Option Trading

Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expire. Options can be purchased like most other asset.

Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract. While buying an option a contract the buyer has the right to exercise the option within the stipulated time period but he or she is not bound to exercise that option. On the other hand if the buyer is willing to exercise the option the seller is bound to honor that contract. In option trading the price that is agreed up on for trading is called the strike price and the date on which the option contract is going to expire is called the expiration time or expiry. There can be different underlying assets for which options are traded including stocks, index, commodity, derivative instrument like the future contract and so on.

Options have contract specifications, which include the option type (calls or puts), underlying asset, strike price, expiration date, contract size and exercise style.

Options based on equities, more commonly known as “stock options,” typically are a natural lead for traders new to options. It is important to understand the details of a stock option quote before you make a move— like the cost and expiration date.

However, options are not the same thing as stocks because they do not represent ownership in a company. And, although futures use contracts just like options do, options are considered lower risk due to the fact that you can withdraw (or walk away from) an options contract at any point. The price of the option (its premium) is thus a percentage of the underlying asset or security.

While it is a little more complex than stock trading, options can help you make relatively larger profits if the price of the security goes up. That’s because you don’t have to pay the full price for the security in an options contract. In the same way, options trading can restrict your losses if the price of the security goes down, which is known as hedging.

Options as Derivatives

Options belong to the larger group of securities known as derivatives. A derivative's price is dependent on or derived from the price of something else. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps securities, among others.

Options derive their value from the underlying asset. Again, there are various options out there, but we’re focused on stock options. Just for reference, index options are cash settled and some multiple of the underlying index’s value. The underlying asset of futures options is a futures contract.

Trading in option contracts

For trading in the option contracts you have to pay the premium price to the writer of the option contract. Like in other forms of derivative trading in option trading as well you have to buy or sell the option contract for one or more lot. A lot comprises a fixed number of underlying assets and the price of the lot is determined by calculating current valuation of the asset in the market and the number of units in the lot.

From an investors point of view there are double folded benefit of option trading. Firstly, the leverage of the option trading that lets you control greater value of investment with significantly lower deposits. In option trading you need much lower deposits to trade in option trading than investing or buying the same quantity of asset outright. Apart from leverage, the option trading has lower risk that investment in cash segment or trading in the future contracts.

If you have a speculation that the price of particular stock is going to rise, you can buy the call option of that stock. If the stock rises to your expectation within the expiry date then you can always exercise that option contract to make your profit, else you can let the option expire worthless. Even in that case you need not pay anything more than the premium of the option contract. On the opposite side if you think that price of a certain stock is going to fall, you can buy the put option instead of selling a future contract. In this case also you can make profit by exercising the put option within the period or let it expire without any action on your part.

With so much advantage of the option it is strange that maximum traders make loss while trading in option contracts. The major reason behind this is they end up buying really overpriced option contracts and most of these contracts expire worthless. So if you want to make sure that you make profit from option trading, you need to determine the fair value of the option before trading in that option.

Types of option contract

There are mainly two types of option contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put Option’.

Call Option

When you are buying a call option it will give you the right to buy the underlying asset at the strike price within the stipulated time period. The option writer, who is creating the call option, will have the obligation to sell the asset if you are willing to buy as per the contract. For buying the call option you will have to pay the premium price of the contract to the option writer.

Call option is a derivative contract between two parties. The buyer of the call option earns a right (it is not an obligation) to exercise his option to buy a particular asset from the call option seller for a stipulated period of time.

Once the buyer exercises his option (before the expiration date), the seller has no other choice than to sell the asset at the strike price at which it was originally agreed. The buyer expects the price to increase and thus earns capital profits.

Buying a call Option

When you buy a call option, you hold the right to buy a specified quantity of the underlying stock at the strike price on or before the expiration date.

If you are bullish on a stock you could purchase a call option at a predetermine (Called it as the strike price) that is lower than the appreciation you expect then, if all goes well and the stock price does rise beyond the strike price + the premium you have paid, on or before the expiration of the contract, you can exercise your option to buy the stock at the strike price and simultaneously sell it in the spot market. i.e. the cash market to book your profit.

If, on the other hand the price of the stock in the cash market does not rise beyond the strike price + premium, you can let the contract lapse, i.e. you do not buy the underline stock at the strike price. Your loss in such a case would be premium you have paid. However in India equity options and futures are currently cash settled and are not settled by delivery.

Example

Current spot price per share = Rs 1000
Premium payable per share = Rs 100
ABC company has a lot size = 500 shares

If the spot prices rise to Rs 1200 per share before the contract expires you could exercise your option to buy the shares at Rs 1000 and then sell them in the market for Rs 1200. Your profit in this transaction would be Rs 50,000 (Sale price of Rs 1200 x 500 – purchase of 1000 x 500) – premium of 100 x 500).

If, on the other hand if the price does not go beyond Rs 1000 until the expiry date, you could just let the contract lapse. In this case, your loss would be equal the premium that you have paid. i.e. Rs 50,000.

Put Option

A put option is the opposite of the call option. When you are buying a put option it will give you the right to sell off the asset in the strike price on or before the expiry of the option contract. While you will have the freedom to either honor the put option or ignore it, the seller of the put option will be legally bound to buy the put if you are willing to sell.

Put option is a derivative contract between two parties. The buyer of the put option earns a right (it is not an obligation) to exercise his option to sell a particular asset to the put option seller for a stipulated period of time.

Once the buyer of put exercises his option (before the expiration date), the seller of put has no other choice than to purchase the asset at the strike price at which it was originally agreed. The buyer of put expects the value of asset to decrease so that he can purchase more quantity at lower price.

Buying a put Option

When you buy a put option, you hold the right to sell a specified quantity of the underlying stock at the strike price on or before the expiration date.

If you are bearish on a stock you could purchase a put option at a pre-determine (strike price) that is higher than the fall you expect in the price of the stock.

If all goes well and the stock price does fall beyond the strike price - the premium you have paid, on or before the expiration of the contract, you can exercise your option to sell the stock at the strike price and simultaneously buy it in the spot market. i.e. the cash market to book your profit.

If, on the other hand the price of the stock in the cash market does not fall to the strike price - premium you can let the contract lapse, i.e. you do not sell the underlying stock at the strike price. Your loss in such a case would be premium you have paid.

Example

Current spot price per share = Rs 1000
Premium payable per share = Rs 100
ABC company has a lot size = 500 shares

Going with the above example if the spot prices depreciate to Rs 800 per share before the contract expires you could exercise your option to sell the shares at Rs 1000 and then buy them in the market for Rs 800. Your profit in this transaction would be Rs 50,000 (Sale price of Rs 1000 x 500 – purchase of 800 x 500 – premium of 100 x 500).

If, on the other hand if the price does not fall below Rs 1000 until the expiry date, you could just let the contract lapse. In this case, your loss would be equal the premium that you have paid. i.e. Rs 50,000.