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Learn the basics of option trading, simple & complete explanation

Jan 22, 2011  at 2:43:00 PM


Learn the basics of option trading, simple & complete explanation 

Option and future contracts are made between two parties ie a buyer and a seller. Options and futures are the derived products of the underlying asset; the asset can be a stock or Index. That’s the reason why options and futures are called as a derivatives,their value is derived from the underlying asset.

Read >How to derive future price and option premium from the underlying asset
 
Now you know that option prices are derived from the spot prices (current price of underlying asset), There is also a relation between future and option prices (read > future-option-pricing-and-arbitrage)

Learn about other option basic terms > option-trading-basic-terms-explained

Nse India allows to trade in stock options,index options and currency options. As mentioned earlier value/price of a stock option is derived from the value/price of stock and the index options price is derived from the underlying index .

To make a contract two sides are necessary, a buyer and a seller. The option buyer pays some amount of money(premium) to the option seller and makes the contract. The option seller is commonly known as option writer. 


More simply, Option writer is a person, who is short selling the options (short selling means selling first and buying later). Exit from a option position is called "squaring off" of the position.

There are two types of options, call options and put options.

Call options- The Right to Buy

Call options gives you the right to buy the underlying asset on the expiry date, at the price mentioned in the contract (strike price).

Example :
You are buying a nifty call option of strike price 6000. At expiry imagine that nifty is at 6150, that means your contract is in profit, the asset is at 6150 and you have the right to buy that at 6000.

How to calculate profit in this trade? read> option-buyer-and-seller formula-to calculate profit at expiry

Say , You are buying a nifty call option of strike price 6000 at a premium of 50 RS, that means you are giving 50 Rs to the seller as premium amount to make the contract.

At expiry imagine nifty is at 6150, so what’s your profit ?

Profit =6150-6000-50 = 100 RS , Total profit 5000 RS. (100* 50), 50 is the lot size of Nifty.

Lot size is different in the case of stock options or other index options and it is decided by the stock exchange.

There are different type of options, they are In the Money Options, at the money options and out of the money options.

It can be explained easily by an example. Imagine Nifty Spot price is 6000,

6000 call is call as at the money call option (Strike Price is equal to Spot price)

Less than 6000 strike calls are called in the money call option (Strike price is less than spot price), example 5900 call,5800 call etc

Greater than 6000 strike calls are called out of the money call option ( Strike price greater than spot price),6100 call, 6200 call etc

Out of the money options at expiry :
 
At expiry all the out of money options expire as worth less. You can not exercise out of money options.

Example, At expiry if nifty is at 6150, and you are holding a 6200 call option that means, you can not exercise that option and you will loose the premium amount that you paid to the option seller.

The maximum loss in the case of option buying is the premium amount, and the maximum gain (profit potential) is unlimited.   

Basic strategy > Buy call options,when you are bullish (expecting an increase in the price) on the underlying asset. Sell call options (option writing) when you are bearish (expecting a decrease in price) on the underlying asset.Option writing is a very risky activity and can end up in unlimited losses. 

Put options- The Right to Sell

Put options gives you the right to sell the underlying asset on the expiry date, at the price mentioned in the contract (strike price).

Example :
You are buying a nifty put option of strike price 6000. At expiry imagine nifty is at 5850, that means you are in profit, the asset is at 5850 and you have the right to sell that at 6000.

To calculate the profit in this trade, You have to reduce the premium charges,
(Get the formula to calculate the profit at option expiry> option-buyer-and-seller-formula-to-cacluate-profit-at-expiry).

Say , You are buying a nifty put option of strike price 6000 at a premium of 50 RS, that means you are giving 50 Rs to the seller as premium amount to make the contract.

Nifty lot size is 50, so the total amount required to buy the put option in this example, 50 X 50 = 2500 RS ,

At expiry imagine nifty is at 5850, so what’s your profit ?

Profit =6000-5850-50 = 100 RS , Total profit 5000 RS. (100* 50), 50 is the lot size of Nifty.

Different type of put options: Imagine Nifty Spot price is 6000,

6000 put is called as at the money put option (Strike Price is equal to Spot price)

Less than 6000 strike puts are called out of the money put option ( Strike price is less than spot price), example  5900 put,5800 put etc

Greater than 6000 strike puts are called in the money put option (Strike price greater than spot price), 6100 put, 6200 put etc

As stated above,you can not exercise the out of money options at expiry.

Example, At expiry if nifty is at 5850, and you are holding a 5800 put option, that means, you can not exercise that option and you will loose the premium amount that you paid to the option seller.

Basic strategy > Buy put options,when you are bearish (expecting a decrease in the price) on the underlying asset.Sell put options (option writing) when you are bullish (expecting an increase in price) on the underlying asset.Option writing is a very risky activity and can end up in unlimited losses. 


Types of options based on expiry date

European type options and  American options > read

What is the difference between option exercising and squaring off ( read from earlier post OPTIONS: EXERCISING AND SQUARING OFF)
As of now, only European types of options are available in Nse India.

A closer look in to option premium - Intrinsic Value and Time Value
Option premium is composed of two parts, that is intrinsic value and time value.
Option premium = Intrinsic value + time value

Intrinsic Value is the difference between the spot price and strike price, and later part of the premium is called time value or extrinsic value. (Out of money option premium is composed of time value alone.)

Example: nifty 5000 call option is trading at 80 Rs, and say spot is currently at 5050,
then  Intrinsic value = 5050-5000 = 50 RS and
        Time value     =   80- 50 = 30 RS

Premium calculation / Option pricing model

Options are traded in the exchange like stocks. Like stocks traded at its price, options are traded at its Premium Amount.

The Black Scholes Option pricing model and the Binomial Model is the main two methods to find out the theoretical premium of option.

There are many factors affecting the option premium prices, including the buyer- seller sentiments, volatility, risk free interest rate etc.

Get excel tool to calculate option prices > Option price calculator
 
Implied volatility and option prices : read about implied volatility.

Volatility-Index (Vix) & option Entry : VIX at high levels - Time to buy,  VIX at low levels - Look out below, read Know more about India VIX -Volatility Index Interpretation

Option selling/ Option writing: Option writing is high risky and should be done with proper knowledge or strategy. The maximum profit in the case of option writing is limited to the premium received, and the maximum loss possibility is unlimited.  
 

Option strategies: There are many bullish, bearish or neutral strategies involving the options. Options can be used to make wide range of positions( high risky speculative positions to time decay earning neutral positions).

Bullish – Buy call/ sell put
Bearish – Buy put/ sell call

Nse India is providing a study material to educate the Option traders, you can download the  zip file from the nse India site

Nse India also provides a study material on forex /currency option strategies  get it,OPTION TRADING STRATEGIES- BULLISH, BEARISH,NEUTRAL

Option arbitrage and neutral strategies

Option arbitrage is possible, to lock the profit when ever the opportunity is available, its  possible when there is mispricring  of options from its fair value.

Option Trading, Advantage and disadvantage

Advantages in option buying:
1.Buying options requires only very less capital compared to stock/ future trading. 2. High profitability, if the underlying asset moves as per calculations, options will give very high returns (with low capital).

Disadvantages in option buying: 1.Time decay 2. the change in market sentiments will affect the option prices( read about implied volatility )


Flexibility is biggest of advantage of Options, it can be used to make different of strategies, bullish, bearish or neutral. Options can be used to hedge positions in futures/cash.

Disadvantage in option writing includes 1.Unlimited loss possibility 2.difficulty in understanding many complex option strategies 3.High margin requirements (read >Margin requirement for option writing/ selling)

Advantages in option writing: As stated many times earlier, option writing is a heavy risky activity, this is mainly done by institutions and professional traders. The main aim of option writing is to capture time decay and changes in implied volatility.