Options are versatile derivative instruments. Options have helped to revolutionize finance. Corporations use them in their financing decisions to control risk.
Options are means of insurance against adverse price movement. A call option is as means of ensuring a maximum purchase price and a put option provides a minimum selling price. A hedger uses options when the price movement is uncertain. So, options supply the insurance needed to overcome the uncertainty in prices.
Options provide high leverage as with a small investment in the form of premium, one can take exposure in the underlying asset of much greater value.
There is a pre-known maximum risk and a large profit potential for option buyer.
Employers Stock Options (ESOPs) have become a popular compensation tool with more and more companies offering the same to their employees. ESOPs are subject to lock-in periods, which could reduce capital gains in falling markets. An ESOP holder can buy put options in the underlying stock and exercise the same if the market falls below the strike price and lock-in his sale price.
Many investors trade options to speculate on the price movements of the underlying stock.
Institutional investors, such as mutual funds and pension funds, use options to adjust the risk-and-return characteristics of their portfolio.
Trading in options is cheaper than trading in stocks due to lower transaction costs in options trading.
Options provide a means of taking a short position on a stock puts or writing calls. Options allow speculators to take views on the direction of stock price movements, on the speed and extent of such movements, and no changes in market expectations and extent of price volatility.
Options help creating synthetic products which reveal and increase the trading potential of otherwise not traded assets/contract.
Pay off Profile of Call Options:
Call Option Buyer: A call option gives the buyer of that option the right, but not the obligation, to buy the underlying asset at a particular price, known as the exercise, or strike, price. The buyer of an option has to pay a premium at the time the option is bought. As the buyer is not obliged to exercise an option, he can simply disregard it or not exercise it, in which case he losses the premium paid. His risk or maximum loss is limited to the extent of the premium paid. But there is no upper limit to his potential profits if prices of the underlying asset go up. His break point is equal to the strike price plus premium.
Consider a share whose strike price is Rs 100 per share and the call premium is Rs 6 per share. If, at expiration, the share price is Rs 100 or lower, the option expires worthless. The call buyer will lose the premium of Rs 6 per share. If the share price on the expiration date is Rs 106, the call buyer breaks even (Rs 100 strike price plus Rs 6 premium less Rs 106 share price on expiration). At any share price above Rs 106, the call buyer will profit. For every one rupee rise in the stock price, the call is worth Re 1 more.
The buyer of a call option is said to have a long call position. There are no margin requirements for a call option buyer. Time affects the call buyer adversely as with passage of time the value of the call option falls to nearly zero.
Call option Seller:
For every buyer of an option, there must be a seller who is usually referred to as the writer. The seller of the call option is said to have a short call position. The seller is moderately bearish as he expects the prices of the underlying asset to go down. As options are zero-sum games, profits of the buyer must equal losses of the seller, and vice-versa. The seller or writer of a call option must deliver the stock at the strike price agreed upon if the buyer chooses to exercise the option. The call option seller receives the premium from the buyer. He is subject to margin requirement. This margin can change on a day-to-day basis, depending predominantly on the price of the scrip itself. The call option seller’s risk profile is unlimited, if prices go up. His profit potential or maximum profit is limited to the premium received. His break even point is equal to the strike price plus premium received. A call option will fail in value if the underlying scrip or index falls. The investors, in such case, should buy it back and earn profits. Suppose, Reliance is quoting at Rs 285 and the Reliance 280 call is quoting at Rs 20. If reliance falls to Rs 265 in a week, the call might have moved down to Rs 10. The investor on buying it back earns a profit of Rs 10.