What is an Outright Option?

Time plays a crucial role in trading and traders want to buy and sell assets at the ‘right time’ to make more profit. Options can help a trader make the most of market ‘timing’ by allowing the trader to buy or sell stocks within a time frame.

Options are a type of financial derivatives which are available in various types; one of them is the outright option. This blog talks about the meaning of outright options, what are the types of outright options and how to use them.

Outright Option

Options are a way for traders to hedge and limit their losses, also called ‘downside risk’. However, the outright option does not use a counter hedging strategy. It is also not part of a larger trade.

Then, what makes an outright option different from the other options?

Technically, the word ‘outright’ can mean direct. Thus, an outright option is bought and sold individually, and not as a part of a mixed option strategy. Meaning, that when someone places the outright option, they do not place a second contract to hedge their option.

Just like any other option strategy, the outright option also uses ‘call’ and ‘put’ to trade the underlying security.

Why is an Outright Option used?

Traders use the outright option to increase the chances of gains in trade. When the potential for gains increases, the risk in trade also increases. While using an outright option, the trader cannot hedge this risk.

What are the types of outright options?

The outright option can be a call option or a put option.

Traders use the call option because it gives them the option to sell the stock at a higher price before the expiration date.

A put option gives traders protection against downside risk by giving them the option to sell the stock before it goes down below a limit. The put option can be exercised anytime before its expiration date.

What is an outright option explained with the help of an example?

Let us understand outright options with an example.

Consider that a trader expects a stock to rise substantially. The trader’s bullish expectation of the stock in the future makes them buy the ‘call’ option.

Suppose, the ‘call’ option is bought in July and the stock is trading at Rs. 200. The trader believes that the stock price would go up and be around Rs. 220 in October. The trader can buy an option readily with their money.

Suppose they buy the stock at a strike price of Rs. 200. Here, the total cost for 100 stocks would be Rs. 20 (ask price for October) multiplied by 100, which is equal to Rs. 2000/-. However, if the stock price doesn’t reach Rs. 220, the option will be worth a very small amount which is Rs. 22. Therefore the total profit of the trader would be [(Rs.22-Rs.20) x 100] = Rs.200.

If the trader exercises their option, they can buy stocks at the July price (Rs. 200). Then, they can sell it when the price rises to Rs.220.

So, what is the risk for the trader?

The trader has two option possibilities

• Option one

  If the price of the stock falls, then the trader loses up to Rs. 2000. The trader may experience the biggest loss if the stock falls to its buy price in July. Therefore, the trader stands the risk of losing the entire premium amount. However, the trader can sell them before the stock price falls to that level.

  What are the other options available to the trader?

  Another option is to use the ‘near to money’ or ‘out of the money’ option. This will even be a call-type outright option.

• Option Two

  Consider that the trader purchases Rs. 210 strike price call option for an asking price of Rs. 9. For 100 stocks, this will cost the trader Rs. 900.

  Therefore, if the stock is trading at Rs. 220, the trader can sell the option and can net a profit of around Rs. 10 (minus commission) per share. The total profit of the trader would be Rs. 10 multiplied by 100 which is equal to Rs. 1000. Here, the trader has paid Rs. 900 for buying the option.

  To make any profit, the trader needs to sell the stock at Rs. 220. Every option comes with a pre-specified expiration date. Therefore, the price has to touch Rs.220 before or on the expiry date of the option.

  If the price per share goes up to Rs.225, the total profit would be Rs.25 multiplied by 100. This is equal to Rs. 2500. Here, the trader has paid Rs. 900 for the option. With this, the total profit left with the trader will be Rs. 16 per share.

  If the trader compares the above mentioned two options, the first one seems to be more expensive. In the first option, the price has to fall to or below Rs. 200. The trader, in this option, has a chance to recover some of the cost even if the price does not go as expected.

  In the second option available to the trader, they will lose value. The profit available to the trader will be zero if the price does not rise above Rs. 220 before or at expiry. To make a profit in the second option, the price has to cross Rs. 225.

To conclude

Increasing profit potential is the aim of an outright option. The trader can use either the outright call option or the outright put option, but not use them together. The trader is not allowed to hedge using more than one option in a trade. Therefore, as discussed with the above examples, the trader increases their risk of losses as they increase their profit potential. This makes an outright option meaning “outright” in terms of options. Traders can use a variety of options like the outright option with the IIFL trading account. To explore the benefits and open your IIFL trading account, click here.