Stock Options Definition Types Explained With Examples

Stock Options Definition

Stock Options are derivative instruments that give the holder the right to buy or sell any stock based on its predetermined prices regardless of the prevailing market prices.

Generally, the following are its components –

#1 – Strike price – Strike PriceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more is the price of purchased or written options.#2 – Expiry date – All the stock options will have a predetermined expiry date on which the instrument will be squared off.#3 – Premium – The price of the options one can write or buy.#4 – Lot size – Stock options based on the prevailing market price of a share consists of a fixed number of shares termed Lot Size.

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Types of Stock Options

The following are the two types –

1 – American Style – American optionAmerican OptionAn American option is a type of options contract (call or put) that can be exercised at any time at the holder’s will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade.read more can be exercised at any time, even before the expiry.2 – European Style – The European optionEuropean OptionA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman’s terms, once an investor has purchased a European option, even if the underlying security’s price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more that can be exercised only at the time of expiry can be exercised only at expiry.

Calculation and Example

The payoff in options will always be considered at maturity. Initially, while writing or b

At maturity, the payoff in options is always considered. Initially, premium inflow or outflow will occur while writing or buying options. On maturity, cash inflow (in case of profit) or cash outflow (in case of loss) net off premium will occur.

Hence, the following is the formula for Payoffs:

Payoffs Formula = (Maturity Price – Strike price) * Lot Size – Premium paid on the inception.

Example #1

Current market price – $30The strike price of the option – $40Premium – $5The market price on expiry- $20 and $60Lot size – 100 shares

Solution

If the Market price is $20, it is below the strike price. Hence, the option will lapse.

Hence total loss = $5

If the Market price is $60, it is above the strike price. Hence, the option can be exercised.

Calculation of Payoff Maturity

Payoff on maturity = ($60 – $40) * 100 – $5

= ($20) * 100 – $5 = $2,000 – $5 = $1,995

Example #2

Mr. A bought the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more of Facebook Inc. with the expiry date of 30th April. On 1st April, the market price of Facebook Inc was $136. The put option premium for a strike price of $150, with the expiry of 30th April, is $1,000. 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 can buy the share if the price goes below the strike price. For example, on 30th April, if the market price is $110, it is below the strike price of $150. Hence, please put it in the money, and options will be exercised.

On 30th April, if the market price is $180, it is above the strike price; hence, options will lapse.

Therefore, total loss = $1,000

Calculation of Payoff

Therefore, payoff = ($150 – $110) * 1000 – $1,000

= $40,000 – $1,000

= $39,000

Benefits of Stock Options

Leverage – Buying stock requires upfront payment on the inception, which requires a huge cash outflow. However, with the less initial investment, an investor can take huge exposure over the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more in an option.Ease of Shorting – Short selling Short SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more shares brings a huge amount of risk and legal repercussions. However, with options, one can easily take a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more by paying a premium based on the speculation or having specific insight.Flexibility – Options can be structured based on the needs of investors. There are numerous strategies like a straddle, stranded, and bull call spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more which refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range, bull call spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more, etc., based on which investors can design and earn huge profits.

Disadvantages of Stock Options

Risk – Option buyers will have losses limited to the premium amount paid. However, the writer of the options will face a huge risk. It can even be unlimited. Hence, stock options come with a huge risk compared to a direct purchase.No Stock Holder Privileges – Shares, once purchased, can be sold even after a hundred years at investors’ wish. However, there is a fixed, predetermined expiry date on which an instrument is needed to be squared off in options. Due to this, even if the investor incurs negative profits, they will have to forcefully square off the instrument even at a loss.Constant Observation of Market Prices for Premium Payoffs – Generally, the investor pays the purchase price in share investment. After that, no payment is needed. However, the option seller will have to monitor the market prices constantly based on which the market to marketMarket To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company’s actual financial condition.read more price of an instrument will be settled at the end of the day.

Indicators of the Stock Options

The following are the indicators of stock options performance:

Delta: The degree to which option price will change concerning change in the market price.
Gamma: The degree at which the option’s delta (as discussed in 1) would change concerning the change in market price. In simple terms, it is termed the delta of the delta.Theta: The degree of change in option price concerning a change in the expiry of the option instrument.Rho: The degree of change in option price concerning a change in risk-free interest rate.Vega: The degree of change in option price concerning the change in volatility.

Conclusion

Stock options are a preferred financial instruments by asset management companiesAsset Management CompaniesAn Asset Management Company (AMC) refers to a fund house, which pools money from various sources and invests the same in purchasing capital on behalf of their investors.read more, portfolio managers, foreign institutional investors, stock options are preferred financial instruments, etc. It gives the benefits of betting with huge exposure based on the specific insight of the stock price movement in a particular direction.