If you’re new to the world of investing and trading, terms like “options” and “premium” can seem confusing. But don’t worry! This article will explain options trading in a simple, easy-to-understand way. By the end, you’ll have a basic understanding of how call options, put options, and option strategies work, and how you can use them in your trading journey.
What is an Option?
At its core, an option is a type of financial contract that gives the buyer the right (but not the obligation) to buy or sell an asset at a set price on a specific date. The asset could be anything from natural gas, stocks, crude oil, and gold, to indices like Nifty, Sensex, or even currencies.
Options are considered a type of derivative contract, meaning their value is based on the price of something else (like the stock of a company or a commodity). A key feature of options is that they are “wasting assets,” meaning they lose value over time and become worthless after their expiry date.
Two Types of Options: Calls and Puts
There are two main types of options you need to know about: call options and put options.
- Call Options: A call option gives you the right to buy the underlying asset (like a stock or index) at a specific price (called the “strike price”) before the option expires. If you expect the price of the asset to go up, you buy a call option. You can make a profit by either selling the option itself (if its value increases) or by exercising the option and buying the asset at the lower strike price.
- Put Options: A put option gives you the right to sell the underlying asset at a specific strike price before the option expires. If you expect the price of the asset to go down, you buy a put option. Just like with call options, you can make a profit by selling the option or exercising it to sell the asset at a higher price than the current market price.
You can refer our article difference between a call option and put option to learn more.
How Does Options Trading Work?
Let’s break it down with a simple example.
Buying Call Options
Imagine you believe the stock of ABC Limited (currently trading at Rs 100 per share) will rise to Rs 115 in the future. You can buy a call option to buy 250 shares of ABC at Rs 100 each.
- If the price rises to Rs 115, you can either sell the call option at a higher price or buy the shares at Rs 100 and sell them at the current market price of Rs 115, making a profit.
- For example, if the call option costs Rs 2,500 and rises to Rs 2,700, you make a profit of Rs 200 (Rs 2,700 – Rs 2,500). If you buy the shares and sell them at Rs 115, your profit is higher: Rs 1,250 (calculated by taking the difference in price per share, multiplying by the number of shares, and subtracting the premium you paid).
This shows how call options allow you to make a profit with a smaller initial investment, especially if you’re right about the price direction.
Buying Put Options
Now, let’s say you believe that the stock price of ABC Limited will drop to Rs 85 per share. Instead of selling the stock short, you can buy a put option. This gives you the right to sell the stock at Rs 100 (the strike price), even if the market price falls to Rs 85.
- If the price drops, you can sell the put option at a higher premium or exercise it to sell the stock at Rs 100, making a profit from the price difference.
- If you bought the put option for Rs 2 per share, and the stock falls to Rs 85, you can sell it at a higher premium and make a profit.
Buying put options is often done when traders expect a stock’s price to fall, which is known as having a bearish view.
Selling (Writing) Options: A Different Strategy
You can also sell options (also known as writing options). This means you are offering the option to someone else in exchange for a premium.
- As a seller, your goal is for the option to expire worthless. In this case, you keep the premium you received as your profit.
- However, if the buyer decides to exercise the option, you must fulfill the contract. For example, if you sold a call option and the stock price rises above the strike price, you might have to sell the stock at the lower strike price, causing a loss.
Selling options can be more risky because your losses can be unlimited if the market moves against you.
Why Do Traders Prefer Buying Options?
Options allow traders to potentially earn high returns with a lower initial investment. For example:
- If Mr. Kumar wants to invest Rs 10,000 in ABC Limited, currently trading at Rs 1,000 per share, he could buy 10 shares.
- If the stock price rises to Rs 1,100, his profit would be Rs 1,000 (10 shares * Rs 100 profit per share).
Alternatively, with Rs 10,000, Mr. Kumar could buy call options for ABC Limited at a strike price of Rs 1,000 (Rs 50 per share for 100 shares). He could buy 2 lots (200 shares) for Rs 10,000 and, if the stock price rises to Rs 1,100, his call options could be worth Rs 20,000.
In this case, Mr. Kumar would make a 100% return on his capital, which is far greater than the 10% return he would have made by simply buying the stock.
The Risk and Reward of Options Trading
The main advantage of buying options is that your potential loss is limited to the premium you paid for the option. If the market moves against you, that’s all you lose. But if the market moves in your favor, your profit can be substantial.
The potential downside is that options can expire worthless, and if the asset price doesn’t move in the direction you expected, you could lose the premium you paid for the option.
For option sellers, the profit is limited to the premium received, but the risk is higher since losses can be much larger if the market moves against them.
Conclusion: Is Options Trading Right for You?
Options trading can be a great way to earn high returns with a small initial investment, but it also comes with risks. As a beginner, you need to understand the mechanics of how call options and put options work, along with the different strategies available.
Before diving into options trading, consider consulting a financial advisor to help guide you through the risks and rewards involved. Always start small and continue learning as you go.Options trading can offer great opportunities, but it’s important to approach it carefully and understand both the potential rewards and risks.
Frequently asked questions (FAQs)
What is the strike price?
Strike price is set by the seller or writer of the option contract.
When you buy a call option, strike price is the price at which you are agreed to buy the underlying asset if the contract is exercised. Strike price also determines whether the option contract is a At the money (ATM), In the money (ITM) or out of the money (OTM).
What is the option premium?
Premium is the amount of fee paid by the buyer for buying an options contract. Premiums vary based on how the option contract is traded in the market and the value of the underlying asset.
The Buyer pays the premium and the seller receives the premium.
Buyer has liberty to sell the right on option contract to another buyer in stock exchange for higher or lower premium based on how the contract is traded in the market. The new buyer will become the holder of the option contract.
What is implied volatility?
Implied volatility is known as IV. You don’t need to calculate it.
You can find Implied Volatility (IV) in the option chain. Implied volatility is a prediction of how much the price of the security will move over a given period of time.
What is the Expiration date in Option contract?
All option contracts must have an expiration date after which they will become worthless. An European option can only be exercised at expiry but an American option can be exercised at any time before expiry.
Different option contracts can have different expiry dates.
What is the European Option?
European option is a type of option contracts in which the buyer or holder is allowed to exercise the contract at expiry. The buyer can not exercise his or her rights on the option contract before expiry.
The holder or buyer has the right to exercise the option but are not obliged to do so. They can even let the option expire worthless without exercising it.
What is the American Option?
American option is a type of option contract in which the buyer can exercise his or her rights at any time before the expiry. Which means he or she can exercise rights at any time between the day they purchase the contract and the expiry date.
What is theta in options?
Option value decreases as it nears expiration date. This change in value is measured by Theta.
Theta is also known as time decay.
What is delta in options?
Delta measures the change in option price with respect to change in the price of the underlying asset.
All at the money (ATM) option contracts are considered as 0.5 Delta. Which means if the price of the underlying asset moves 2 points then option price will move 1 point.
In the money (ITM) option contracts have high delta and out of the money (OTM) option contracts have negative delta.
What is In the money (ITM), At the money (ATM) and Out of the money (OTM) options?
A call option will be considered as In the money (ITM) if the current market price of the underlying asset is higher than the strike price.
A put option contract is considered as In the Money (ITM) when the price of the underlying asset is lower than the strike price.
When the strike price of a call option contract is higher than the current market price of the underlying asset, the contract is considered as Out of the money (OTM).
A put option contract will be considered as out of the money (OTM), if the price of the underlying asset is higher than the strike price.
If the strike price and price of the underlying asset is same, then the option contract is considered as At the money (ATM).
What are spreads in option trading?
Naked trading in options is very risky as the trader may have unlimited loss. To minimize losses and protect profit, traders use different strategies.
Spreads are hedging strategies used in option trading to minimize risk. In spreads, traders buy and sell a combination of different option contracts for the same underlying asset.
Spreads are categorized as credit and debit spreads based on net premium credited or debited based on the strategy used. We have debit spread, credit spread, straddle, strangle and Butterfly as a spread strategy used by option traders.
What is a covered call?
Covered call is a hedging strategy used when you are holding shares of a particular stock and you have a bearish view on the same stock for a short period of time.
In a covered call, the owner of the stock writes a call option at a strike price which is the same as current market price or above it to collect premium from the buyers.
When market price moves down and expires below the strike price, then the seller earns the premium as the buyer will not exercise his rights. Instead if the market moves up and closes at or above the strike price, then the buyer will exercise their rights by which the seller will sell the shares at the strike price and retain the premium.
Covered calls are executed when the traders think that the market price of the underlying will not close at or above the strike price. They are not even expecting a drastic fall in price.
What is a protective put?
Protective put is a hedging strategy in which the trader is expecting a downside in the stock’s price that they own. In a protective put, the trader buys a put option by paying premium for the stock which he is holding in his or her portfolio.
Protective put acts like an insurance policy for the investor against losses.
If the price of the stock expires above the strike price, then the put option expires worthless. Buyer’s loss in this case is the premium amount paid.
Instead of moving up, if the stock closes far below the strike price, the put option premium increases to cover the losses of the portfolio. The buyer can either exercise by selling their holdings at the strike price to make profit or the put option contract before expiry can be sold to another buyer to pocket the profit arising from the rise in option premium price.
Instead of buying a lower strike price put option, if you have decided to buy an at-the-money (ATM) put option to cover the downside of your existing long position, then the strategy used is referred to as married put.
What are long straddles?
When a trader does not know in which direction the market or stock price will move, they prefer to use long straddles. In this hedging strategy, they buy both a call option and put option at the same strike price and expiration on the same underlying asset.
In long straddles, maximum loss is restricted to the premium paid on buying both call and put options. Traders will make money if prices break out either way.
What are long strangles?
Long strangles are similar to long straddles.
In long strangles, the trader buys an out-of-the-money (OTM) call option and a put option at the same time having the same expiry date. Put strike price should be below the call strike price.
Traders will be paying less premium but in order to make profit, the market should make a strong move to close at or above either side of the strike price.
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
