What are Options? Understanding options with one simple explanation

What are Options? Understanding options with one simple explanation
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What are options? If you have been asking yourself this question even after going through a lot of guides, tutorials and videos and still confused, then please read this article till the end.

I have a simple explanation to help you answer just that.

Understanding options can be complicated for a beginner or even for an experienced investor or trader.

Years of experience in options trading, and the many times that I have burned my capital, what I have realized with options trading is that in the first place itself, we usually start with a mindset that options are complicated.

Thus, even our learning process also begins with reading complicated books and other materials which adds more to the pile of confusion. 

So, what I would try to do is show you a very simple way which would give you the basic or grassroot level understanding of what are options really about!

What are Options? – Standard definition:

 An ‘option’ is a derivative which derives its value from its underlying asset that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date.

The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.

My definition of what are options?

In my simple understanding, options are merely Insurance Policies! 

When I say Insurance Policies, I’m referring to policies which we are familiar with such as your Car, Health or Life Insurance.

For example, you bought a Health Insurance policy from LIC, for a period of 1 year with maximum coverage of INR 4,00,000 by paying an annual premium of INR 15,000/-.  

This means that by paying a sum of INR 15,000, the Insurance Company is liable to pay you an amount maximum up to INR 4,00,000, if you in the insured period of 1 Year are hospitalized, treated for some minor or major ailments as per the terms & conditions of the Contract.

Thus, we can sum up that you have potential of unlimited gain (Up to INR 4,00,000) by taking a limited risk (Premium paid of INR 15,000).

Any investment giving above 100% of your investment capital can be considered as unlimited income. In this case, the unlimited income potential is up to 2666% of your paid premium or investment.

Let us tabulate the following possible scenarios that can occur over a period of 1 year:

Scenario 1: You had a minor ailment and were hospitalized for 2 days and ran up a bill of INR 20,000.

Outcome: The Insurance Company will reimburse you to a maximum amount of INR 20,000.

Scenario 2: You had a major ailment and were hospitalized for 15 days and ran up a bill of INR 2, 00,000.

Outcome: The Insurance Company will reimburse you to a maximum amount of INR 2, 00,000.

Scenario 3: You had a very serious, complicated ailment due to which you had to undergo complicated surgery and were hospitalized for 3 months, thus running up a bill of INR 4, 00,000.

Outcome: The Insurance Company will reimburse you to a maximum amount of INR 4, 00,000.

Scenario 4: You did not have any health issues for the whole insured year.

Outcome: The Insurance Company keeps the whole premium (INR 15,000) you paid for taking the risk of giving you an Insurance of INR 4, 00,000 for a period of 1 year. Basically your Insurance policy is now worthless.

Let us discuss the last Scenario a little more. 

How your Policy expired worthless after 1 year?

 When we pay the amount of INR 15,000 as premium, we are essentially paying for time only. It does not have any intrinsic value. So, if we calculate the time value paid per day, it comes to INR 41 approximately (INR 15,000 divided by 365 Days).

So theoretically, every day that passes without any health issues, Rs 41 gets deducted and that happens till your Policy premium is reduced to 0 by day 365.

But anytime during the 1 year period, if any of the above first 3 scenarios come into play then the intrinsic value kicks in.

So what kind of effect on Intrinsic value when Scenarios comes into play?

If Scenario 1 occurs then Intrinsic Value = Rs 20,000 + (Rs 41 * Remaining insured days)

If Scenario 2 occurs then Intrinsic Value = Rs 2, 00,000 + (Rs 41 * Remaining insured days)

If Scenario 3 occurs then Intrinsic Value = Rs 4, 00,000 + (Rs 41 * Remaining Insured days)

Thus it means that value of your Insurance policy comes into work only when one of the scenarios that we discussed occurs within the insured period of 1 year, and all scenarios being subject to occurring wholly upon your Health status.

Let us relate all the above scenarios with terms applicable to options trading:

Health = Underlying Asset

Scenario 1 – 4 = Moneyness of an option (ITM, ATM, OTM)

Insured premium = Option Premium

Insurance Buyer = Option Buyer

Insurance Company = Option Writer/Seller

Insured Period = Expiry

Premium = Time Value + Intrinsic Value

Trading with Nifty Options:

Let’s say, we bought a Nifty Call Option with strike price of 9500 when Nifty 50 Spot price is 9300 by paying a premium of INR 10 per share (1Lot = 75 shares) to a total investment of Rs 750. Here, Nifty 50 Spot price is the underlying asset for which Nifty 9500 CE will derive its value.

Let us assume that we bought the NIFTY 9500 CE, as we are bullish about the market uptrend and expect to cross 9500 within a period of 1 month.

At the time of buying, when Nifty spot price is at 9300, the premium of Rs 10 paid is only for time value as the Strike price bought that is 9500 CE has no intrinsic value.

Now, summarizing the possible scenarios that can occur over a period of 1 year here also, we can observe that:

Scenario 1: If Nifty 50 Spot price is 9520 by the end of Expiry

Outcome: Your premium is now worth INR 20 per share, Rs 1500 per lot thus giving you a profit of INR 750, as Intrinsic value is 20 (9520 – 9500 = 20)

This is a case of your out-of-the-money (OTM) Strike price becoming at-the-money (ATM) option.

Scenario 2: If Nifty 50 Spot price is 9600 by the end of Expiry

Outcome: Your premium is now worth INR 100 per share, Rs 7500 per lot thus giving you a profit of INR 6,750, as Intrinsic value is 100 (9600 – 9500 = 100),

This is a case of your out-of-the-money (OTM) Strike price becoming in-the-money (ITM) option.

Scenario 3: Nifty 50 Spot price is 9800 by the end of Expiry

Outcome: Your premium is now worth INR 300 per share, INR 22500 per lot thus giving you a profit of INR 21,750, Intrinsic value is 100 (9800 – 9500 = 100).

This is a case of your out-of-the-money (OTM) Strike price becoming deep in-the-money (ITM) option.

Scenario 4: If Nifty 50 Spot price is 9450 by the end of Expiry.

Outcome: Your premium is now worth INR 0 per share, INR 0 per lot thus giving you a loss of INR 750 (The premium amount paid), as Intrinsic value is 0 or Negative.

(9450 – 9500 = – 50),

This is a case of your out-of-the-money (OTM) Strike price remaining an OTM option by expiry.

 Here,

Nifty 50 = Underlying Asset

Option Premium =INR 750 paid for buying Nifty 9500 CE

Now let us analyze the similarity between the scenarios of your Health Insurance and that of Nifty options:

1. When you paid INR 15,000 as premium to buying the Health insurance for a period of 1 year, it is similar to paying a premium of INR 750 for an OTM option of strike price Nifty 9500 CE for a period of 1 month.

2. When you had a minor ailment and received INR 20,000 as reimbursement, this is similar of your out-of-the-money option expiring as at-the-money option and profiting INR 750.

3. When you had a major ailment and received INR 2, 00,000 as reimbursement, this is similar of your out-of-the-money option expiring as in-the-money option and profiting INR 6750.

4. When you had a serious and complicated ailment and received INR 5, 00,000 as reimbursement, this is similar to your out-of-the-money option expiring as deep in-the-money option and profiting INR 21750.

5. When you had a no health issues for the whole year, your Insurance Policy becomes worthless, this is similar to your out-of-the-money option expiring as out-of-the-money option and losing your entire premium amounting to INR 750.

So, from the above examples, we can say that option derivatives at its grassroot level work the same as a normal Insurance policy. 

There are definitely more topics to learn such as Option Greeks, volatility, time decay, option strategies before we fully understand options trading but I believe this basic explanation will give you a solid and strong basic understanding as to what an option is and how it works!

Conclusion – Now what are options?

Hopefully, now that you have an answer to the question – What are options, I would suggest you to invest time reading good books on Options trading. You can also practised paper trading and experience the results yourself before putting in real money.

If you found my post to be useful or helpful, please share it!

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