If you are an investor looking for short-term financial instruments, Option is a great option. It is a derivative contract that gives the owner the right to buy or sell securities at an agreed-upon price within a certain period. Although there are many types of options in the stock market, there are broadly two types of options namely,Call and Put.
Call Option
A call option contract, in simple terms, is a “right to buy”. It gives the owner of this contract the right to buy a stock at an agreed-upon price, also known as the strike price, at any time before or on the expiration date. This Options type is bought when the investor expects the market price of the stock to rise in the future (i.e. a bullish market). When the market price goes up, the contract-holder can exercise their option and buy the stock at the strike price, which is below the market price at the time, thereby making a profit.
Put Option
Conversely, a Put option gives the owner a “right to sell”. A Put holder can sell as stock at a strike price within the expiration period. When an investor expects the market price to fall in the future (i.e. a bearish market), that’s when they place a Put Option. As the market price of the underlying asset falls, the Put holder can exercise their right to sell it at the strike price, which is higher than the market price at the time. Thus, the investor makes a profit.
What happens when the price movement is not favorable to the investor?
In both types of options in the stock market, the loss is limited to the premium of the Options contract. In case one buys a call option and the price falls, they are not obligated to exercise their right to buy. They can simply let the contract expire without exercising it. Similarly for a put-holder, if the market price of the stock were to increase, they can choose not to sell at all.
Options are further classified based on the underlying security and the expiration cycle. In the Indian Options market, there are various securities for which an Options contract, both Call and Put, can be purchased. The expiration cycles between different Options can range from weekly to long-term (up to three years). Here’s a closer look at these types of Options.
Types of Options based on an underlying security
The most common type of option is a stock option in which the underlying security is stock in a publicly listed company. Therefore, there are various option types depending based on the assets. Here are a few examples of different types of options based on underlying security:
- Stock Options: A very popular choice amongst investors, it has the shares of a publicly listed company as its underlying security.
- Index Options: Quite like the stock options, instead of a particular company’s shares, the Index option is based on an index like NSE, BSE, etc.
- Forex/Currency Options: This option type gives the owner the right to buy or sell a specific currency at an agreed exchange rate.
- Futures Options: For this type of option the underlying security is a specified futures contract. A futures option allows the owner to enter into that specified futures contract.
- Commodity Options: In Commodity Options, the underlying asset can either be a physical commodity or a commodity futures contract.
Types of options based on Expiration Cycle
The expiration cycle refers to the time frame within which the contract-owner can exercise their right to buy or sell the relevant asset. While some option types are available with a fixed expiration cycle, you can choose an expiration cycle for other types of options.
Examples of different types of options based on the expiration cycle are listed below:
- Regular Options: These options have a standard expiration cycle. You can choose between at least four different expiration months, according to your preference and strategy.
- Weekly Options: This option type has a much shorter expiration date and they are also known as weeklies. However, they work on the same principles as regular options.
- Quarterly Options: These are also known as quarterlies. The investor can choose any expiration cycle between the nearest four quarters plus the final quarter of the following year.
- Long-Term Expiration Anticipation Securities: This type of option, as the name suggests, is for a long term lasting from one to three years before expiry. Regular Options: These options have a standard expiration cycle. You can choose between at least four different expiration months, according to your preference and strategy.
With various types of Options contracts available to invest in, it can be tricky to choose the one suitable for you. The ideal way to make the best out of your investing journey is to do your research or consult the experts at IIFL to help you choose the right strategy that will suit your financial goals.
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Frequently Asked Questions Expand All
What are exotic options?
Exotic options are a more complex type of Options. It has a different expiration cycle, strike price, payment structure and underlying asset. These are hybrid securities that can often be customized to the investor’s needs. The advanced and complex nature of these options makes them more profitable and perfect for hedging and risk management.
What is an example of a Put and Call option?
Example of Call option: Stocks of Company X are trading at ₹500. You buy a call contract at a strike price of ₹500 for a premium of ₹10. The trading price of Company X’s stocks starts rising and has reached ₹550. You can exercise your right to buy at the strike price, i.e. ₹500 and sell it at the market price i.e. ₹550. Thus, you have made ₹40 as profit (₹50 - ₹10 paid as premium).
Example of Put option: SImilarly, you expect the price of Company X’s stock to fall and buy a put option for a strike price of ₹500 for a premium of ₹10. The market price of the stock falls and becomes ₹470. You can exercise your right to sell at the strike price i.e. ₹500, making a profit of ₹20 ( ₹30 - ₹10 paid as premium).
How do I know what options to buy?
Your financial goals will determine the best options strategy you should use. There are various strategies like straddle, a bear call spread; bear put spread, bull call spread, bull put spread, etc. that you can use to maximise returns. It is recommended to have a clear exit strategy in mind before trading in Options.
