What Are Options?

Options are tradable contracts that investors use to speculate about whether an asset’s price will be higher or lower at a certain date in the future, without any requirement to actually buy the asset in question.

Nifty 50 options, for example, allow traders to speculate as to the future direction of this benchmark stock index, which is commonly understood as a stand-in for the entire Indian stock market.

At first glance, options seem a little counterintuitive, but they’re not as complicated as they appear. To understand options, you just need to know a few key terms:

Derivative Options are what’s known as a derivative, meaning that they derive their value from another asset. Take stock options, where the price of a given stock dictates the value of the option contract.

Call option and put option A call option gives you the opportunity to buy a security at a predetermined price by a specified date while a put option allows you to sell a security at a future date and price. Strike price and expiration date. That predetermined price mentioned above is what’s known as a strike price. Traders have until an option contract’s expiration date to exercise the option at its strike price.

Premium The price to purchase an option is called a premium, and it’s calculated based on the underlying security’s price and values.

Intrinsic value and extrinsic value Intrinsic value is the difference between an option contract’s strike price and current price of the underlying asset. Extrinsic value represents other factors outside of those considered in intrinsic value that affect the premium, like how long the option is good for.

In-the-money and out-of-the-money Depending on the underlying security’s price and the time remaining until expiration, an option is said to be in-the-money (profitable) or out-of-the-money (unprofitable).

How Options Pricing Works

Let’s make sense of all of this terminology with an example. Consider a stock that’s currently trading for INR 100 a share. Here’s how the premiums—or the prices—function for different options based on the strike price.

When trading options, you pay a premium up front, which then gives you the option to buy this hypothetical stock—call options —or sell the stock—put options—at the designated strike price by the expiration date.

A lower strike price has more intrinsic value for call options since the options contract lets you buy the stock at a lower price than what it’s trading for right now. If the stock’s price remains INR 100, your call options are in-the-money, and you can buy the stock at a discount.

Conversely, a higher strike price has more intrinsic value for put options because the contract allows you to sell the stock at a higher price than where it’s trading currently. Your options are in-the-money if the stock stays at INR 100, but you have the right to sell it at a higher strike price, say INR 110.