Part 1 Ride The Big Moves

1. Introduction to Options

An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, called the strike price, before or on a specified expiration date. Unlike stocks, options do not represent ownership in a company; instead, they are derivatives whose value is derived from the underlying asset (stocks, indices, commodities, or currencies).

There are two primary types of options:

Call Option: Grants the holder the right to buy the underlying asset at the strike price.

Put Option: Grants the holder the right to sell the underlying asset at the strike price.

Options can be American style (exercisable any time before expiration) or European style (exercisable only on the expiration date).

2. Key Terminology in Options Trading

To trade options effectively, you must understand the key terms:

Strike Price (Exercise Price): The price at which the underlying asset can be bought (call) or sold (put).

Premium: The cost of buying an option. Determined by factors like intrinsic value, time to expiration, volatility, and interest rates.

Expiration Date: The date on which the option contract becomes invalid.

In-the-Money (ITM): A call option is ITM if the stock price > strike price; a put is ITM if stock price < strike price.

Out-of-the-Money (OTM): A call option is OTM if the stock price < strike price; a put is OTM if stock price > strike price.

At-the-Money (ATM): The stock price is approximately equal to the strike price.

3. How Options Work

Options allow investors to control a larger number of shares with relatively small capital. Let’s look at an example:

Example:

Stock price of XYZ Ltd.: ₹1,000

Call option strike price: ₹1,050

Premium: ₹50

Expiration: 1 month

If the stock rises to ₹1,200, the call option holder can exercise the option, buy at ₹1,050, and sell at ₹1,200, making a profit of ₹150 per share (minus the premium of ₹50, net profit = ₹100).

If the stock stays below ₹1,050, the option expires worthless, and the loss is limited to the premium paid.

This limited-loss feature makes options attractive for hedging.

4. Participants in Options Market

Options trading involves different market participants with varying objectives:

Hedgers: Use options to protect their existing investments from adverse price movements. For example, a stock investor buys a put option to safeguard against a potential fall in stock price.

Speculators: Seek profit from price movements without owning the underlying asset. They take higher risk for potentially higher rewards.

Arbitrageurs: Exploit price discrepancies between options and the underlying assets to earn risk-free profits.

5. Option Pricing Models

Option pricing is critical for traders. The two most commonly used models are:

Black-Scholes Model (for European options):
It calculates the theoretical value of options using factors such as stock price, strike price, time to expiration, volatility, and risk-free interest rate.

Binomial Model:
Uses a step-by-step approach to evaluate options, useful for American options due to their early-exercise feature.

Factors Affecting Option Premiums:

Intrinsic Value: Difference between the underlying price and strike price.

Time Value: Additional value due to remaining time until expiration.

Volatility: Higher volatility increases premiums.

Interest Rates and Dividends: Can influence option pricing.