Stock Option is a privilege, sold by one party to another, which gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date. In the U.K., it is known as a "share option". American options can be exercised anytime between the date of purchase and the expiration date. European options may only be redeemed at the expiration date. Most exchange-traded stock options are American. Companies are increasingly offering employees stock options as a partial substitute for payroll in an attempt to build morale and company pride. Due to this trend, there are many people who have a substantial monetary interest in understanding them. A call is the right to buy a specified number of shares at a given price before a specific date. A put is the right to sell a specific number of shares at a given price before a specific date.
The earliest known options trade dates from 7th century BCE. Thales of Miletus speculated that the year's olive harvest would be especially bountiful, and put a deposit on every olive press in his region of Greece. The harvest was huge, demand for olive presses skyrocketed, and Thales sold his rights, or options, to the presses at substantial profit. The modern history of stock options trading begins with the 1973 establishment of the Chicago Board Options Exchange (CBOE) and the development of the Black-Scholes option pricing model
In early periods options were used as because it provided a good leverage. For a little price which was paid as premium the speculators can play with large amount of risk. The use of leverage helped many of them to inflate prices of underlying on which options were created. Though it provides large profits it can also produce high losses to the writer of option. One of the catastrophic events that happen because of the option trading was closing down of Barings Bank in 1995. Barings wasn't always hedging his options positions and began to incur huge losses from his trading mistakes and after the 1995 earthquake of Japan when Nikkei fell drastically Barings incurred a loss of $ 13 million.
In 1973, the Chicago Board Options Exchange (CBOE) became the first U.S. exchange to trade listed stock options. The CBOE offered call-option trading on 16 different stocks. Before this, there was no exchange set up to match buyers and sellers of option contracts. In United States in 1975, the Securities and Exchange Commission enabled the Options Clearing Corporation (OCC) to serve as the central clearinghouse for all exchange-traded options. This helped ensure the validity and liquidity of the market. OCC acted as the guarantor, made sure that all obligations of the option contracts bought and sold are fulfilled. The OCC operates under the jurisdiction of the SEC.
With the birth of new communication channels and exchanges coming online there is huge rise of the online brokers. This has given power and tools to individual traders to invest in stock options like never before. This has also led to free offering of trading tools which may have cost in thousands in earlier period. The commission for trading in stock options is huge and they are continuously growing.
Stock options have some specifications. Stock options are standardised products because they are traded in option trading exchanges. The attributes of specifications are:
Underlying Stock: This specifies the stock on which option is given.
Expiration Date: This is the date at which the option expires. The buyer of the option has to exercise the option before the expiration date, otherwise it becomes invalid. Option price is positively related to expiration date. That is, the longer is the expiration date, the higher is the price of option.
Strike Price: The price which at which acts as the benchmark for the buyer of the option to exercise the option. For a call option buyer if the stock price goes above the strike price exercising the option will be profitable. For a put option buyer if the stock price comes below the strike price, exercising the option will be profitable
Type of Option: Call option gives the buyer the right to buy stock at predetermined price and put option gives the buyer the right to sell stock at predetermined price.
Lot Size: Each option contract cover a definite number of stocks. Like an option contract of ACC can have 200 shares of the company as underlying
Terms of Delivery: This defines how the final settlement has to be done. Call option sellers sell and deliver the underlying stock to the buyer if exercised and put option sellers buy the underlying stock from the buyer if exercise by cash.
Stock option in India
Stock options are traded on BSE and NSE in India. Based on the eligibility criteria set up the bodies in these exchanges the stocks are approved for the approval of options. The contracts are settled by cash and all are American style options. Equity Futures & Options were introduced in India having a maximum life of 3 months. These options expire on the last Thursday of the expiring month. In the market investors started to ask for options with shorter maturity. To cater to this need of the market participants BSE launched weekly options on September 13, 2004 on 4 stocks and the BSE SENSEX. In NSE the index option trading started on June 2001, and in August 2003 it launched the futures and options trading on CNX IT index. Options of BANK Nifty index began trading in June 2005. June 2007 saw the launch of futures and options trading on CNX 100 and CNX Nifty Junior Contracts. This was followed by starting of options and futures trading on Nifty Midcap 50 on October 2007. In March 2008 NSE started long term option contracts on S&P CNX Nifty Index.
The creation and empowerment of Securities and Exchange Board of India (SEBI) has helped in providing higher level accountability in the market. New institutions like National Stock Exchange of India (NSEIL), National Securities Clearing Corporation (NSCCL), and National Securities Depository (NSDL) have been the change agents and helped cleaning the system and provided safety to investing public at large. With modern technology in hand, these institutions did set benchmarks and standards for others to follow. Microstructure changes brought about reduction in transaction cost that helped investors to lock in a deal faster and cheaper. One decade of reforms saw implementation of policies that have improved transparency in the system, provided for cheaper mode of information dissemination without much time delay, better corporate governance, etc. The capital market witnessed a major transformation and structural change during the period. The reforms process have helped to improve efficiency in information dissemination, enhancing transparency, prohibiting unfair trade practices like insider trading and price rigging. The objective of these reforms has been to move the Indian market to such a level where it would fully integrate with the global developed markets. Introduction of derivatives in Indian capital market was initiated by the Government through L C Gupta Committee report. The L.C. Gupta Committee on Derivatives had recommended in December 1997 the introduction of stock index futures in the first place to be followed by other products once the market matures. The preparation of regulatory framework for the operations of the index futures contracts took some more time and finally futures on benchmark indices were introduced in June 2000 followed by options on indices in June 2001 followed by options on individual stocks in July 2001 and finally followed by futures on individual stocks in November 2001.
