What is an inflation indexed bond?
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These bonds protect your returns against inflation. As a result, your yield in percentage terms remains flat over your investment horizon.
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What Are Stock Options & How Do They Work?
By Bajaj Broking Team
August 31, 2024
8 mins read
Share Market
Synopsis:
Inflation indexed bonds are issued by the Reserve Bank of India (RBI) and provide investors protection against inflation. This is how they work. The government increases their principal every year based on the consumer price index (CPI). A flat coupon rate is applied to the adjusted principal every year. Hence, the investors get a fixed coupon rate over and above the rate of inflation. While such bonds protect against inflation, they usually offer lower yields than other bonds. Hence, they may not be the best investment option for everyone.
Stock options are a financial instrument that offers investors and traders the kind of profit potential and flexibility that traditional stock trading seldom does. Many factors make up the working of stock options, and traders must understand each of these to understand stock options better. However, like every other security in the stock market, despite having the potential to offer significant returns, options do have risks associated with them as well. This is why to help you make the best investment decision when it comes to stock options, we have here everything you need to know about them.
What Is The Meaning of Stock Options
With the help of a stock option which is a financial instrument, the investor who holds the option, has the right to buy or sell a previously agreed-upon quantity of a specific stock without having the obligation to do so. This quantity is to be sold at a price that was pre-determined and on or before the expiry date of the option. This expiry date is also predetermined in the contract between the buyer and the seller.
Stock Options Parameters
The various stock option parameters are listed below:
The Strike Price:
Also known as the exercise price
The price the underlying stock is bought or sold by the option holder
Set when the option’s issued and stay the same till its expiry
Has a major role in determining the option’s value.
Expiration Date:
The option cannot be exercised when it expires
Influences the option’s time value.
There can either be short-term, i.e. weekly or monthly OR long-term expiration dates.
Premium:
The price a buyer pays A seller for the option contract.
Has intrinsic monetary and time value
Volatility:
Is the price fluctuations of the underlying stock.
When volatility is high, the option premium is higher
This is because greater price movement leads to possibly higher profits for the option holder.
Intrinsic Value:
This is the difference between the stock’s current price and the strike price for in-the-money options.
The current stock price minus the strike price gives the intrinsic value of a call option
The strike price minus the current stock price gives the intrinsic value of the put option
Time Value:
Time value is the extra amount an investor wants to pay over and above the intrinsic value
The value depends on the time remaining until expiration.
The farther away the expiration date, the higher the time value
This is because of the increased probability of the option becoming profitable.
Underlying Asset:
The stock on which the option is based is the underlying asset
Its value and performance will directly affect the option’s value and profitability.
Types of Stock Options
There are two types of stock options and investors need to understand how they vary from each other.
Call Options
Gives the option holder the right to buy the shares of a particular stock without the obligation to do so
This is done at the option’s Strike Price or a predetermined price.
It also has to be carried out within a specified time frame.
Call options can be categorized as a bullish strategy
Here, the belief is that the stock’s price will cross the strike price and the premium paid for the option.
Investors can benefit from the upward movement of the underlying stock in call options.
Put Options
GIves the option holder the right to sell shares without the obligation to do so
This is done at a predetermined price and within a specified time frame.
This is a bearish trade strategy
Depends on the decline of the stock’s price below the strike price minus the premium.
Investors can profit from a downward movement in the underlying stock
This adds some flexibility and better risk management provisions to their investment portfolios.
How Stock Options Work
Below are some of the details about how stock options work:
Options represent the rights to buy or sell the underlying stock at a predetermined price within a specified timeframe.
Options can be seen as contractual agreements between buyers and sellers
They offer flexibility and leverage to traders as the chances of them profiting from price movements, without needing to own the underlying asset.
With such flexibility, investors can take advantage of market fluctuations
Options work to minimize risk as investors can commit to the purchase or sale of the underlying asset, with a minimal value, thus limiting their exposure to risk
Options let an investor hold a larger position in the market with a small investment, increasing their gain potential
Benefits of Trading Stock Options
Let's look into these advantages one by one.
Cost-Efficiency:
Stock options come with significant leveraging power.
An option position is very similar to a stock position but investors can end up saving plenty by investing in the former
However, for a stock option to be profitable for an investor, the right call option needs to be purchased
This option needs to mimic the stock position properly.
Known as stock replacement, this strategy is practical and cost-efficient.
Potential for Risk Mitigation:
Options make for a good hedging strategy when used well, potentially making them safer than stocks
Stop-loss orders in stocks get triggered when the stock value is either at or below the indicated limit when there's high market volatility and there are gap openings leading to potentially higher losses
With a put option, the investor has the right, but not the obligation, to sell the stock at a predetermined strike price notwithstanding the market price of the underlying stock.
Higher Potential Returns
With an option, an investor pays for the right, but not the obligation, to buy or sell an asset
This is done at a specific price on or before the predetermined expiry date of the option
As a result, with a small investment, investors can control a larger portion of the underlying stock
So if the stock price goes up, a call options value can increase manifold
Features of Trading Stock Options
Below is a list of the main features of trading stock options:
Volatility
The volatility of the underlying stock influences options pricing.
More volatility = higher option premiums as there is greater potential for price swings.
Time Decay
The closer to the expiration date an option gets, the more they diminish
The main reason for this is that there are fewer chances of significant price movements in a smaller time frame.
Intrinsic and Extrinsic Value
Both the intrinsic and extrinsic value of an option make up its total value
Intrinsic value is the difference between the current stock price and the strike price.
Extrinsic value is the price of an option outside of its intrinsic value.
Risks and Challenges of Stock Options
Some of the risk and challenges of stock options include:
Selling options in the stock market has an unlimited risk if the price moves against an investor.
If an investor sells a call option, there can be a huge risk if the price shoots up
When selling a put option risk arises when the price crashes
Even with stop losses, overnight risks will still exist
The only way to manage such risks is to write options better.
When investors buy an option, volatility can work in their favour but such volatility will have the opposite effect when selling options.
When selling options, a higher initial margin is risky and when buying options, investors end up paying premium margins, which is the maximum loss they might potentially endure
Option selling has the potential for unlimited losses
Mark-to-market margins in selling calls or puts need to be filled up when the price movement goes against the seller.
This is to avoid any risk of liquidation of assets for the seller of the option, in case the total margin falls below the maintenance margin.
Strategies for Trading Stock Options
Some of the strategies for stock option trading include:
The Long Call:
A strategy where an investor buys a call option with the expectation that the value of the underlying stock would surpass the strike price before its expiration
In this strategy, if the movement is in favour of the trader, then there is potential for unlimited profit
However, if it moves against the trader, then they lose their entire investment
The Covered Call:
Here the trader sells a call option while buying 100 shares of the underlying stock for each call sold
This is done expecting that the stock price will hover below the strike price of the option
If the stock price finishes above the strike price, then the option owner has to sell it to the call buyer at the strike price.
The Long and Short Put:
In the long put, a trader buys a put expecting the stock price to fall below the strike price before the option expires, possibly generating multiples of the initial investment
In the short put, a trader sells a put expecting the stock prices to rise above the strike price before the expiration of the option. When a put is sold, the trader will receive the premium from the buyer which is the maximum a trader can earn in this instance.
Conclusion
There are a total of two stock options; call options and put options.
A call option gives the holder the right to buy the shares of a particular stock without the obligation to do so, at its strike price, within a specified time frame.
A put option gives the option holder the right to sell shares without the obligation to do so at a predetermined price and within a specified time frame.
Options pose benefits like being cost-efficient, mitigating risks and potential for higher returns
They also come with risks like price crashes, stock liquidation etc
This is why it is important to gauge all the pros and cons of investing in stock options before doing so.
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Frequently Asked Questions
How do inflation indexed bonds work?
- Answer Field
-
The government increases the principal of these bonds every year based on inflation. On the principal thus adjusted, the interest is calculated by applying the coupon rate. By doing this, the government protects the interest and principal of investors against inflation.
What are the benefits of investing in inflation indexed bonds?
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These bonds protect the real return on investments by providing a shield against inflation. Besides, they are issued by the government; hence, their creditworthiness tends to be very high.
How are inflation indexed bonds different from regular bonds?
- Answer Field
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Regular bonds don’t offer protection against inflation; however, inflation indexed bonds are designed to provide such protection.
Who should consider investing in inflation indexed bonds?
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Those investors who want guaranteed protection against inflation should consider investing in these bonds.
What are the risks associated with inflation indexed bonds?
- Answer Field
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Their prices change based on the level of interest rates. So, you take market risk by investing in these bonds. Besides, the CPI may not be the best benchmark for inflation. Hence, such bonds may not offer you adequate protection against inflation.
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