Options are contracts that provide the bearer with the right, but not the responsibility, to purchase or sell a predetermined quantity of an underlying asset at a predetermined price at or before the contract's expiration date. Options, like most other asset classes, can be purchased through brokerage accounts. In this article, we will see the meaning of options, types of options and benefits of options.

What is Options Trading?

• A contract that is connected to an underlying asset, such as a stock or another security, is known as an option. Options contracts are valid for a specific length of time, which could be as little as a day or as long as a few years.
• When you acquire an option, you have the opportunity but not the obligation to trade the underlying asset. It's called exercising the choice if you decide to do so.
• Options contracts, like futures contracts, reduce the risk for purchasers by establishing a pre-determined future price for an underlying asset. However, unlike futures contracts, options contracts do so without the commitment to buy.
• The 'options writer' is the person who sells an options contract. In an options contract, the seller, unlike the buyer, has no rights and is obligated to sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date in exchange for an upfront payment.
• At the moment of signing into an options contract, no tangible documents are exchanged. The transactions are simply recorded on the stock market where they are routed.

Different Types of Options

Calls and puts are the two main types of options

What is a call option?

• A call option offers you the right to purchase underlying securities at a specific price within a specified time frame (think of it as calling the underlying security to you.) The strike price is the amount you pay. The expiration date is the deadline for exercising a call option.
• There are two types of call options: American and European. You can acquire the underlying asset at any moment up until the expiration date using American-style options. You can only buy the asset on the expiration date with European-style options.
• For instance, Assume a trader purchases one call option contract with a strike price of Rs.100 on RBC stock for 100 shares. For the option, he pays Rs.10. RBC stock shares are selling for Rs.110 on the option's expiration date. The option's buyer/holder exercises his right to buy 100 shares of ABC for Rs.100 each (the option's strike price). He sells the stock at the current market price of Rs.110 a share right away.
• The potential payment for a call option on RBC stock with an Rs.10 option premium and an Rs.100 strike price is shown below. If the price of RBC's stock does not rise over Rs.100, the buyer loses Rs.10. The call writer, on the other hand, is in the money as long as the stock price remains below Rs.100.

What is a put option?

• The opposite of a call option is a put option. A put option, rather than giving you the right to buy the underlying security, provides you with the right to sell it at a certain strike price (think of this as putting the underlying security away from you.)
• Expiration dates apply to put options as well. When you can use them, the same style rules apply (i.e., American or European).
• For instance, an investor buys a put option of RBC stock at Rs.90 by paying a premium of Rs.10 to the writer. He can sell the stock any time to the writer before the expiry date at the strike price of Rs.90. If the investor expects the price of RBC stock to fall below Rs.90 in the coming days then he can use the put option to minimize the losses.
• The payoff for a hypothetical RBC put option with an Rs.10 option premium and a strike price of Rs.90 is shown in Figure. The maximum loss for the buyer is the cost of the put option contract (Rs.10) if the stock price doesn’t fall and he doesn’t execute his put option.

Options - Benefits

• Options are better hedging-and-trading tools than futures.
• The buyer's losses are restricted, and costs are lower. The buyer is less affected by market price volatility.
• The introduction of options will increase total market participation while also complementing current futures.
• It makes the commodities market more efficient.
• The use of futures and options together can provide market participants with the benefit of futures price discovery.

Futures vs Options

Conclusion

Options are used to generate income, speculate, and hedge risk. Because they draw their value from an underlying asset, options are referred to as derivatives. A stock option contract normally represents 100 shares of the underlying stock, but options on any underlying asset, including bonds, currencies, and commodities, can be negotiated.

FAQs

What is options trading?

What are the types of options?

How does options trading differ from futures trading?

What are the benefits of options trading?

How does one start options trading?

MCQs 

1. What is a call option?

A) The right to sell an underlying asset at a specified price

B) The right to buy an underlying asset at a specified price

C) The obligation to buy an underlying asset

D) The right to execute the contract at any time

2. Which of the following is true about a put option?

A) It allows the buyer to sell the asset at a predetermined price

B) It obligates the seller to buy the asset

C) It provides the buyer with the right to buy the asset

D) It is similar to a futures contract

3. How does options trading differ from futures trading?

A) Options obligate the buyer to execute the trade, while futures are optional

B) Futures have limited risk, while options have unlimited risk

C) In options trading, the buyer has the right but not the obligation to execute the trade

D) Options are only available for stocks, whereas futures can be traded on commodities

4. What does a trader pay to buy an options contract?

A) Premium

B) Margin

C) Commission

D) Spread

5. Which of the following is a benefit of options trading?

A) Unlimited potential loss

B) High upfront cost

C) Limited risk for the buyer

D) No flexibility in strategies

GS Mains Questions and Model Answers

Q1: Discuss the significance of options trading in the Indian financial markets.

Answer: Options trading plays an important role in the Indian financial markets by offering investors and traders the ability to hedge risks, speculate on price movements, and increase market liquidity. With the introduction of options in India, market participants can protect their portfolios from adverse price movements in stocks and other assets. The flexibility of options allows traders to adopt various strategies, such as covered calls or protective puts, to manage risk. Furthermore, options enhance price discovery and contribute to a more efficient market by allowing investors to express views on market direction with relatively low initial capital. Over time, options trading has become a vital tool in the derivatives segment of the Indian financial markets, attracting both institutional and retail investors.

Q2: Evaluate the risks and rewards involved in options trading for retail investors in India.

Answer: For retail investors, options trading presents an opportunity to benefit from price movements with relatively low initial investment. The key reward in options trading is the potential for high returns due to the leverage provided by options. However, the risks can be significant, particularly if the trader does not fully understand the mechanics of options. The primary risk for a buyer is the loss of the premium paid for the option if the market does not move as expected. For sellers of options, the risk is theoretically unlimited, as they may be forced to buy or sell the underlying asset at an unfavorable price. Despite these risks, options trading can be an effective tool for risk management and generating income when approached with the right knowledge and strategy.

Q3: Compare and contrast options trading with futures trading in the context of the Indian economy.

Answer: Options and futures are both derivative instruments used for hedging and speculation, but they differ significantly in terms of risk and obligation. In options trading, the buyer has the right, but not the obligation, to buy or sell an asset at a predetermined price, while in futures trading, both parties are obligated to execute the contract at the agreed price at the expiration date. This makes options a more flexible and less risky instrument compared to futures. Options are typically used for hedging strategies that require limited risk exposure, while futures can be used to hedge against more significant price fluctuations, though they come with the obligation to fulfill the contract. In India, the futures market has been widely used for commodities and stock indices, while options trading is growing in popularity, especially among retail investors due to its lower upfront cost and flexibility.

Previous Year Questions on Options Trading

1. UPSC CSE 2017

Question: "Analyze the role of derivatives like options and futures in the Indian financial markets."

Answer: Derivatives like options and futures have become important tools in the Indian financial markets for hedging risks, speculating on market movements, and enhancing liquidity. They allow investors to gain exposure to underlying assets without having to own them directly. Options provide flexibility and limited risk for buyers, while futures contracts offer a more straightforward method for managing price risk. Both instruments contribute to efficient price discovery, though they also come with inherent risks. The growth of derivatives markets has facilitated more sophisticated investment strategies and provided risk management solutions in the Indian context.

2. UPSC CSE 2019

Question: "Explain the concept of options trading and assess its advantages and disadvantages for Indian investors."

Answer: Options trading is the process of buying or selling options contracts, which provide the right but not the obligation to buy or sell an asset at a specific price within a set period. For Indian investors, options offer a way to hedge against market volatility, speculate on price movements, and manage risk with a relatively low initial investment. The advantages include limited risk for the buyer (restricted to the premium paid) and the ability to use various strategies. However, the complexity of options, potential for significant losses for sellers, and the need for a sound understanding of market trends are disadvantages. Despite these risks, options trading provides flexibility and opportunities for investors willing to invest time in learning the mechanics.