Have you ever wondered how you can invest in the stock market without actually buying the stocks? Or maybe you’ve heard of options trading and want to know what it’s all about. Well, you’re in the right place! Today, we’re going to break down the basics of options trading, explain how it works, and why it might be an interesting option for your investment strategy.
Table of Contents
The Official Definition of an Option
An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified time period. The buyer pays a premium for this right.
- Options are financial derivatives. This means their value is derived from the value of an underlying asset, like a stock.
What is options trading in simple words?
Options trading is like having a special contract that gives you the right to buy or sell an asset (like stocks) at a specific price (strike price) before a certain date. Think of it as making a deal with someone to buy or sell something in the future, but with more flexibility.
A Simple Example
Imagine you have an option to buy a bike. The term “option” means you have a choice. This option lets you choose to buy the bike or not. It’s totally up to you. If you decide to buy the bike, you get it after paying the price. If you don’t want to buy it, you simply walk away.
In the same way, options trading lets you buy or sell stocks at a fixed price within a set time frame.
Right, Not Obligation
Having an option means you have the right to buy or sell the asset, but you’re not obligated to do so. This gives you a lot of flexibility.
The Cost of Flexibility: Premium
To get this flexibility, you have to pay a fee to the other person involved in the deal. This fee is called a premium.
Why Pay a Premium?
Think of it from the seller’s perspective. If you make a deal to buy the stock but then decide not to, the seller might have wasted his time waiting for you to buy it. In the meantime, he could have sold his asset to someone else but did not, just for you. To make it fair, the seller charges you a premium. This way, he gets some money for giving you the option. It’s like a fee for the privilege. Even if you decide not to exercise the option, the seller keeps the premium as their compensation.
Types of Options
There are two main types of options:
Call Options
- A call option gives you the right to buy an asset at a specific price before a certain date. For example, if you think a stock’s price will go up, you might buy a call option to purchase it at today’s price, even if the price goes up in the future.
Put Options
- A put option gives you the right to sell an asset at a specific price before a certain date. This can be useful if you think the stock’s price will go down. You can sell it at today’s price even if the price drops.
There are also types of options based on the method of exercising them. The most common ones are American and European options.
- American Options: These can be exercised at any time before the expiration date.
- European Options: These can only be exercised on the expiration date.
In India, the options traded on the stock exchanges are primarily European-style options. This means that they can only be exercised on the expiration date. Both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) offer European-style options on various stocks and indices.
There are also exotic options, which have more complex features and are usually used by advanced traders. Exotic options include things like barrier options and binary options, which work differently than regular call and put options, offering unique structures and payoffs.
Why is it Important?
Options trading is popular because it allows investors to:
- Diversify their portfolios: Spread out investments to reduce risk.
- Hedge against risks: Protect against potential losses in other investments.
- Speculate on market movements: Make bets on whether prices will go up or down.
ALSO READ – The History of Options Trading in India
How Options Trading Works
Basic Mechanics
Options contracts are agreements between two parties: the buyer and the seller. The buyer pays a premium for the option, which is like a fee for having the right to buy or sell the asset.
Key Elements
- Strike Price: The price at which the asset can be bought or sold. For call options, it is the price at which you can buy the asset. For put options, it is the price at which you can sell the asset.
- Expiration Date: The date by which the option must be exercised.
- Premium: The cost of buying the option.
Examples
(1) Buying a Call Option: Imagine you buy a call option for a stock with a strike price of ₹2,000. A call option gives you the right, but not the obligation, to buy the stock at this price within a certain time frame. If the market price of the stock rises to ₹2,500, you can exercise your option to buy the stock at ₹2,000. This means you can purchase the stock for ₹500 less than its current market price, resulting in a profit. Here’s how it works:
- Buy Call Option: You pay a premium (let’s say ₹50 per stock) to buy the call option with a strike price of ₹2,000.
- Market Price Increases: The market price of the stock goes up to ₹2,500.
- Exercise the Option: You exercise your option to buy the stock at ₹2,000.
- Profit Calculation:
Market Price: ₹2,500
Strike Price: ₹2,000
Premium Paid: ₹50
Profit per Stock: ₹2,500 – ₹2,000 – ₹50 = ₹450
By exercising the option, you can buy the stock at ₹2,000 and sell it at the market price of ₹2,500, making a net profit of ₹450 per stock (after deducting the premium).
(2) Buying a Put Option: Imagine you buy a put option for a stock with a strike price of ₹400. A put option gives you the right, but not the obligation, to sell the stock at this price within a certain time frame. If the market price of the stock falls to ₹350, you can exercise your option to sell the stock at ₹400. This means you can sell the stock for ₹50 more than its current market price, resulting in a profit. Here’s how it works:
- Buy Put Option: You pay a premium (let’s say ₹20 per stock) to buy the put option with a strike price of ₹400.
- Market Price Decreases: The market price of the stock drops to ₹350.
- Exercise the Option: You exercise your option to sell the stock at ₹400.
- Profit Calculation:
Market Price: ₹350
Strike Price: ₹400
Premium Paid: ₹20
Profit per Stock: ₹400 – ₹350 – ₹20 = ₹30
By exercising the option, you can sell the stock at ₹400 and avoid selling it at the market price of ₹350, making a net profit of ₹30 per stock (after deducting the premium).
Conclusion
Options trading offers exciting opportunities for traders who understand its basics. By learning about options, how they work, and the key concepts involved, you can start your journey. Keep educating yourself and practice with small trades to gain experience. Happy trading!
What is the difference between call and put options?
A call option gives you the right to buy, while a put option gives you the right to sell.
How is the price of an option determined?
It’s based on factors like the underlying asset’s price, the strike price, the time to expiration, and market volatility.
Related Post
- TradingView offers demo accounts or virtual trading platform to practice options trading without real money. Read here to know how – 6 easy steps for doing Paper Trading in Nifty & Bank Nifty Options on Trading View