An (equity) option is linked to a specific stock. The price of the option is much less than the price of the underlying stock, which is a major reason for the attractiveness of options. If the price of the stock changes, the price of the option also changes, although by a smaller amount. As the price of a stock goes through its daily ups and downs, the price of an associated option undergoes related fluctuations.
For a call option, if the stock price goes up, the option price also increases. If the stock price goes down, the price of the call decreases. For a put option, if the stock price goes down, the option price increases. If the stock price goes up, the price of the put decreases. This sounds like owning a call option is similar to holding a long position in the stock because you have the potential to make a profit when the stock price goes up. And owning a put option is similar to holding a short position in the stock because you have the potential to make a profit when the stock price goes down. In a rough sense, this analogy is true, but there are some significant differences.
Options and stocks difference
Options typically cost only a fraction of the stock price. If you think XYZ stock, currently at Rs 49 per share, is going up in price, you can purchase 100 shares at a cost of Rs 4,900. If instead you buy 1 call option contract (1 contract represents 100 shares of stock), you might pay only Rs2 per share for a total of only Rs 200 to participate in an upward price movement of XYZ. Analogously, if you think XYZ is going down in price, you could short 100 shares of stock, but that creates a margin responsibility in your brokerage account, which can become costly if XYZ goes up. If instead you buy one put contract, you might pay just Rss 2 per share for a total of only Rs 200 to participate in a downward price movement of XYZ.
Time Limitation
One reason options are cheap is that they are time-limited. A long or short position involving stock can be held indefinitely, but an option position can be held only until the expiration date associated with the option. When you buy an option, you can choose from various expiration dates. You always have the choice of various monthly options that expire on the last thursday of the expiration month. The expiration months offered to you include the current month, the next month, and a selection of other months extending out to a year or more. Some stocks and ETFs now offer weekly options with a 9-day life also expiring on a Friday.
PRICE MOVEMENT
As the stock price changes, the option price also changes, but by a lesser amount. How closely the change in the option price matches the change in the stock price depends on the reference price designated in the option contract. This reference price is called the strike price. When you decide to purchase an option, you can choose from several strike prices. For higher-priced stocks, the strike prices of its options are set at RS 150 increments within the broad trading range of the stock. For lower- and medium-priced stocks, strike prices are offered in increments of rs 10 or even Rs 20 . There is a terminology used by options traders to describe the relative relationship between the stock price and the strike price of an option. If the strike price of either a call or a put is nearly the same as the stock price, the option is said to be at-the-money. If the strike price of a call (put) is above (below) the stock price, the option is said to be out-of-the-money. If the strike price of a call (put) is below (above) the stock price, the option is said to be in-the-money.
For example, suppose XYZ stock is priced at rs 49 and a call option with a Rs 50 strike price is purchased for Rs 2 per share. If the price of XYZ stock rises by RS 2 up to Rs 51 soon after purchasing the option, the price of the call would typically increase by about Rs 1, raising its price by up to Rs 3 per share. Suppose instead, a call option with a Rs 55 strike price was purchased for Rs 0.75 per share. Then the same Rs 2 move in the stock price might increase the price of the call by only Rs 0.20, up to Rs 0.95 per share. On the other hand, a call option with a Rs 45 strike price and a cost of Rs 5 per share might see an increase in the price of the call by as much as Rs 1.60, up to Rs 6.60 per share.
Financial Risk
When you buy an option, your maximum risk is limited to your original cost of that option. The worst outcome is that you hold the option until expiration, at which time it has become worthless because the stock price failed to move in a beneficial manner. For example, if you buy one option contract for a price of Rs 2 per share, your cost is Rs 200 (2 × 100 = 200). This is the most that you can lose. Compare that dollar risk with the risk of either owning or shorting 100 shares of stock. When the stock price undergoes a substantial move against your long or short position in the stock, the dollar loss will be much greater than the cost of a call or put option. A major risk with options is that you invest heavily by purchasing numerous contracts and then allow them to expire worthless. This represents a 100 percent loss on a significant investment. Of course, it is rarely necessary to lose all your original investment when the stock does not move as expected. Typically, you can sell your options before expiration and recover some part of your original cost.
For a call option, if the stock price goes up, the option price also increases. If the stock price goes down, the price of the call decreases. For a put option, if the stock price goes down, the option price increases. If the stock price goes up, the price of the put decreases. This sounds like owning a call option is similar to holding a long position in the stock because you have the potential to make a profit when the stock price goes up. And owning a put option is similar to holding a short position in the stock because you have the potential to make a profit when the stock price goes down. In a rough sense, this analogy is true, but there are some significant differences.
Options and stocks difference
Options typically cost only a fraction of the stock price. If you think XYZ stock, currently at Rs 49 per share, is going up in price, you can purchase 100 shares at a cost of Rs 4,900. If instead you buy 1 call option contract (1 contract represents 100 shares of stock), you might pay only Rs2 per share for a total of only Rs 200 to participate in an upward price movement of XYZ. Analogously, if you think XYZ is going down in price, you could short 100 shares of stock, but that creates a margin responsibility in your brokerage account, which can become costly if XYZ goes up. If instead you buy one put contract, you might pay just Rss 2 per share for a total of only Rs 200 to participate in a downward price movement of XYZ.
Time Limitation
One reason options are cheap is that they are time-limited. A long or short position involving stock can be held indefinitely, but an option position can be held only until the expiration date associated with the option. When you buy an option, you can choose from various expiration dates. You always have the choice of various monthly options that expire on the last thursday of the expiration month. The expiration months offered to you include the current month, the next month, and a selection of other months extending out to a year or more. Some stocks and ETFs now offer weekly options with a 9-day life also expiring on a Friday.
PRICE MOVEMENT
As the stock price changes, the option price also changes, but by a lesser amount. How closely the change in the option price matches the change in the stock price depends on the reference price designated in the option contract. This reference price is called the strike price. When you decide to purchase an option, you can choose from several strike prices. For higher-priced stocks, the strike prices of its options are set at RS 150 increments within the broad trading range of the stock. For lower- and medium-priced stocks, strike prices are offered in increments of rs 10 or even Rs 20 . There is a terminology used by options traders to describe the relative relationship between the stock price and the strike price of an option. If the strike price of either a call or a put is nearly the same as the stock price, the option is said to be at-the-money. If the strike price of a call (put) is above (below) the stock price, the option is said to be out-of-the-money. If the strike price of a call (put) is below (above) the stock price, the option is said to be in-the-money.
For example, suppose XYZ stock is priced at rs 49 and a call option with a Rs 50 strike price is purchased for Rs 2 per share. If the price of XYZ stock rises by RS 2 up to Rs 51 soon after purchasing the option, the price of the call would typically increase by about Rs 1, raising its price by up to Rs 3 per share. Suppose instead, a call option with a Rs 55 strike price was purchased for Rs 0.75 per share. Then the same Rs 2 move in the stock price might increase the price of the call by only Rs 0.20, up to Rs 0.95 per share. On the other hand, a call option with a Rs 45 strike price and a cost of Rs 5 per share might see an increase in the price of the call by as much as Rs 1.60, up to Rs 6.60 per share.
Financial Risk
When you buy an option, your maximum risk is limited to your original cost of that option. The worst outcome is that you hold the option until expiration, at which time it has become worthless because the stock price failed to move in a beneficial manner. For example, if you buy one option contract for a price of Rs 2 per share, your cost is Rs 200 (2 × 100 = 200). This is the most that you can lose. Compare that dollar risk with the risk of either owning or shorting 100 shares of stock. When the stock price undergoes a substantial move against your long or short position in the stock, the dollar loss will be much greater than the cost of a call or put option. A major risk with options is that you invest heavily by purchasing numerous contracts and then allow them to expire worthless. This represents a 100 percent loss on a significant investment. Of course, it is rarely necessary to lose all your original investment when the stock does not move as expected. Typically, you can sell your options before expiration and recover some part of your original cost.
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