What are Options: Guide to Call and Put Options

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Have you ever wondered what are options?

If so, then this is the perfect time to learn about them.

Options are one of the most popular and widely used derivative securities globally.

They provide a way for investors to make money from increasing or decreasing price movements in an underlying asset.

Options are little complex concepts, but I will make them very simple for you to understand. 

In this post, I will walk through everything from what are options and why people use them and their benefits and risks. 

You don’t need any prior knowledge or experience to get started. 

And if you already have some idea of how options work, I can help take your understanding to the next level.

So let’s get started.

What are Options:-

what are options

Options are contracts between two parties, giving the right to buy or sell an asset for a defined price within a specified time frame.

Options are derived from underlying assets. 

For example, an ‘X’ stock option is derived from ‘X’ itself.

Stock ‘X’ fall would make the options prices go down. The stock going up will make the option prices go up.

Options are bought and sold with different strike prices and expiration dates; they will cost more or less, depending on how likely the underlying asset is to move close to the condition stated in the contract.

Options are also called derivatives because the option’s price is derived from an underlying asset, such as stocks, commodities, or indices. 

Most commonly, people trade in these derivatives to make short-term gains. 

Options are based on mathematics because they have formulas, and you can learn them if you want to know the behaviour of the option. 

We call “options” because they have a variety and flexibility that other financial contracts do not have.

Options are also known as “leveraged instruments”. If you don’t understand this point, then don’t worry.

I have discussed why options are “leveraged instruments” in this post.

Options are one of the most powerful tools in your investing arsenal and can be used for hedging, speculation, income generation and more.

Options trade on an exchange like any other stocks and shares. 

“Options can be used in your portfolio to limit risk.

They allow investors to place bets that prices will go up (calls) or down (puts). 

But options are complicated.

Go in with a well-planned strategy that fits your investing style and goals. And use options with caution — beware of market volatility and time decay.”

History Of Options:-

history of option

The earliest known options are found in ancient Greece, where the right to buy or sell certain commodities was traded many years before Christ.

The word “option” itself has its origin in the Greek language, meaning “to be chosen”.

Options were first used in Greece by an olive speculator. The olive speculator felt that the upcoming olive harvesting season would be good.

On the other hand, the olive farmers were uncertain about the upcoming harvesting season and the current market price of their product olive crops.

Hence, the olive speculator issued a contract to buy olives crops from farmers at a given price on a future date.

So with this contract, both are happy.

If the market price increases, it benefits speculators who can purchase olives at a lower price and sell them at a higher price.

But if the market price was decreased, it benefits farmers who don’t have to sell their crops at a loss.

As it turned out, at the end of the harvesting season, there was a great demand for olives, leading to an increase in market price. 

In this way, olive speculators who had purchased options could receive a substantial profit from their contract.

Since then, options have evolved into a standardised contract traded in organised exchanges around the world.

Types of Options:-

There are 2 types of options:

1. Call Option

2. Put option  

1. Call Option:

call option

A call option is a type of financial contract that gives a person who buys it the right but not the obligation to buy a stock, commodity, or other asset at a certain price and in a certain time frame.

The underlying asset can be a stock, a bond, or a commodity.

When the underlying asset’s price rises, a call buyer makes money.

It is a bullish position.

The Buyer and Seller of Call Option have different roles and responsibilities.

Call Option Buyer:

Call options buyers have the right to buy a company’s stock at a specific price by a certain period of time. For this right, they have to pay the premium, which is the cost of the option.

Whereas,

Call Option Seller:

The Sellers of Call Option has an obligation to sell a Company’s stock at a specific price by a certain period of time. For this obligation, they receive the premium, which is the option cost.

Understand Call Option with Example:-

call option example

Let’s say there’s a house that may be used as an underlying asset, and there are two people involved: one is the buyer, and the other is the seller.

The seller wants to sell his home for 2 crores, and the buyer likes it and is willing to pay 2 crores for it.

The current value of the house is Rs. 2 crores. This is called the strike price of a house. This is an At The Money (ATM) Option.

Options are ATM ITM or OTM. To learn, click here

However, the buyer will need some time to arrange the funds, and during that time, the property’s worth may rise or fall by the time he buys it.

Therefore, the buyer needs 60 days, so he asks the seller if I buy the land now, you have to sell the land in 60 days for 2 crores.

In such a case, a contract is signed between both parties with a clause that Mr. X will have the right to buy this house from Mr Y for Rs. 2 crores for 60 days, but is not obliged to do so if he does not want to.

For such a contract, Mr X will pay a small premium (say Rs. 1,00,000) to Mr Y as consideration for the contract and sign a legal agreement.

In this case, Mr X is the decision-maker, and Mr Y is the selling party as his property has been locked in a contract for a period of 60 days.

If the market price of the property after 60 days is Rs. 2.5 crores, Mr X will exercise his right and buy this property for Rs. 2 crores.

Buyer Total Cost = 2 Crore + 1 Lakh= 2.1 Crore

Buyer Profit = 2.5 – 2.1 = 40 Lakhs

In this situation, the buyer will profit Rs 40 lakhs, even though he only invested Rs 1 lakh.

But if the market value of the property is Rs. 1.5 crore after 60 days, he will not exercise his right and let the contract expire.

Here Mr X will lose Rs. 1 lakh (i.e., the premium amount he paid to Mr Y). Mr Y will gain Rs. 1 lakh, which is the premium amount he received from Mr X for this contract.

Here, Mr X has a right to buy the property at a specified price but is not obliged to do so, and he will exercise his right only when the property’s market price is more than the strike price.

This gives him a sense of control over the property he will buy in the future rather than leaving it in the hands of the market.

Both Buyers and sellers can close their position anytime (during market hours) or by expiry.

This is referred to as a Call Option.

Important Takeaways from this Example:

  1. The buyer has the right to buy the house at a Strike Price of 2 Crore.
  2. The buyer paid a premium of 1 lakh for this right.
  3. The seller has an obligation to sell at a Strike Price of 2 Crore.
  4. The expiry of this Option/Contract is 60 days.
  5. The buyer loses premium whether he buys a house or not.
  6. Call Option created on Underlying asset (house.)

Takeaways From Buyer Perspective:

  1. If you are an option buyer, your loss is limited to your paid premium. In the above example, it is Rs. 1 lakh.
  2. Call option buyers can make unlimited profits.
  3. If you are a call option buyer, you expect the asset’s value to increase.
  4. If the value of the underlying asset rises, the call option’s value also rises with it.
  5. Buyer Leveraged the 02 Crore worth house with only 1 lakh.

Takeaways From Seller Perspective:

  1. The maximum profit can be limited to the premium received. In the above example, it is Rs. 1 lakh.
  2. For Call Option sellers, the loss is unlimited.
  3. If you call option seller, you expect asset value to decrease or remain constant.
  4. If the asset’s value falls dramatically, the seller can make only limited profits.

Now, here’s a crucial question: why would anyone want to be a seller of options if their losses are unlimited and their profits are limited?

But there is something more interesting about options sellers. Selling a Call Option becomes like selling insurance. Sellers of this option (insurance) will get a premium.

If an insurance buyer does not claim the insurance, it is an automatic win situation.

Options are wasting assets; they lose their value daily. This benefits option sellers because the buyer’s premium is gradually eroding every day.

It’s known as time decay in technical terminology. Do not be concerned about Time Decay at this time. It is a Greek option. There are more Greek alternatives available, which you may learn about here.

Call Option Summary:

  1. Gives Buyer the Right to Buy, and Seller the Obligation to sell 
  2. Buyer pays premium – profits unlimited, loss limited, the stock must move in a bullish direction to make a profit 
  3. Seller receives premium – profit limited, loss unlimited, stock can remain flat or go bearish 
  4. Options are wasting assets and lose value every day to time decay 
  5. Time decay is Buyers enemy and Sellers friend 
  6. ITM, OTM and ATM have different prices and probabilities 
  7. ITM options have intrinsic and extrinsic value
  8.  ATM and OTM options have only extrinsic or time value

2. Put option:-

put option

A put option, also known as a put, is a contract that gives the holder the right to sell an asset at a set price before a predetermined date. 

Put options are the ultimate protector of your asset or portfolio against market volatility.

Put options are designed to protect investors from a downturn in the market. 

Put options increase in value when stock or asset goes down. They are powerful Bearish instruments.

The Buyer and Seller of the PUT Option have different roles and responsibilities.

Put option buyer:

 The buyer of a Put option has the right but not the obligation to sell a stock (underlying) at a certain price (strike price) by a certain date (expiry).

Put Option Seller: 

The seller of the PUT option has an obligation to buy a stock (underlying) at a certain price (strike price) by a certain date (expiry).

Understand PUT Option with Example:-

put option example

Insurance is the best example to understand the Put option. 

Assume if you buy a car for 20 lakhs (underlying asset). Here the underlying asset is the car. 

And here you pay a premium of Rs. 10000 per year as insurance for protecting your car.

Now, if a car has an accident and its value goes to zero, then this insurance(Put Option) allows us to sell this car at 20 lakhs.

You will get reimbursed by the insurance company.

The seller of the PUT Option insurance company has an obligation to buy it back, provided the car has been damaged or totalled.

Takeaways from this example:

  1. Buyer has right to sell at strike price of 20 lakh.
  2. Buyer paid a premium of 10K for this right.
  3. Seller has an obligation to buy at strike price of 20 lakh
  4. Expiry of this option is 1 year.
  5. Buyer losses premium regardless of what happens.
  6. Put option created on underlying asset car.
  7. Current price = 20 lakh (strike price)

Put Option Buyer Key features:

  1. Want stock or asset to go down (Bearish)
  2. Loss limited to the premium paid.

Put Option Seller Key features:

  1. Wants stock or asset to stay flat or go up. (Flat or Bullish)
  2. Wants move to happen slowly (Time Decays)
  3. Profit is capped to the premium

Some of the Key features of an option contract:

option contract
  1. Contracts can be bought and sold at any time before their expiration date. This means that options are traded over the counter, which means you need to find somebody to sell or buy.
  2. The buyer of the option pays the price, known as the premium, in exchange for the right but not the obligation to do something concerning that asset. If you purchase an option, you will have the right to exercise that contract as long as it is still valid, i.e. within the time limit agreed upon by both parties.
  3. The person who sells an option also gets a fee. He is said to have sold an Option. 
  4. Options are utilised for more than just trading; they are also used for hedging and speculation.
  5. The option’s value is decided by the strike price, the contract’s expiration date, the volatility of the underlying asset, and the underlying asset’s price.\

Why Options Are Called Leveraged instruments:

leverage instrument

Options are called Leveraged instruments because they allow investors to control large amounts of equity with only a small amount of capital.

Let’s take a look at a real-life example. Consider the following two individuals: Rishab and Vaibhav.

Case 1:

Rishab wishes to invest Rs. 1 lakh in the company “X Stock.” Stock X has a price per share of Rs. 1000.

As a result, Rishab owns 100 shares of an “X Stock” after investing Rs 1,00,000 in it.

Assume that “X Stock” grows 10% to Rs. 1100 per share.

Rishab, who owns 100 shares of X, now has an asset worth Rs 110,000 (Rs 110,000 + 10% increase), representing a profit of Rs 10,000 on a Rs 1,00,000 investment.

Case 2:

Vaibhav is interested in investing in a company known as “X Stock.” However, he lacks the necessary funds (1 lakh).

So instead of buying 100 shares of the company, which would cost 1 lakh, he purchases a single option contract for Rs. 10,000 for a limited time period.

Vaibhav buys this option and controls 100 shares of “X Stock” (1 contract x 100 shares per contract).

If the price of “X Stock” rises 10% to Rs. 1100 per share.

Vaibhav now owns an asset valued at Rs 110,000 (Rs 1,00,000 + 10% increase). Vaibhav, on the other hand, has put in Rs. 10,000 (as a premium) to gain control of this asset.

His profit will be Rs.10,000 on an investment of Rs. 10,000 whereas Rishab’s profit is Rs. 10000 on investment of Rs.1,00,000

The option contract allows Vaibhav to make the same return as Rishab but only 10% of the capital. 

This is how options are leveraged instruments.

Note: However, keep in mind that a contract has a finite lifespan. When an option expires, it loses all of its extrinsic value, and you may lose all of your money (Rs. 10,000 in our example).

Conclusion:-

conclusion

Options are a type of derivative where investors profit from price fluctuations in the underlying asset without taking ownership.

Trading in options is a skilled game. You can lose a lot of money relatively quickly if you don’t understand the basics. 

One slight mistake, and you could have lost your entire investment in seconds.If you want to trade-in options, you need a lot of effort and dedication.

I hope you enjoy your time here with me. But if you don’t find what you’re looking for, feel free to contact me directly by clicking here!

Disclaimer: This article is for educational purposes only and should not be considered as financial advice or a recommendation of any kind. The author of this piece does not guarantee its accuracy.
Always consult a financial advisor and do your research before trading or investing in any market!
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1 thought on “What are Options: Guide to Call and Put Options”

  1. It really gives me great knowlege.
    If a lerson wants to understand about options in stock market he or she should visit this site.

    Reply

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