Demystifying Options Trading: Understanding Calls, Puts, and Option Pricing Models
Published by Sharekhan Education | June 19, 2024
Options trading can seem complex and intimidating, but with a clear understanding of the basics, anyone can grasp the concepts of Calls, Puts, and how Options are priced. This blog aims to demystify these components and make Options trading accessible even for beginners.
What Are Options?
Options are financial instruments that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific date. The underlying asset can be stocks, commodities, indices, or currencies. Popular underlying assets include shares of companies listed on the NSE (National Stock Exchange) and indices like the Nifty 50 and the Bank Nifty. There are two primary types of Options: Calls and Puts.
Calls
A Call Option gives the buyer the right to buy an asset at a specified price (Called the strike price) within a certain period. Investors buy Call Options when they believe the price of the underlying asset will rise.
Example, Imagine you buy a Call Option for Reliance Industries shares with a strike price of ₹2,600, expiring in one month. If Reliance’s share price rises to ₹2,800, you can buy the shares at the lower strike price of ₹2,600 and sell them at the current market price of ₹2,800, making a profit.
Puts
A Put Option gives the buyer the right to sell an asset at a specified price within a certain period. Investors purchase Put Options when they believe the price of the underlying asset will fall.
Example, Suppose you buy a Put Option for Infosys shares with a strike price of ₹1,500, expiring in one month. If Infosys’ share price falls to ₹1,300, you can sell the shares at the higher strike price of ₹1,500, securing a profit.
Key Terms in Options Trading
Before diving deeper, let us clarify some essential terms in Options trading,
Strike Price – The predetermined price at which the Option trader can buy (Call) or sell (Put) the underlying asset.
Expiration Date – The date by which the Option must be exercised, or it becomes worthless.
Premium – The price paid by the buyer to the seller (or writer) of the Option for the rights granted by the Option.
In-the-Money (ITM) – A Call Option is ITM if the current price of the underlying asset is above the strike price. A Put Option is ITM if the current price is below the strike price.
Out-of-the-Money (OTM) – A Call Option is OTM if the current price of the underlying asset is below the strike price. A Put Option is OTM if the current price is above the strike price.
At-the-Money (ATM) – When the current price of the underlying asset is equal to the strike price.
Factors Affecting Option Prices
Underlying Asset Price: The current price of the asset directly affects the Option’s value. For Calls, as the asset price increases, the Call Option becomes more valuable. For Puts, as the asset price decreases, the Put Option becomes more valuable.
Strike Price: The strike price determines the intrinsic value of the Option. For Calls, the lower the strike price relative to the current asset price, the higher the value. For Puts, the higher the strike price relative to the current asset price, the higher the value.
Time to Expiration: Options lose value as they approach their Expiration date due to time decay. Longer-term Options are more valuable because there is more time for the asset price to move favourably.
Volatility: Higher volatility increases the likelihood of the asset price moving significantly, which can make the Option more valuable. Both Call and Put Options benefit from increased volatility.
Risk-Free Interest Rate: The risk-free interest rate impacts the present value of the strike price. Higher interest rates can increase the value of Call Options and decrease the value of Put Options.
Understanding Option Pricing
Option pricing can seem daunting, but it is about understanding the factors that influence the premium. Two common models help in determining the fair price of an Option: The Black-Scholes Model and the Binomial Model.
The Black-Scholes Model
The Black-Scholes Model is one of the most widely used methods for pricing European-style Options (which can only be exercised at Expiration). The model considers the current price of the underlying asset, the strike price, time to Expiration, risk-free interest rate, and volatility to calculate the Option’s theoretical value.
The formula for the Black-Scholes Model is complex and involves advanced mathematics, but the key takeaway is that it provides a standardized way to estimate the fair value of an Option.
The Binomial Model
The Binomial Model is another popular method for pricing Options. It uses a tree of possible future prices for the underlying asset over different time periods. Each node in the tree represents a possible price at a specific point in time. By working backwards from the Expiration date, the model calculates the Option’s value at each node, eventually arriving at the present value of the Option.
The Binomial Model is flexible and can be used for American-style Options (which can be exercised at any time before Expiration), making it more versatile than the Black-Scholes Model.
Things to keep in mind for Options Traders
Start Small: Begin with a small investment to understand the mechanics of Options trading without risking significant capital.
Educate Yourself: Take advantage of educational resources, webinars, and practice accounts offered by brokerage firms.
Understand the Risks: Options can be highly leveraged and volatile. Be aware of the potential for significant losses.
Use Simple Strategies: Start with basic strategies like buying Calls or Puts before moving to more complex strategies like spreads or straddles.
Monitor the Market: Keep an eye on market trends, news, and events that could impact the price of the underlying asset.
Conclusion
Options trading does not have to be a mystery. By understanding the basics of Calls, Puts, and how Options are priced, you can start exploring this exciting area of finance with confidence. Remember, the key to successful Options trading is continuous learning and practice. With time and experience, you will be able to make informed decisions and leverage Options to enhance your investment portfolio. Whether you are looking at Reliance, Infosys, or the Nifty 50, the principles remain the same, making it possible for you to navigate the Options market with ease.
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