A stock option is a type of derivative that gives you the right, but not the obligation, to purchase a certain quantity of a particular stock at a predetermined price at a set date in the future. To understand exact stock options meaning it’s essential to take into account `right, not the obligation’. What this means is that when you buy this type of contract, you can choose whether or not to buy it at that particular price.
These were introduced in India in India in 2002. Today you can trade in futures and options on the exchanges in as many as 175 securities.
Stock options explained
Why would anyone want to trade in them? Well, for one, you can do so by investing a fraction of the capital. Let’s see how that works.
Let’s say; you are expecting shares of Company ABC to increase in the future from Rs 100 to Rs 120 and want to take advantage of it. You then purchase 1,000 options contracts of the stock at Rs 120 each (the `strike price’) for Rs 120,000. The best part of it is that you don’t have to pay the entire Rs 120,000, but only the premium when you enter into the contract. The premium is only a fraction of the value of the underlying asset (stock). So if the stock price rises to Rs 120, you can make a profit of Rs 20,000 (120-100×1000) without having to spend Rs 120,000!
If the stock moves in the opposite direction and falls to Rs 80, you have the choice of not exercising your right to buy the shares. In that case, the only amount you stand to lose is the premium. Therefore the losses you will make is restricted to the premium paid, even if the share prices go into a freefall to Rs 50!
Another advantage is the leverage you get. Since the premium is only a fraction of the value of the underlying (stock), you can trade much higher volumes. Let’s say, if you had Rs 1 lakh to invest and purchased stock, whose prices then went up by 10 percent to Rs 110,000, you would have made a profit of Rs 10,000. If you invest that Rs 1 lakh, you would get exposure to Rs 10 lakh worth of shares (assuming premium is 10 percent). If stock prices rise by 10 percent, you will stand to gain Rs 90,000!
How to invest in stock options
You can trade in these options, just like shares. You have to pay a premium, which is determined by several factors like the length of time between the beginning of the contract and the expiry date, the current price of the stock, and so on. The premium keeps changing over time, depending on developments in the stock. You have to pay premium to the broker, which is passed to the exchange, when then passes it on the seller of the stock option, or `writer’.
Stock options contracts are for periods of 1, 2 or 3 months. However, a buyer can exit the contract at any time before the expiry date either to book profits or to contain losses. The options seller or writer too can exit the contract if prices don’t move favourably. But in this case, he would have to pay a premium to the buyer. This premium will be higher since the contract is in the buyer’s favour, and not in the seller’s.
Types of stock options
There are two basic types of stock options. One is the call option , which gives you the right to buy stock. Another is the put option, which gives you the right to sell the stock. Generally, call options are preferred when stock prices are expected to go up. Put options are preferred when stock prices are expected to go down.
For the risk-wary investor, stock options offer an excellent way of getting into the stock market. Since there is no compulsion to buy/ sell at the end of the expiry period, your potential losses are limited. It is better than buying the stock itself since your downside in case its price goes into a free-fall is unlimited.
Features of Stock Options
Understanding the features of stock options is crucial for any trader. Here are the main characteristics:
- Expiry Date
Options allow traders to bet on a stock’s price movement within a specific timeframe, known as the expiration date. The expiration date is vital because it helps traders assess the time value of puts and calls, a key component in various option pricing models.
- Strike Price
The strike price determines whether an option should be exercised. By the expiration date, a trader anticipates the stock price to be above (for a call option) or below (for a put option) this level. For instance, if a trader believes IBM’s stock will rise, they might purchase a call option with a specific strike price and expiration month.
- Contract Size
Each options contract represents a specific number of underlying shares a trader intends to buy. Typically, one contract equates to 100 shares of the underlying stock.
- Premium
The premium is the cost of purchasing an option. It is calculated by multiplying the price of the call or put by the number of contracts and then by 100. This cost is the upfront payment a trader makes to acquire the option.
How to invest in stock options
Investing in stock options can be rewarding if you understand the process. Here are simple and engaging steps to get started:
1. Understand the Basics
Before diving in, familiarise yourself with key terms like strike price, premium, expiry date, and contract size. Knowing these will help you navigate the options market more confidently.
2. Choose Your Options
Choose between purchasing a put option, which bets the stock will decline, or a call option, which bets the stock will climb. Your decision is based on your investing plan and market forecast.
3. Pay the Premium
You’ll need to pay a premium to your broker, which is then passed to the exchange and finally to the option seller or the “writer.” The premium amount fluctuates based on time until expiration, stock price, and market conditions.
4. Select Contract Duration
Options contracts typically last for 1, 2, or 3 months. Choose a duration that aligns with your trading strategy and market predictions.
5. Monitor and Manage
Keep an eye on your options. You can exit the contract anytime before expiry to lock in profits or limit losses. Sellers can also exit, but they may need to pay a higher premium to the buyer if the market is unfavorable to them.
6. Vesting and Exercising
You can only exercise options that have vested. If your options are granted, you have a few choices:
- Pay Cash: Execute the options at the strike price if you have enough funds.
- Cashless Exercise: Some employers allow you to sell enough options to cover the costs of exercising the others.
- Sell Immediately: Exercise and sell your options at the current market price to avoid future price volatility and upfront cash requirements.
7. Be Aware of Time Constraints
Recognise that options expire, on average, five to ten years from the award date. If you leave your job before your options vest, you might lose the unvested options.
Conclusion
Stock options offer flexibility and leverage in the market, allowing investors to potentially profit from price movements with limited risk. Understanding their mechanics, types, and key features is crucial for navigating this financial instrument effectively. Whether you’re bullish or bearish on a stock, options provide strategic opportunities aligned with your market outlook.
Ready to explore stock options and elevate your trading strategy? Open a demat account with Angel One today to access advanced tools, comprehensive research, and a seamless trading experience.
FAQs
Is options are better than stocks?
Options can offer higher potential returns but come with greater risk and complexity. They are better suited for experienced traders looking for flexibility and leverage.
What's the difference between a stock and an option on a stock?
A stock represents ownership in a company, while an option is a contract that gives the right (but not the obligation) to buy or sell the stock at a specified price within a certain timeframe.
How can I buy stock options?
To buy stock options, you need to open a brokerage account, understand key terms like strike price and premium, choose between call or put options, and pay the premium. Options can be purchased through online trading platforms like Angel One.
