Equity options

Equity options

Equity options work in the same manner as forex or commodities options. An equity option is a type of contract that gives the owner the right but not the obligation to buy or sell shares of the underlying security at a specified price on or before the last date, which is considered the expiration date. It usually represents 100 shares of an underlying stock.  

 

Equity option example

Let’s suppose that ABC shares are being traded at $60,000. So, you buy an option to purchase ABC shares before the end of the week at $70,000 and pay a premium of $3,000 to do so. If the shares of ABC exceed the value of $73,000, then the trade is in profit and you are free to go through with the trade.  

 

What is a Non-Equity Option?

Like other derivatives, options allow investors to speculate on or hedge against the movements of the underlying assets. The instrument uses non-equity options on securities that are not traded on the stock market. Non-equity options, like conventional options, provide the holder the right, but not the responsibility, to trade the underlying asset at a certain price on or before a certain date. 

 

Over-the-Counter Options

Option contracts that are traded between private parties rather than on exchanges are known as over-the-counter options. While exchange-traded options are executed and settled through clearing houses, over-the-counter option deals do not involve this process. Often, investors prefer over-the-counter options when their needs are not met by already listed options. They also opt for this option as it is more flexible.

Equity Options Types

There are two types of Equity options: 

  • Puts: This type of option gives the equity holder the right to sell 100 shares of the underlying security at the price of the strike. This option is available to the holder at any time before the expiration date. The seller is obligated to buy the shares. 
  • Calls: This type of option gives the equity holder the right to buy 100 shares of the underlying security at the price of the strike. This option is available to the holder any time before the expiration date. The seller of is obligated to sell the shares.  

Using Equity Options

In most cases, investors use equity options when they do not want to hold a permanent place and do not want to buy or short the stock. They use equity options to take a long or short position in the market. This allows for more leverage and therefore, more profit can be gained from the price movement of an underlying asset. The option trader also usually makes a better percentage return.  

The Options Premium

The price of the option is knowns as its premium. The possible loss for the option holder is limited to the contract’s initial premium. On the other hand, the writer’s potential loss is limitless. The initial premium obtained for the contract helps to offset some of this loss. Investors, using limited capital can make use of the two types of equity options; puts and calls to take a position in the market and to hedge against the risk of the market.  

Expiration Day

The exact date and time when derivatives contracts stop trading and associated obligations or rights become due or expire is known as the expiration time.

Risk and reward

Investing can be profitable, but it is also risky. The maximum loss in the long put or call option is the premium you pay. The maximum profit on a short position is the premium you earn when selling the option, whether it is a call or a put option. The call option short position has unlimited loss potential. The exercise price multiplied by the contract size and the number of contracts the investor has in a position, less the received premium, is the maximum loss for a short position in a put option. 

Frequently Asked Questions

There are two ways through which an equity option can be settled: 

  • Physical Settlement: Such contracts are settled with the transfer of the underlying asset from the seller to the buyer physically. The settlement takes place on a specific stock.  
  • Cash Settlement: Such contracts are settled through cash value on or after the expiration date. There is no need for physical delivery of the underlying assets after expiry.  

In many cases, equity is considered to be better than options as options have an expiration date whereas equity can be held indefinitely by a buyer. Equity also has a lower risk in a carry forward position. Equity also allows investors to fix the price over a fixed period of time at which they can buy or sell 100 shares of an equity at a premium.  

Options are riskier due to many reasons. Many individual stock options do not have volume at all, which further leads to higher spreads as they lack liquidity. They also cost an investor more and are very complicated to understand for beginners. Even experienced investors are unaware of the risks.

Methods like Black-Scholes and Binomial pricing models can be used to price equity options mathematically. Apart from this, the price is usually made of two parts. 

  • Intrinsic Value: It is determined by the profit of an option based on the comparison between the strike price and the stock price. 
  • Time Value: It is determined by the projected volatility of the underlying asset and the remaining time until the option expires. 

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