Stock Options Definition
Stock Options are derivative instruments that provide the holder either the right to buy or sell any stock based on the predetermined stock prices regardless of the prevailing market prices.
Generally, the following are its components –
- #1 – Strike price – Strike Price is the price for which options are purchased or getting written.
- #2 – Expiry date – All the stock options will have a predetermined expiry date on which instrument will be squared off.
- #3 – Premium – The price of the options, at which one can write or buy, is termed as premium.
- #4 – Lot size – Stock options based on the prevailing market price of a share will be consist of a fixed number of shares, termed as Lot Size.
Types of Stock Options
The following are the two types –
- 1 – American Style – American option that can be exercised at any time, even before the expiry
- 2 – European Style – European option that can be exercised only at the time of expiry
Calculation and Example
Pay off in options will always be considered at maturity. Initially, while writing or buying options, either premium inflow or outflow will take place. On maturity, Cash inflow (in case of profit) or cash outflow (in case of loss) net off premium will take place.
Hence, the following is the formula of Payoffs:
Call option of Amazon.com :
- Current market price – $ 30
- The strike price of the option – $ 40
- Premium – $ 5
- The market price on expiry- 1. $ 20, $ 60
- Lot size – 100 shares
If the Market price is $ 20, then it is below the strike price. Hence, the option will lapse.
Hence total loss = $ 5
If the Market price is $ 60, then it is above the strike price. Hence, the option will be exercised.
Calculation of Payoff Maturity
Pay off on maturity = ($ 60 – $ 40) * 100 – $ 5
= ($ 20) * 100 – $ 5 = = $ 2000 – $ 5 = $ 1995
Mr. A bought the put option of Facebook, Inc. with the expiry of 30th April, on 1st April. On 1st April, the Market price of Facebook, Inc is $ 136. The premium of the Put option for a strike price of $ 150, with the expiry of 30th April, is $ 1000. The lot size is 1000 shares. Calculate the payoff for the option if the market price on 30th April is
- $ 110 $ 180
Here Mr. A is the buyer of the Put option. Hence he has the right to buy the share if the price goes below the strike price. On 30th April, if the Market price is $ 110, then it is below the strike price of $ 150.Hence, put is in the money, and options will be exercised.
On 30th April, if the market price is $ 180, then it is above the strike price, and hence calls will lapse.
Therefore, total loss = $ 1000
Calculation of Payoff
Therefore, payoff = ($ 150 – $ 110) * 1000 – $ 1000
= $ 40,000 – $ 1000
= $ 39,000
Benefits of Stock Options
- Leverage – Buying Stock physically requires upfront payment on the inception, which requires a huge cash outflow. However, In option, with less amount of initial investment, an investor can take huge exposure over the underlying asset.
- Ease of Shorting – Short selling of shares brings a huge amount of risk along with legal repercussions. However, with options, one can easily take a short position, just by paying a premium based on the speculation or having specific insight.
- Flexibility – Options can be structured based on the need of investors. There are numerous strategies like a straddle, stranded, bull call spread, bull put spread, etc., based on which investor can design and earn huge profits.
Disadvantages of Stock Options
- Risk – Option buyer will be having loss limited to the premium amount paid. However, the writer of the options will be facing a huge amount of risk. It can be even unlimited. Hence, Stock options come with a huge amount of risk as compared to a direct stock purchase.
- No Stock Holder Privileges – Shares, once purchased, can be sold even after hundred years. It will be sold at the wish of investors. However, in options, there will be a fixed, predetermined expiry date on which instrument is needed to be squared off. Due to this, even if the investor is in a position to incur negative profits, the investor will have to forcefully square off the instrument even at a loss.
- Constant Observation of Market Prices for Premium Payoffs – Generally, an investment in the shares, the investor will upfront pay the purchase price. After that, no payment is needed. However, Option Seller will have to constantly monitor the market prices, as based on that market to market of an instrument will be settled down at the end of the day.
Indicators of the Stock Options
The following are the indicators of Stock option performance:
- Delta– Degree at which option price will change with respect to change in the market price.
- Gamma – Degree at which delta( as discussed in 1) of the option is getting the change with respect to change in market price. In simple terms, it is termed as the delta of the delta.
- Theta– Degree of change in option price with respect to a change in the expiry of option instrument
- Rho – Degree of change in option price with respect to a change in risk-free interest rate.
- Vega– Degree of change in option price with respect to the change in volatility.
Stock options are a preferred financial instrument by the asset management companies, portfolio managers, foreign institutional investors, etc. It gives the benefit of betting with huge exposure just based on the specific insight of the movement of the stock price in a particular direction.
This has been a guide to Stock Options and its definition. Here we discuss the components, types of stock options along with examples and explanations, benefits, and disadvantages. You can learn more about accounting from the following articles –