What are Stock Options?

What is a Stock Option?

A stock option is a derivative contract that has the equity stock of a company as its underlying asset. It gives the holder of the option the right, but not the obligation, to buy or sell a specific number of shares at a predetermined price (the strike price) on a predetermined date (the contract expiration date).

Stock options derive their value from the underlying stock. So if the price of the underlying stock increases, the premiums of the call options of the stock will increase and those of put options will decrease. On the other hand, if the price of the underlying stock decreases, the premiums of the put options of the stock will increase and those of call options will decrease.  

Features of Stock Options

Stock options possess several unique features that make them a truly unique financial instrument in the Indian markets. Here is a quick overview of some of the key aspects of this investment option.  

• Leverage 

Stock options are leveraged financial instruments that enable investors to control a large position with a relatively small investment. One of the many advantages of leverage is that it can significantly amplify potential returns. However, it can also magnify losses if the markets were to move adversely.

• Limited Risk for Buyers

Since stock option buyers only have the right and not the obligation to purchase the underlying asset on the contract expiration date, they enjoy limited risk. The maximum loss for option buyers is limited to the premium paid for the option, regardless of how much the underlying stock price moves against their position. 

• Flexibility

Stock options are highly flexible financial instruments. They can be used for various strategies ranging from simple directional bets to complex multi-leg strategies for hedging or income generation.

• Sensitivity to Time

All stock options have a fixed expiration date and are highly sensitive to changes in time. Options are susceptible to a phenomenon known as time decay, where they tend to lose their value as the contract expiration date approaches. This can significantly affect the calculation of stock option premiums and strategy selection. 

• Standardized Terms

Options that are traded on a stock exchange are standardized in terms of contract size, expiration dates, and strike prices. These standardized terms help enhance liquidity and ease of trading stock options. 

• Risk Management

Stock options are highly useful for managing overall portfolio risk. For instance, investors can hedge the risk against a stock investment by taking up an offsetting position in an options contract with the said stock as the underlying asset to reduce potential downside risk.

How Does a Stock Option Work?

Understanding how stock options work is crucial if you wish to trade in them. Here is a quick breakdown of the key mechanics of this financial instrument.

Stock options can be categorized into two types: call options and put options. Purchasing call options gives you the right (and not the obligation) to purchase the underlying stock at the chosen strike price on the contract expiration date. Meanwhile, purchasing put options gives you the right (and not the obligation) to sell the underlying stock at the chosen strike price on the contract expiration date.

Since option buyers have the right, they get to choose whether to exercise the right or let the option expire worthless. Option sellers, on the other hand, are obligated to perform their end of the contract. Here is a hypothetical example of stock options to help you understand how this works. 

Assume there is a stock XYZ Limited that is currently trading at Rs. 2,000 per share on the spot market. You expect the price to rise in the future and therefore decide to purchase a call option with a strike price of Rs. 2,000. Now, on the contract expiration date, the price of the stock rises to Rs. 2,200, just as you expected. 

As an option buyer, you hold the right to purchase the stock at Rs. 2,000 per share even though the current price of the stock is Rs. 2,200. Therefore, you decide to exercise the call option. The seller who sold the call option contract to you is obligated to deliver the stock at Rs. 2,000, even if it means incurring a loss of Rs. 200 per share (Rs. 2,200 - Rs. 2,000). 

However, let us assume that the share price fell to Rs. 1,800 on the contract expiration date. If you exercise your call option contract at this point, you would essentially be purchasing the stock at Rs. 2,000 per share, even though the price is just Rs. 1,800 per share on the spot market. Since you would incur a loss of Rs. 200 if you exercise the option, you can choose to let the option expire worthless. In this case, the seller of the option would not be obligated to perform their end of the contract.  

How to Exercise Stock Options?

Exercising stock options is the process by which the option buyer implements their right to buy or sell the underlying stock at the strike price. Here is a step-by-step guide on how to exercise stock options. 

1. Determine if Exercising is Profitable

As an option buyer, before you decide whether to exercise your right or square off your position, you must first determine if exercising the option is profitable. 

In the case of a call option, exercising your right to purchase the stock is profitable only if the current stock price is higher than the strike price of the contract. In the case of a put option, exercising your right to sell the stock is profitable only if the current stock price is lower than the strike price of the contract.    

2. Check Your Trading Account 

Once you have decided to exercise your option, ensure you have sufficient funds (for call options) and shares (for put options) in your account to complete the transaction. 

3. Hold the Option Until the Contract Expiration Date 

Since stock options in India require compulsory delivery, all you need to do is simply hold the options contract until the end of the contract expiration date to exercise your right. If you do not wish to exercise your right, make sure to square off your position before the end of the last trading session.  

Also Read: Understanding Option Chains

Conclusion

Stock options are useful financial instruments that enable investors and traders to implement a wide array of strategies for speculation, income generation, and risk management. However, despite the potential benefits, options involve increased complexity and risk. 

The mechanics of option pricing, the impact of time decay, and the various trading strategies require a solid understanding and careful management. Here is where Motilal Oswal’s Research 360 can help. The platform provides you with real-time option-related data such as options chains, options Greeks, open interest, and a whole lot more. Sign up for the platform today and make trading stock options easier and more profitable.