Options Overview - Intro, Types, How to trade Call n Put Options

Published on Monday, April 2, 2018 by Chittorgarh.com Team | Modified on Friday, November 8, 2019

Options have emerged as a popular investment avenue. In the last few years, we have seen a growing participation from retail investors in the options market. Though options trading is an old phenomenon in the world markets, options trading in India started with the launch of index options on June 4th, 2001. On July 2nd, 2001, stock options were launched. And from there, index and stock options have risen to over Rs 4,45,561 crores in value in 2017-18.

Source: NSE

What is an option?

Options are a form of 'Derivatives'. Derivatives are financial instruments that derive their value from an 'underlying' instrument like stocks of a company, currency, gold, etc.

Curd is a derivative of milk i.e. derived from milk. Similarly, options are derived from an underlying financial instrument say a share of a company or a currency or gold.

Now, we all know, as the price of milk moves up and down, the price of curd also move up and down accordingly. The same way price of options moves up and down with the movement in prices of its underlying instrument.

How options are traded?

In the normal stock market, investors buy and sell shares. The prices of the shares move up/down frequently in the market. If you think a particular share will move up in the next few days/weeks/months, you buy a quantity of the shares by paying the market value at that time. The transaction value (price of shares + brokerage) is deducted from your trading account and the shares are delivered to your account in a couple of days.

When the share's price reaches your expectation, you sell it and earn a profit. But if the shares prices go below your buying price, you incur losses when you sell it. In both cases, the shares are deducted from your trading account and the transaction value is credited to your account.

Options trading is a little different from shares trading.

In options, instead of buying shares and getting it delivered to your account, you buy the choice to exercise an action at a predetermined price and within a predetermined period. The action is to buy/sell or opt out. The second difference is that there is no delivery of options. All transactions are settled in cash.

An options contract gives you the option or choice to enter into a deal to buy a fixed number of shares at today's price at a future date. You need to pay an amount (much smaller than the value of the underlying shares) to buy this choice. The amount you pay is called premium. But if the deal doesn't look favorable to you at that future date then you have the choice to opt out of it. In that case, you lose the premium paid while buying the choice.

Every option contract mentions its strike price, premium, lot size and expiry date.

• Strike price: The price at which the buyer and the seller of an option have agreed to enter the option contract is the strike price. Each option on the underlying has multiple strike prices.
• Premium: The payment made by the buyer to the seller to earn his right of an option contract.
• Expiration day: The last day that the option owner can exercise the option.
• Lot Size: The fixed number of units of the underlying instrument form part of a single Options contract. The lot size differs for each stock and is decided by the exchange.

Now let's look at how this plays out in an illustration:

Let's say there is an option available on Infosys for the month of August at the strike price of Rs 2000 and a premium of Rs 200 for a lot size of 100 shares of Infosys. This option allows you the right to buy 100 shares of Infosys at Rs 2000 anytime from now until the end of August. To earn this right, you pay a premium of Rs 200 X 100 shares = Rs 20000. Now, if the market price of Infosys at any time during August is higher than Rs 2200, then you may exercise the right and earn profits. But if you see that the price is lower than Rs 2200 and exercising the deal will result in losses, in that case, you can choose to opt out. You will lose the premium amount paid at the time of buying the options.

So an option allows you to buy shares when it is profitable to you and opt out of the deal when you see there's loss for you.

Types of Options

Options are of two types - Calls and Puts

Calls give you the right, but not the obligation to buy a given quantity of the underlying asset, at a stated price on or before a predetermined future date.

Puts give you the right, but not the obligation to sell a given quantity of the underlying asset, at a stated price on or before a predetermined future date.

Options can be classified as European or American based on the type of exercise. American Options are contracts that can be exercised at any time up to the expiration date while European options can be exercised only on the expiration date. In India, American Options can be exercised on individual securities like Reliance, SBI, etc. and options on indexes like Nifty 50, Nifty bank etc., are European options.

Example of a Call Option

You buy a call option on SBI for August month at the strike price Rs 1000 and a premium of Rs 100 for a lot size of 100 shares. This allows you the right to buy 100 shares of SBI at Rs 1000 anytime from now until the end of August. To earn this right, you pay a premium of Rs 100 X 100 shares = Rs 10000. Now, if the market price of SBI at any time during August is higher than Rs 1100, then you may exercise the right and earn profits. Say the option price is Rs 1150 on expiry. As all the financial derivative contracts are settled in cash, and no delivery of the underlying is made, the contract will be settled by paying you an amount of-

Rs 150 (Strike Price- Market Price) X 100 shares= Rs 15000.

Your profits will be Rs 15000 - Rs 10000 = Rs 5000.

Now, if on the expiry date the stock price falls below Rs 1000, then you have the right not to exercise this option. You would only lose the premium amount of Rs 10,000 paid at the time of calling the option.

Example of a Put Option

You buy a Put option on SBI at the strike price of Rs 1200, at a premium of Rs 50 for a lot size of 100 shares. You pay a premium of Rs 50 X 100 = Rs 5000 while buying the option. If the market price of SBI on the expiry day is less than Rs 1250, then you will earn profits by exercising your right to sell the option. However, if the stock price had increased over Rs 1250 then you could choose not to exercise the option and lose the premium.

Some options related jargons you must know:

• In the money: For a Call option, 'In the money' means the underlying instrument price is trading higher than the strike price. For a Put option, 'In the money' means the underlying instrument price is trading lower than the strike price.
• Out of the money: For a Call option, 'Out of the money' means the underlying instrument price is trading lower than the strike price. For a Put option, 'In the money' means the underlying instrument price is trading higher than the strike price.
• At the money: When the underlying price is equal to the strike price.