Q. What do you understand by the term Option ? Write in detail various types of options.
Ans. MEANING OF OPTION: Options is the form of derivative in which a specified security can be bought or sold at a specified price at some future date at current price or exercise price. These are different to other financial investments such as shares, commodities and currencies. These instruments are based on other financial instruments, therefore, they derive their value from other asset. In the options contract, one party grants the right to buy a specific asset at a specific price to other party. The person who grants the right is known as ‘Option writer’ and the person who has received the right to buy is called as ‘Option buyer.’
The right to sell a security is called as ‘Put option’ and the right to buy is the ‘call option’.
These are like futures contract as they are made to minimise the risk. Options also help the investor in earning profits from changes in share prices without investing the full price of the contract. One obtains the full right over the specified asset without buying them outright. These are also helpful in protecting from fluctuations in the value of the investment.
TYPES OF OPTIONS: The call options and put options are the two types of options:
1. Call Option: The call option provides the right to buyer for buying an underlying asset at the strike price on or before the expiration date. The buy has to pay the premium in return of the right to seller.
2. Put Option: This provides the right to seller to sell an underlying asset at a strike price on or before the expiration date. The seller receives the amount of premium in return of that right granted.
The options can also be classified on the basis of expiration time. On this basis, they may be divided in American and European Options. American Options refers to that options, which can be executed at anytime on or before the expiry date whereas European Options refers to those which can be executed only on the expiry date.
The other categorisation may be done on the basis of method of their trade. Under this categorisation, the options may be divided in two types: Exchange Traded Options and Over The Counter Option. Exchange Traded Options are those which are traded on recognised exchanges. Over the counter options are those which are not traded on exchanges, rather they are directly traded by buyer and seller. There are no standardised strike prices and expiration dates.
In addition to these, there are some other complex types of options also. These may be divided into following two types.
I. Simple Options: Various types of simple options are as follows:
(1) Stock Options: The options created on particular stocks are called as stock options. Every stock is not allowed for options trading by SEBI. SEBI has permitted only certain stocks that meet its stringent criteria.
(2) Index Options: This option is written on the exchange indices such as CNX, Nifty 50, CNX IT and Bank Nifty, Sensex, etc. The trade is made on the general movement of stock market index movement. They are settled by payment of cash. The amount of settlement depends upon the difference between the closing price of index and strike price of option.
(3) Commodity Options: Commodity options are derivatives contract which give the right to buy or sell a specific commodity at a pre-determined price at some point of time in future. A commodity option contract establishes a specific price at which the contract may be exercised. It has an expiration date.
(4) Bond Options: A bond option is an option to buy or sell a bond at a specific price on or before the expiry date. They provide the right to the investors, but not the obligation. It provide investors with a tool for hedging interest rate fluctuations.
(5) Currency Options: These are exchange traded with pre-defined maturities. These provide safeguard against the adverse exchange rate fluctuations. Like other options, they provide right to sell or buy foreign currency at a fixed price at some future date.
(6) Options on Futures: As the name states, this type of options is the combination of futures and options. An option on a futures contract is the right, but not the obligation to buy or sell a particular future contract at a specific price on or before a certain expiration date.
II. Exotic Options: Exotic options are not traded on exchanges and are mainly traded over-the-counter. The terms of the options are negotiated by brokers or dealers. They are more complex in nature and are customised by combining the various types of options. These are as follows:
(1) Range Forward: It is a variation of regular forward contract which is used primarily to hedge the risk. This contract involves taking to opposite positions in options. It is set up in a way that they involve simultaneous sale and purchase of put options and call options on the same amount of principal and the same maturity but the exercise price is different. The range forward contract is used to reduce the cost of hedging to zero level. It is done by a hedger by receiving the premium on sales and paying the premium on purchase of options.
(2) Ratio Range Forward (RRF): It is the flexible variation of a range forward. They differ in amount. In these call and put positions are unequal. The investors choose the ratio of two amounts to bring down the upfront fees.
(3) Swaptions: It is a combination of swap and option. It provides its owner the right but not the obligation to enter into an interest rate swap on a specified date. In return, buyer pays a premium to the seller. Call swaptions and put swaptions are the two types of it. In the put option, the holder has a right to receive a fixed interest payment. But in the call option, the holder has to pay a fixed interest payment.
