The vast majority of total trade volume at the BSE and NSE is accounted for by options trading. The cost of investment in options trading is typically between 3-4% of the cost of investment in stock trading. As a result, it is extremely popular among traders.
Options are tradable contracts that allow investors to speculate on whether the price of an asset will be higher or lower at a future date without having to buy the asset in question. For example, Nifty 50 options allow traders to speculate on the future direction of this benchmark stock index, which is widely regarded as a proxy for the entire Indian stock market.
Types of Options
Options are of two types – Calls and Puts
Calls option:
A call option gives you the right, but not the obligation, to purchase a specified amount of the underlying asset at a specified price on or before a specified future date.
Example of a Call Option
You purchase a call option on SBI for the month of August with a strike price of Rs 1000 and a premium of Rs 100 per lot size of 100 shares. This grants you the right to purchase 100 shares of SBI at Rs 1000 at any time between now and the end of August. You must pay a premium of Rs 100 X 100 shares = Rs 10000 to obtain this right. Now, if the market price of SBI is higher than Rs 1100 at any time during August, you may exercise the right and profit. Assume the option price at expiry is Rs 1150. Because all financial derivative contracts are settled in cash and no underlying is delivered, the contract will be settled.
(Strike Price-Market Price) X 100 shares = Rs 15000.
Your profits will be Rs 15000 minus Rs 10000 equaling Rs 5000.
Now, if the stock price falls below Rs 1000 on the expiry date, you have the option not to exercise it. You would only lose the Rs 10,000 premium paid when you called the option.
Puts option:
Put options give you the right, but not the obligation, to sell a specified amount of the underlying asset at a specified price on or before a specified future date.
Example of a Put Option
You purchase a Put option on SBI with a strike price of Rs 1200 and a premium of Rs 50 per lot of 100 shares. When you buy the option, you pay a premium of Rs 50 X 100 = Rs 5000. If the market price of SBI on the expiry day is less than Rs 1250, then you will profit from selling the option. If the stock price rose above Rs 1250, you could choose not to exercise the option and forfeit the premium.
To understand options, you just need to know a few key terms:-
- Derivative:- Options are a derivative, which means that their value is derived from another asset. Consider stock options, where the value of the option contract is determined by the price of the underlying stock.
- Strike price and expiration date:- A strike price is the previously mentioned predetermined price. Traders have until the expiration date of an option contract to exercise the option at the strike price.
- Premium:- The cost of purchasing an option is known as a premium, and it is calculated using the underlying security’s price and values.
- Intrinsic value and extrinsic value:- The intrinsic value of an option contract is the difference between the strike price and the current price of the underlying asset. Extrinsic value refers to factors that affect the premium that are not considered in intrinsic value, such as how long the option is valid for.
- In-the-money and out-of-the-money: – An option is said to be in-the-money (profitable) or out-of-the-money (unprofitable) depending on the underlying security’s price and the time until expiration.
Options Trading Benefits and Risks-Advantages and Disadvantages Explained:-
Advantages of Options Trading
- Small investment, higher profits: – Trading in options, also known as leverage in the trading world, allows you to make larger gains with a smaller investment. This is due to the fact that when you buy options, you are paying a premium amount rather than the value of the shares. And your profit is determined by the change in the value of the shares.
Let’s understand this with an example:
Assume you buy a TATA MOTORS option with a strike price of Rs 2000 and a premium of Rs 200 for a lot size of 100 shares. You must pay Rs 200 (premium per share) X 100 (lot size) = Rs 20,000 to purchase this option. If the share price of TATA MOTORS rises to Rs 2500 before the expiry date, you will receive Rs 500 X 100 = Rs 50,000. After deducting the premium amount of Rs 20000, the net profit will be Rs 30000.
If you had traded in shares during that time, you would have needed to invest Rs 2000 (share price) X 100 = Rs 2,00,000 and profited Rs 500 (price movement) X 100 = Rs 50,000.
As a result, options are available to you.
- Profitability in both price rises and price falls of the underlying instrument: – As an investor, you may not know which way a particular stock or instrument will move, but you are certain that some event will cause significant movement in the share price. This occurs during the announcement of quarterly results, budgets, policy changes, and so on. You can use the ‘Long Straddle Option Trading Strategy’ at such times. The strategy entails purchasing both a call and a put option with the same strike price and expiration date. This allows you to profit when there is a significant price movement in the company’s share, regardless of whether it moves up or down.
Let’s understand it with an example:-
Reliance Options is now available for purchase, just ahead of its quarterly results.
Call option at a strike price of Rs 2,000 at a premium of Rs 200 for a lot size of 100 shares.
Put options at a strike price of Rs 2,000 at a premium of Rs 210 for a lot size of 100 shares.
You buy both by paying Rs 20,000 for the call option and Rs 21,000 for the put option.
If the share price of Reliance rises to Rs 2500, you exercise the call option and earn-
Profits = [(current price- strike price)X(lot size)]-(premium paid)]
Profits = [(2,500-2,000)X(100)]-(20,000)] = Rs 30,000
But you would also lose the premium amount of Rs 21,000 paid for the put option and hence your net profit would be Rs 9,000.
If the share price of Reliance falls to Rs 1500, you exercise the buy option and earn-
Profits = [ (Strike price- current price) X (lot size)]- (premium paid) ]
Profits = [ 2,000-1,500) X (100)]- (21,000) = Rs 29,000
Here again, you would also lose the premium amount of Rs 20,000 paid for the call option and hence your net profit would be Rs 9,000.
Disadvantages of Options Trading
- To be profitable, you must have good understanding: – Many investors get into options trading because of the leverage it provides for higher returns on smaller investments. However, options are a little difficult to grasp. So, before diving into options trading, investors should spend some time thoroughly understanding options.
- Short-term investments: – Options are short-term investments that last several months. The shorter time frame allows for less time for price recovery. As a result, the chances of losing money are just as high as the chances of profiting from it.
- Prices could change quickly: – Because options are a derivative of stocks, indexes, and so on, a small movement in the underlying stock or index price can cause a sharp movement in the option pricing.
- Loss of the entire investment possible:- In a down market, you could lose all of your premium payments. Options include high-risk, high-reward wagers. However, by using proper understanding and strategies, one can minimize risks and profit from options trading.
