Option is a derivative contract which gives its buyer the right, but not the obligation, to buy or sell a certain quantity of assets at a fixed price on a given date. Assets can be stocks, crude oil, agri commodities, natural gas, silver, gold, cotton and currencies.
Underlying assets can also be Indices such as Nifty, Bank Nifty, Nifty Midcap, sensex, Bankex and Finnifty.
You can not apply buy-and-hold investment strategy to option contracts as after expiry these are worthless. That is why options are called wasting assets.
We have two types of options: calls and puts. Both can be bought and sold on Indian stock exchanges like NSE, BSE and MCX.
In call options, the buyer of the contract purchases the right to buy the underlying asset at a predetermined price on the date of expiry. In put options, the buyer of the contract acquires the right to sell the underlying asset on the date of expiry at a predetermined price.
Call and Put option buyers are charged an amount called a premium by the seller for the right on contracts. You can refer our article difference between a call option and put option to learn more.
Predetermined price is also referred to as strike price or exercise price.
Let us discuss certain basic trading styles used by investors and traders in option trading.
Buying call options
If a market participant has a bullish view on a stock or index, then they may buy a call option instead of directly buying the underlying asset.
For example, suppose Mr Kumar is expecting the price of ABC limited, a listed stock, to rise from the current trading price of Rs 100 per share to Rs 115 per share in the near future. Due to this expectation, he decides to buy a call option of 250 shares at a strike price Rs 100 per share.
When stock of ABC limited rises to Rs 115 per share, Mr Kumar can either sell the option contract to another buyer by profiting from the rise in premium that he paid initially or he can buy shares of ABC stock at Rs 100 per share to sell it at the current market price of Rs 115.
If the call option premium while buying is Rs 2,500 and it rises to Rs 2,700 at a market price of Rs 115 per share, then his profit is Rs 200 (Rs 2,700-Rs 2,500).
In case he decided to buy shares of ABC limited at Rs 100 to sell at Rs 115, then his profit = (Sale value per share – purchase value per share) * number of shares – Premium paid = (Rs 115 – Rs 100) * 250 – Rs 2500 = Rs 3,750 – Rs 2,500 = 1,250
In the second option, he will have more profit, but it requires higher investment. A minimum amount of Rs 27,500 is required to earn a profit of Rs 1,250. In the first option, Mr Kumar requires only the premium amount of Rs 2,500 to earn a profit of Rs 200.
In the first option Mr Kumar earned 8% on his capital. In the second option, Mr Kumar earns 4.5% on his capital,
Due to higher return on capital invested, many traders in India nowadays prefer option buying as a trading career.
As a buyer when price of the underlying asset moves in your favor you gain, instead if it moves against you, then your losses are limited to the premium paid for the options and no more.
In option trading, buying calls is referred to as long calls.
Buying put option
When traders expect the price of a particular stock to decline, they short it at a higher level to cover it at a lower level by profiting from the difference in price.
Instead of shorting a stock, in option trading, what traders do is they buy a put option of the same stock at a strike price which is near the current market price.
Traders and investors buy a put option when they have a bearish view on the market or stock. Which means they are expecting the prices of the stock to decline in the near future.
For example, suppose stock of ABC limited is currently trading at Rs 100 per share in a stock exchange. Mr Kumar is expecting the prices to fall to Rs 85 per share in near future.
Instead of shorting the stock, Mr Kumar bought a put option at a premium of Rs 2 per share.
When stock’s price declines to Rs 85 per share, Mr Kumar has two options, he can either sell the put option contract to another buyer at a higher premium or he can wait for expiry date to buy the stock at Rs 85 per share to sell at Rs 100 per share by exercising put option contract rights.
In option trading, buying puts is referred to as long puts.
Writing call and put options
Another method used by investors is option selling or writing.
The writer or seller makes money from the option premium that he or she has received from the buyer. If the buyer exercises his or her option, then the profit of the buyer is the loss of the seller. Seller makes money when the option expires worthless.
When as a buyer Mr Kumar buys a put or call option based on his strategy, the premium that he has paid for buying goes to the seller of that contract.
In option trading when the contract expires worthless, then the maximum loss of the buyer for buying call options or put options is the premium amount paid. In option selling, loss of the writer can be unlimited based on how prices of the underlying stock moves against the seller.
Why do many traders prefer option buying to make money?
Suppose Mr Kumar wants to invest Rs 10,000 in a stock which is currently trading at Rs 1,000. With this amount Mr Kumar can buy 10 shares for Rs 1000 per share.
If price of the stock increases to Rs 1100 over a month, then Mr kumar’s profit by selling the shares will be Rs 1,000 (i.e. Rs 100 per share * 10 shares). While calculating profit we have ignored brokerage commision, security transaction tax and other transaction fees.
By investing in stocks with a capital of Rs 10,000, Mr Kumar has earned 10% profit.
Instead of investing directly in stock, suppose Mr Kumar has decided to go for a call option. Suppose a call option at a strike price of Rs 1,000 is trading at a price of Rs 50 per share, which comes with 100 shares per lot, therefore in total its cost is Rs 5000 per lot.
With a capital of Rs 10,000, Mr Kumar has decided to buy 2 lots (Rs 10000 / Rs 5000). Which means the underlying shares in this case is 200 shares.
If stock moves 10% from current market price of Rs 1000 to Rs 1,100 on the date of expiry, then the call option will expire in-the-money (ITM). In this case, on the date of expiry the call option will be worth 100 per share (Rs 1100-1000), or Rs 20,000 for 200 shares.
Before expiry, Mr Kumar can sell his call option contract to some other buyer to earn Rs 20,000 (approx). Now with a minimum investment of Rs 10,000, Mr Kumar has earned Rs 20,000, which is 100% of the capital invested.
Mr Kumar instead of selling his call option to another buyer, if decided to wait for expiry, then by executing his rights he can buy the underlying shares at Rs 1,000 per share to sell it at Rs 1,100 per share to earn profit. In this case, he can earn Rs 20,000 ((Rs 1100*200) – (1000*200)).
Above example is just to understand the concept. We have many factors which can affect the option premium based on how the underlying asset price moves.
As a trader you have to understand all these factors before getting into option trading.
Option trading can give you high returns with less capital.
Risk and reward in option trading
A buyer’s loss for a long call or put is limited to the option premium paid.
Theoretically, potential profit of a buyer is unlimited as the option premium will increase based on how the underlying asset’s price moves.
Due to higher return with less capital, many retail and institutional traders are jumping into option trading.
Option trading is very complex, make sure that you understand the risks and reward involved before starting out.
You can buy a call or put option using less capital than the underlying asset itself. But do note that these benefits come with high risk. Traders and investors before starting option trading advised to consult a financial advisor before adding these financial instruments into their portfolio.
Many professional traders and investors prefer hedging strategies to reduce the risk of losing money in option trading. You can use different hedging strategies to protect your downside and hedge market risk.
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.
