In the world of finance, derivatives are powerful instruments that derive their value from an underlying asset such as stocks, bonds, commodities, interest rates, or currencies. One of the most commonly traded derivatives is the option. Options offer traders and investors a versatile tool for hedging, speculation, and income generation. But not all options are created equal. In this blog, we’ll explore the different types of options in derivatives trading, their characteristics, and how they are used.
What Are Options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (called the strike price) on or before a certain date (called the expiration date).
There are two primary types of options:
- Call Options – These give the holder the right to buy the underlying asset.
- Put Options – These give the holder the right to sell the underlying asset.
Let’s now dive deeper into the different types of options available in derivatives trading.
1. Based on Rights: Call and Put Options
Call Option
A call option gives the buyer the right to purchase an asset at the strike price before or on the expiration date. Call options are typically used when the investor believes the price of the asset will go up.
Example: If you buy a call option on ABC stock with a strike price of ₹100 and the stock goes up to ₹120, you can buy the stock at ₹100, gaining a profit (excluding the premium).
Put Option
A put option gives the buyer the right to sell the asset at the strike price before or on expiration. Put options are used when the investor expects the price to fall.
Example: If you buy a put option on XYZ stock with a strike price of ₹150 and the stock drops to ₹120, you can sell it at ₹150, profiting from the decline.
2. Based on Exercise Style: American and European Options
American Options
American-style options can be exercised at any time up to and including the expiration date. This flexibility can be advantageous, especially when dividends are involved or during periods of high volatility.
Use Case: Traders who want the ability to respond quickly to market movements may prefer American options.
European Options
European-style options can be exercised only at expiration. These are commonly used in index options and tend to have lower premiums due to their limited flexibility.
Use Case: More suitable for investors with a fixed investment outlook or strategy.
3. Based on Underlying Asset
Stock Options (Equity Options)
These are options where the underlying asset is an individual stock. They are among the most common types traded by retail investors.
Example: Buying a call option on Reliance Industries Ltd.
Index Options
These options are based on stock market indices like the Nifty 50 or S&P 500. Instead of physical delivery, index options are settled in cash.Example: Buying a put option on the Nifty 50 if you expect the market to decline.
Commodity Options
Commodity options derive their value from commodities like gold, crude oil, wheat, etc. They are widely used by producers and consumers to hedge against price volatility.Example: A farmer buying a put option on wheat to lock in a minimum selling price.
Currency Options
These are options on currency pairs and are used to hedge against currency risk or to speculate on currency movements.Example: Buying a call option on USD/INR if you expect the dollar to strengthen against the rupee.
Interest Rate Options
Interest rate options are based on interest rate instruments like treasury bills or bonds. They are primarily used by institutional investors and banks to hedge interest rate risks.
4. Based on Moneyness
In the Money (ITM)
- Call Option: When the stock price is above the strike price.
- Put Option: When the stock price is below the strike price.
At the Money (ATM)
When the stock price is equal to the strike price.
Out of the Money (OTM)
- Call Option: When the stock price is below the strike price.
- Put Option: When the stock price is above the strike price.
Understanding moneyness is crucial as it affects the intrinsic value and premium of the option.
5. Exotic Options
In addition to the standard options, there are also exotic options, which have more complex features and payoff structures. These are typically used by institutional investors.
Barrier Options
These options become active or inactive only when the underlying asset reaches a predetermined price level.
Binary Options
Also known as digital options, they offer a fixed payout if the condition is met (e.g., price goes above a level) and nothing if it’s not.
Lookback Options
These allow the holder to “look back” over time to determine the optimal price for exercise.
Asian Options
Instead of the price at expiration, the payoff is based on the average price of the underlying over a certain period.
6. Based on Trading Venue
Exchange-Traded Options
These options are standardized and traded on regulated exchanges like NSE (National Stock Exchange) or BSE (Bombay Stock Exchange) in India.
Benefits:
- Transparent pricing
- High liquidity
- Lower counterparty risk
Over-the-Counter (OTC) Options
These are customized contracts traded directly between two parties, usually large institutions.
Benefits:
- Customizable terms
- Flexibility in structuring
Drawback:
- Higher counterparty risk
- Lower liquidity
Why Trade Options?
Options are used for multiple purposes:
- Hedging: To protect existing investments from price swings.
- Speculation: To profit from price movements with limited capital.
- Income Generation: Strategies like covered calls allow investors to earn premiums.
However, trading options involves risks, particularly for sellers, who may face unlimited losses.
