How options work in the stock market? This is one of the questions a lot of beginner options traders have in their heads before they start their trading journey in this interesting segment!
Well, it’s great that you are pondering over this concept and not just blindly putting in your open for investments without understanding the fundamentals of this segment.
Let’s talk about it in this quick review and understand the intricacies that will set you up for this segment.
How Options Work In Stock Market?
An option is a contract, which gives the holder the right to buy or sell an underlying asset or instrument at an agreed price during a specific date. The option buyers have rights and the option sellers have obligations for the underlying security.
The two main types of options are call option and put option. Both work differently for the holders. So, if you want to know how options work, you must have a good understanding of the inner workings of both (call and put options).
An option holder has the right to participate in the future price change of an underlying asset. So, owning a call is sufficient, if you want to take part in the uptrend of a stock.
Factors of How Options Work
These are the factors that help to determine the option prices:
The current price of underlying security:
The current price of a stock is an important factor in determining the option price.
There is a direct relationship between the current price of the security to the option premium. When the current value of the underlying security increases, call option premium also increases and put option premium decreases.
Another important factor that decides How Options Work is the strike price.
There are different strike prices of an option. Every strike price of an option shows a different response to the changes in the market. Option price changes more for those strikes which are near to the current price of the underlying security and vice-versa.
The period before expiry:
As you know that all options have a definite lifespan and expire after a certain time.
The value of an option increases with more time available before expiry. This is because more time available before expiry gives more chance of profitable movement of the stock.
Both call and put options get affected by the value of the dividend declared by the company.
The price of the stock gets diminished by the price of the ex-dividend price (Stock trades, yet holders get no dividend termed as ex-dividend). With the increasing dividend, the value of put increases and the value of call decreases.
This plays a vital role in the stock market. The difference in the day-to-day price of a stock or any security is volatility.
The chance of making a profit with high volatility is more than the low volatility. Thus, the options on high volatility are expensive than low volatility or no volatility stocks.
How Options Work in India
The value of an option contract goes up with the probability of a rise in the future price event.
An option would be costlier if there is more chance of something to happen or we can say if there is more possibility of profit from an event of the future, the more costly an option would be.
It implies an option depends on determining the possibility of the future price of events up to the maximum extent.
Let’s take an example to understand an option contract more clearly and with that, you will get an easier idea of How Options Work.
Suppose a call option of State bank of India (SBI) stock has the strike price of ₹200 expiring in three months. The current share price of SBI is ₹165. Here, you should keep in mind that you can buy SBI share at any time within the next three months at ₹200.
If the price of the SBI rises above ₹200 within 3 months, then the call option will come under in-the-money.
As an investor, you will always try to get a better value of your call option. The price of the stock which goes closer to the strike price, always increases the value of the call option. And this increases the chance of in-the-money call expiry.
By taking the same example of SBI, We can see if the price of the SBI stock remains at ₹165, then ₹185 strike call will have a higher value than ₹200 strike call. It happens because the possibility to reach the price of the SBI stock to ₹185 is higher than the possibility to reach at ₹200.
You know what? Let’s dig even deeper by going through the below example to understand how options work:
Here you will see what will happen in different scenarios of a call option.
Suppose State bank of India (SBI) stock’s current price is ₹170. An investor purchases a call option of State bank of India (SBI) at a price of ₹10 per contract (1 contract=100 share). So, the actual cost of this option is (₹10*100 shares =₹1000)
Here are different scenarios:
1. At the time of expiry, SBI is trading at ₹190:
Here, the investor has the right to purchase those shares at the price of ₹170 and can immediately sell the same at ₹190. This option is called ‘In-the-money’. As the option is sold for ₹20 per contract (₹190 – ₹170), means the total sale of ₹20*100=₹2000.
Here the profit from this trade is (₹2000 – ₹1000= ₹1000) to the investor. Makes sense, right?
2. At the time of expiry, SBI is trading at ₹170:
By using the same analysis, an investor will get no profit by exercising the call option. As the current price and strike price both are equal to ₹170. So, the investor will get no profit from this trade. This option is called ‘At-the-money’.
In fact, there is a bit of loss involved when the investor has actually paid ₹1000 upfront. This money is never going to come back in this trade and thus, is counted as a loss trade.
3. At the time of expiry, SBI is trading at ₹160:
Again, with the same analysis, an investor will suffer from the loss of ₹(160-170)= ₹(-10*100) = -₹1000.
Adding the additional ₹1000 that was paid upfront makes the total loss to ₹2000
This option is called ‘Out-of money’. Here, the investor will lose 100% of money.