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Understanding Options

Jul 17, 2004

Derivatives markets are important constituents of the capital markets anywhere in the world. Thus, in the Indian stock markets too, derivatives have become an important part, which is evident from the volumes in the derivative segment. The volumes in the derivatives market has gone up steadily in the last three years (since its commencement in India) and during the last one year, they have been consistently higher than the cash market.

Derivative instruments like index futures, index options, stock futures and stock options provide the investor an opportunity to save themselves from any irrationality witnessed in the market time and again, if used prudently, by hedging their equity investments. With the help of these instruments, investors can hedge their portfolio to safeguard against stock price risks (hedging is simply neutralizing of a stance i.e. if you bought HLL in the cash market and at the same time, buy a put option (discussed below) on HLL, the stance in neutralized).

Of all the above derivatives instruments, options are the least popular, owing to they being a more sophisticated derivatives tool compared to futures. It is used less, which is evident from the fact that volumes are merely 10%-12% of the total derivatives volumes. In this article, we will delve deeper into options and their mechanism.

Options are basically contracts, which give the option buyer a right to buy or sell certain asset (underlying). The buyer of an option has the right to exercise the option but does not have any obligation. On the other hand, the seller of an option has an obligation to fulfill the contractual agreement if buyer decides to exercise his option. Lets first understand certain definitions before going further.

There are two types of options, Call options and Put options. Call option are the contracts in which the buyer of the option acquires the right to buy certain asset (underlying), say stock, at an agreed price called exercise price and at an agreed time. For example, if an investor wants to buy a stock of Infosys at Rs 5,450 say in a month's time and does not want any risk of a price increase, he can buy a call option with an exercise price of Rs 5,450 and buy the stock at the same price after a month (by paying a premium discussed below).

Put option: are the contracts in which the buyer of the option gets the right to sell certain asset (underlying), say stock, at an agreed price called exercise price and at an agreed time. Let's understand the following terms.

Strike/Exercise Price: It is the price at which the contract is entered into. There can be several strike prices at which one can enter into contract in the options market.

Spot Price: The price of the underlying asset in the cash market.

Option Price/Premium: The amount paid to buy the option, or the amount received by the seller of the option. The person who will give you the right will get something in return as compensation for giving that right.

It is very important to understand how the premium of the option is calculated. The option premium is calculated using he Black and Scholes Model in which there are five variables determining the price of the option. Although, there are various variants of Black and Scholes model used in the market, the variables remain the same. These variables are,

  1. Spot price

  2. Exercise/Strike Price

  3. Volatility- it is the volatility of the stock returns over a defined period of time, calculated as the standard deviation of the returns of the stock.

  4. Interest Rates- Although theoretically, the interest rate should be the risk free rate (10 yr bond yield), but to prevent arbitrage between futures and options, the interest rates taken is the implied cost of carry from the futures market.

  5. Time to Expiry- It is the time left to the expiry of the contract and is annualized (No. of days to expiry divided by no. of trading days in the year.)

Lets understand how the option price is related to these variables.

Call Option Price Put Option Price
Spot Price Direct Inverse
Exercise price Inverse Direct
Volatility Direct Direct
Interest Rates Direct Direct
Time Inverse Inverse

When all these five variables are put in a model, which is called Black & Scholes model, the price of the option is determined. Now the price (premium) of the option has two constituents, intrinsic value and the extrinsic value. Intrinsic value may be defined as the difference between the spot price and the exercise price. In case of call option, if the exercise price is less than spot price, the difference between these two is the intrinsic value. E.g. let's say exercise price is Rs 50 and the spot price is Rs 60, then the intrinsic value will be Rs 10 (Rs 60- Rs 50).

In case of put option, if the exercise price is more than spot price, then the difference between these two is the intrinsic value of the option. E.g. let's say exercise price is Rs 100 and the spot price is Rs 90, then the intrinsic value will be Rs 10 (Rs 100- Rs 90).

Extrinsic part of the option premium is basically time value of the money and the risk premium, which the seller of the option will receive in order to bear the risk. The main determinants of the extrinsic value are time to expiry (for time value) and volatility (for risk).

In case of call option if the exercise price is less than spot price, the option is said to be 'in the money' otherwise it is 'out of money'. In case of put option if the exercise price is more than spot price than the option is 'in the money' otherwise 'out of the money. If spot price and the exercise price become equal the option is 'at the money' in case of both the call and put options.

To conclude, although derivatives are risky instruments for an investor, he can use it in a prudent manner to increase his returns. Futures are also quite risky tools, but use of options reduces the down side risk and are relatively safer than any other derivatives tool.


Equitymaster requests your view! Post a comment on "Understanding Options". Click here!

2 Responses to "Understanding Options"

Rohit

Jan 23, 2016

I gree with earlier comments. Share few examples to understand it better.

Like 

Dr. K Prabhakar

Oct 1, 2012

All this theory without some actual examples of call option and put option trade , is of no use. The proof of the pudding is in eating. Please strive to give trade examples in real time environment, always !

Like (2)
  
Equitymaster requests your view! Post a comment on "Understanding Options". Click here!

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