Chapter 4: Options Contracts

Objective

In this chapter we will learn about Options contracts in detail. We will learn types of options, how options work, factors influencing options pricing, options strategies and risk involved in options trading.

Section 4.1

Introduction to Options Contracts

Definition: An options contract is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (such as stocks, indices, commodities, etc.) at a specified price (called the strike price) within a specified time frame (called the expiration date).
- Options come in two types: Call options and Put options.
Key Characteristics:
1. Right but not obligation: The key difference between options and futures contracts is that with options, the buyer has the right (but not the obligation) to exercise the contract.
2. Premium: The buyer of an option pays an upfront cost known as the premium to the seller (also called the writer) for this right.
3. Exercise: The option can be exercised by the buyer at any time before expiration (for American-style options) or only at expiration (for European-style options).

Purpose of Options:

Hedging: Options can be used to protect against adverse price movements in the underlying asset.
Speculation: Traders use options to profit from price movements in the underlying asset without actually owning the asset.
Income Generation: Investors can write (sell) options to earn the premium, providing income while taking on the obligation to fulfill the option if exercised.

Section 4.2

Types of Options Contracts

Call Options
- A call option gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price (strike price) within a specific time period.
- Example: A trader buys a call option for ABC stock with a strike price of ₹1,000 and an expiration date of 30 days. If ABC’s stock price rises to ₹1,200, the trader can exercise the option to buy the stock at ₹1,000, making a profit of ₹200 per share.

Put Options

A put option gives the holder the right, but not the obligation, to sell the underlying asset at a predetermined price (strike price) within a specified time period.
Example: A trader buys a put option on XYZ stock with a strike price of ₹500. If XYZ’s stock price falls to ₹400, the trader can exercise the option to sell at ₹500, making a profit of ₹100 per share.

American vs. European Options
- American Options: Can be exercised at any time before or on the expiration date.
- European Options: Can only be exercised at the expiration date, not before.
Exotic Options
- These are customized options contracts that have unique characteristics (such as barrier options, Asian options, and others), and are traded on over-the-counter (OTC) markets rather than exchanges.
- Example: A barrier option becomes active only if the price of the underlying asset hits a certain level.

Section 4.3

How Options Work

Options Premium:

The price paid for an option is called the premium. The premium consists of two components:
- Intrinsic Value: The amount by which the option is in-the-money (ITM).
- Time Value: The value of the option based on the amount of time left until expiration and other factors like volatility.

Example:

For a call option with a strike price of ₹1,000, if the current market price of the stock is ₹1,200, the intrinsic value is ₹200.
If there are 30 days left before expiration and volatility is high, the time value might be ₹50. Hence, the total premium is ₹250.

In-the-Money (ITM), At-the-Money (ATM), and Out-of-the-Money (OTM):

In-the-Money (ITM):
- Call Option: When the current price of the underlying asset is above the strike price.
- Put Option: When the current price of the underlying asset is below the strike price.
At-the-Money (ATM): When the current price of the underlying asset is equal to the strike price.
Out-of-the-Money (OTM):
- Call Option: When the current price of the underlying asset is below the strike price.
- Put Option: When the current price of the underlying asset is above the strike price.

Exercise or Assignment:

The holder of a call or put option can choose to exercise the option if it is in-the-money.
The writer of the option (the seller) is obligated to fulfill the contract if the option is exercised by the buyer.

Section 4.4

Factors Influencing Options Pricing (The Greeks)

Options pricing is influenced by several factors, collectively known as The Greeks. These metrics help traders understand how different factors affect the price of an option.

Delta (Δ):
- Measures the sensitivity of the option’s price to changes in the price of the underlying asset.
- A call option typically has a delta between 0 and 1, while a put option has a delta between -1 and 0.
- Example: If a call option has a delta of 0.5 and the underlying asset increases by ₹10, the price of the option will increase by ₹5.

Gamma (Γ):

Measures the rate of change of delta with respect to changes in the price of the underlying asset.
Gamma is important because it helps options traders understand how delta changes as the underlying asset moves.

Theta (Θ):

Measures the sensitivity of the option’s price to the passage of time, also known as time decay.
Options lose value as they approach expiration due to the decreasing time value.
Example: If a call option has a theta of -0.1, it will lose ₹0.10 in value every day, all else being equal.

Vega (V):
- Measures the sensitivity of the option’s price to changes in the volatility of the underlying asset.
- Higher volatility generally increases option premiums because the likelihood of profitable price movement increases.

Rho (ρ):

Measures the sensitivity of the option’s price to changes in interest rates.
Interest rate changes have a bigger effect on options with longer expiration dates, and typically, call options are positively impacted by higher interest rates, while put options are negatively impacted.

Section 4.5

Option Strategies

Basic Strategies:

Covered Call: This strategy involves holding a long position in an asset and selling a call option on the same asset to generate income from the option premium.
Protective Put: This involves buying a put option to hedge against potential downside risk in an asset that the trader owns.
Long Call: Buying a call option when expecting the price of the underlying asset to rise.
Long Put: Buying a put option when expecting the price of the underlying asset to fall.

Advanced Strategies:

Straddle: A strategy where the trader buys both a call and a put option on the same asset with the same strike price and expiration date. This is used when the trader expects high volatility but is uncertain about the direction of price movement.
Strangle: Similar to a straddle, but the strike prices of the call and put options are different. This is cheaper than a straddle but requires a larger move in the underlying asset to be profitable.
Iron Condor: A combination of two vertical spreads (one call and one put) that involves selling out-of-the-money options and buying further out-of-the-money options. The goal is to profit from low volatility in the underlying asset.
Butterfly Spread: A neutral strategy that involves buying and selling calls or puts at three different strike prices, aiming to profit from minimal price movement around the middle strike price.

Spreads:

Vertical Spread: Involves buying and selling options of the same type (calls or puts) on the same underlying asset, but with different strike prices.
Horizontal (Time) Spread: Involves buying and selling options of the same type and strike price, but with different expiration dates.
Diagonal Spread: Combines elements of both vertical and horizontal spreads, where options have different strike prices and expiration dates.

Section 4.6

Risks Involved in Options Trading

Limited Loss for Buyers:
- The maximum loss for the buyer of an option is the premium paid for the option, which is limited and known upfront.
Unlimited Loss for Sellers:
- The seller of an option (also known as the “writer”) can face unlimited loss in certain circumstances. For example, selling a naked call option exposes the seller to potentially infinite losses if the underlying asset’s price rises significantly.
- Example: If a trader writes a call option on stock XYZ with a strike price of ₹1,000, and the stock price rises to ₹2,000, the trader is obligated to sell the stock at ₹1,000, incurring a ₹1,000 loss per share.

Time Decay:
- As options approach expiration, their time value decays, reducing the premium of the option, especially if the option is out-of-the-money. This is a significant risk for options buyers.
Liquidity Risk:
- In illiquid markets, it might be difficult to enter or exit an options position at the desired price, leading to potential slippage.

Final Takes

Conclusion

Options contracts are powerful financial instruments that offer traders flexibility, leveraging the potential of underlying asset movements. They are crucial in a wide range of strategies for hedging, speculation, and income generation. However, due to their complexity and the risks involved, understanding options pricing, strategies, and the Greeks is essential for anyone looking to trade them successfully.

This chapter has provided an overview of options contracts, including their types, pricing mechanics, and practical strategies. In the next chapters, we will explore how to combine options with futures in advanced F&O strategies, as well as discuss risk management techniques to safeguard your trades.