also known as exercise price, this is the price of the asset at which the two parties agree to buy or sell the underlying asset.
• Premium: This refers to the amount that the buyer pays to the seller of the options contract and the underlying asset to avail the benefits of the options contract. It is the market price of the options contract itself.
• Expiration Date: This refers to the future date until which an options contract can be exercised by the investor. Beyond the expiration date, the options contract will expire worthlessly.

Benefits Of Options Derivatives

Options contract in derivatives provide many benefits. Here is a list of advantages of option contract:-

1. Low Entry Cost – Options contract in derivatives have minimal entry cost. This helps investors to hold a position with a minor entry fee in comparison to the stock market called leverage. Buying real stocks would lead to draining huge amounts of money.
2. Risk Hedging – One of the many advantages of option contract is that it minimises risk by insuring your portfolio. The maximum limit of risk is the premium being paid in most instances.
3. Flexible Nature – An investor can trade any possible movement in underlying security with options. Options strategy can be put to good use if investors can speculate about the security’s price.

Understanding how options are priced

In the monetary market, two components influence the estimating of options contracts: the inherent value and the time value.

An options contract in derivative’s inborn value is its current esteem in the subsidiaries market. The natural value of the options contract characterizes how much the option’s contract is “in-the-money” (when the basic asset’s cost is higher than the option contract’s strike cost). For illustration, if you have a call with a strike cost of Rs 300 on a share that is right now exchanging at Rs 500 in the equity market, the inherent value of the options contract will be Rs 200 (500-300).

The time value of an options contract is the additional cash the buyer is willing to pay over the natural esteem for the extra time an options contract has until the termination date. Time esteem proposes that an options contract has more potential to be “in-the-money”.

Options Risk Metrics

In substance, options in the stock market are considered more complex than other types of fiscal instruments. Within the literature on options, successful options investors and dealers deeply assay Options Greeks.

Options Greeks are fiscal measures included in the threat criteria of an options contract and are grounded on fine formulas aimed at calculating the perceptivity of an options contract’s price. For illustration, if you hold an options contract and want to decide if you should exercise it, you can look at options Greeks to calculate the pitfalls and prognosticate if the beginning asset price will fall or rise.

1. Delta – Delta threat metric calculates the change in the price of the options contract to a unit change in the beginning asset’s price. For illustration, if the delta of an options contract is 0.7, it shows that for each unit of increase or drop in the attached beginning asset, the price of the contract will also increase or drop by 0.7 points.
2. Gamma – Gamma as an options threat metric calculates the change in the beginning asset for the contract’s delta value. For illustration, if the gamma value for an options contract is 0.05, it means that the delta value will change by 0.05 points in the case of the beginning asset changes by 1 point.
3. Vega – Vega helps calculate the price change of the options contract per unit change in the request volatility. Vega is directly related to the values of inferred volatility; the more advanced it is, the more advanced the options price.
4. Theta – Theta measures the rate of an options contract at which it loses the time value as the expiration date nears. For illustration, if the theta value is-2 with everything additional remaining constant, the contract’s price will decline by 3 points on a particular day.
5. Rho – Rho is a threat standard that calculates the change in the price of the options contract for a unit change in the interest rate. For illustration, if the rho of an options contract is -5, it indicates that for each unit increase in the interest rate, the option price will drop by 3 points.

How Is Options Trading Done?

Anytime a party enters into an options contract, they typically do so either because they think that the price of an asset is set to rise or that the price of an asset is set to fall. Apart from speculating on the price of the asset to go up or down, investors also invest in an options contract to hedge a trading position in the market.
To understand how options trading is done in the market, you must be familiar with the type of options derivatives that are employed. Here are the two major types of options contracts:

Call Option

A call option is a type of options contract that gives the holder the right, but not the obligation to buy the asset at the agreed-upon strike price before the expiration date. The call option can be bought by the investor by paying a premium upfront to the seller, also called the Options writer. The option holders, therefore, make a profit if the value of the asset rises in the future. This is because the call option allows them to buy the asset at a much lower price and then sell in the market for its current higher price.
For example, suppose you purchase a call option for stock at a strike price of Rs 200 and the expiration date is in two months. If within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40.

Put Option

A put option is a type of options contract that gives the options holders the right, but not the obligation to sell the asset at the set strike price any time before the expiration date. If the value of the asset falls in the future, the call option gives holders the choice to sell the asset at the agreed-upon higher price, thereby minimising overall risk.
For example, let’s assume you purchase a put option for stock at a strike price of Rs 200 and the expiration date is in a month. If within that period, the stock price falls to Rs 180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of the stock rises above Rs 200, you can choose between exercising the contract or not.

Frequently Asked Questions

Q1.What is the difference between Options and Futures?

Options and futures are both types of options contracts in derivatives. Options give the right but not the obligation to buy or sell an asset at a predetermined price within a specific time, while futures contracts require the parties to buy or sell the asset at a set price on a future date.

Q2. Why are Options used?

Options contracts in derivatives are used for several purposes, including hedging risks against price fluctuations, speculating on the future direction of market prices, and providing leverage in investment portfolios. The advantages of option contracts include the ability to manage risk and potentially achieve significant returns without owning assets.

Q3. Are options better than stocks?

The advantages of option contracts include greater flexibility and leverage compared to stocks. Options allow investors to speculate on price movements and hedge their portfolios. However, stocks provide direct ownership, dividends, and voting rights, which options do not offer. The choice between options and stocks depends on individual investment goals and risk tolerance.

Q4. Is there too much risk in Options trading?

Options trading can involve significant risk due to the leverage and volatility inherent in options contracts in derivatives. While options offer the potential for high returns, they can also result in substantial losses. Investors need to understand the risks and develop strategies to mitigate them, such as using protective options or diversifying their portfolios.

Q5. What are the four types of options?

The four types of options contracts are call options, put options, American options, and European options. Call options give the holder the right to buy the underlying asset, while put options give the right to sell it. American options can be exercised at any time before the expiration date, whereas European options can only be exercised on the expiration date.