If you’re looking to explore new ways to manage risks or earn potential profits in the financial markets, options trading might be an exciting area to explore. But before you dive into it, it’s important to first understand what options are and how they work.
This guide will walk you through the basics of options trading, explain key terms, and help you make more informed investment decisions, even if you’re new to the world of trading.
What Are Options?
An options contract is an agreement that gives you the right, but not the obligation, to buy or sell an asset (like stocks) at a specific price, called the strike price, before or on a certain date, called the expiration date.
Think of it as making a bet on whether the price of something (like a stock) will go up or down within a certain time. If you’re right, you can make a profit. If you’re wrong, you only lose the small premium you paid for the option.
Options are useful because they let you make money by predicting price changes, without having to own the asset itself.
These contracts are mainly used to trade stocks, but they can also apply to other assets like commodities or market indices.
Types of Options Contracts
There are two main types of options contracts:
Call Options
A call option gives the buyer the right to buy the underlying asset (like a stock) at a fixed price (called the strike price) before or on a certain date (called the expiry date).
If you think the price of a stock will go up, you would buy a call option. If the price goes above the strike price, you can buy the stock for cheaper than it’s worth, making a profit.
Put Options
A put option gives the buyer the right to sell the underlying asset at a set price before or on a specific expiry date.
If you think the price of a stock will go down, you would buy a put option. If the price falls below the strike price, you can sell the stock at a higher price than its market value, making a profit.
In return for buying an option, the buyer must pay a fee known as the premium. This premium is the most the buyer can lose if they choose not to use the option.
However, the person selling (or writing) the option takes on more risk because if the market moves against them, their losses can be substantial.
Key Concepts in Options Trading
Before jumping into trading, it’s important to understand a few basic terms that will help you navigate the world of options:
- Spot Market: This is where assets like stocks are bought and sold immediately. The prices in this market impact how options are priced.
- Option Premium: This is the price you pay to buy an option. The premium is influenced by factors such as the price of the underlying asset, how much time is left until the option expires, and market volatility (the degree to which the price of the asset is expected to move).
- Underlying Asset: This is the asset that the option is based on. For example, if you buy an option for a stock, the stock is the underlying asset.
- Strike Price: The strike price is the price at which the buyer of the option can either buy (for call options) or sell (for put options) the underlying asset. Choosing the right strike price is essential because it impacts how profitable the option will be.
- Expiry Date: An option is only valid until its expiry date. After this date, the option expires and becomes worthless if it’s not exercised (i.e., if the buyer doesn’t use it). In many markets, options expire on the last Thursday of the month, but it can vary depending on the exchange.
- Intrinsic Value: This is the difference between the strike price of the option and the current price of the underlying asset. If you have a call option and the asset is trading above your strike price, you have intrinsic value. For example, if you have a call option for a stock with a strike price of ₹3,400 and the stock is trading at ₹3,500, your option has ₹100 of intrinsic value.
- Time Value: Options have a time value because there’s a chance that the price of the underlying asset will move in a favorable direction before the option expires. The more time left until the expiry date, the more time there is for the price to move, and therefore, the higher the option’s premium.
- Volatility: Volatility refers to how much the price of the underlying asset fluctuates. Higher volatility means the asset has a higher chance of making big moves, which increases the chance that an option might end up profitable. As a result, options on highly volatile assets tend to be more expensive.
Also Read: What is Option Moneyness and How Does It Work?
How Do Options Work?
Imagine a stock called XYZ Corp is trading at ₹6,000 per share. You think the price is going to go up in the next month.
Here’s how an options contract might work:
Buying the Stock:
You can buy 100 shares of XYZ Corp for ₹6,000 each, which would cost you ₹6,00,000.
Buying a Call Option:
Instead of buying the stock, you buy a call option for ₹200 per share. The option gives you the right to buy 100 shares of XYZ at ₹6,000 each. This would cost you ₹20,000 (₹200 × 100 shares).
Let’s say the stock price goes up to ₹7,000 after one month.
If you had bought the stock, your profit would be ₹1,00,000 (₹7,000 – ₹6,000 = ₹1,000 profit per share, ₹1,000 × 100 shares = ₹1,00,000).
If you had bought the call option, the value of the option would have gone up. You could sell it for ₹1,000 per share (₹1,000 × 100 shares = ₹1,00,000), minus the ₹20,000 you paid for the option. So your profit would be ₹80,000.
In both cases, you make money because the stock price went up. But buying the option is much cheaper and gives you the chance to earn a big profit with a small initial investment.
American Style vs. European Style Options
You may have heard of American style and European style options. These are just two different ways that options can be exercised:
American Style Options
These options can be exercised (used) at any time before or on the expiration date. So, if you have an American-style option, you can buy or sell the stock whenever you think it’s the best time.
European Style Options
These options can only be exercised on the expiration date itself. This means you can’t use the option early, even if the stock price is just where you want it to be. You have to wait until the last possible day.
Risks and Rewards of Options
Options contracts offer the chance to make good money, but they also come with risks. When you sell or “write” an option, you take on the opposite side of the contract. As a seller, you receive the premium paid by the buyer, but you face more risk.
If the buyer exercises the option, you are obligated to buy or sell the underlying asset at the strike price, which could result in large losses if the market moves against you.
Let’s look at some of the pros and cons:
Advantages of Options:
- Leverage: You can control a large amount of stock with a small investment. This means the potential to make bigger profits.
- Limited Loss: The most you can lose is the premium you paid for the option. If things go wrong, your loss is limited.
- Flexibility: You can use options to hedge (protect) your investments or to speculate (bet on price moves).
Disadvantages of Options:
- Time Decay: Options lose value as they approach the expiration date. If the price doesn’t move in the direction you expected, you could lose the premium you paid.
- Risk of Losing Your Investment: If the price of the stock doesn’t go above (for calls) or below (for puts) the strike price, the option becomes worthless.
Simple Example of a Call Option
Let’s say you think XYZ Corp stock will go up. The stock is currently priced at ₹6,000 per share. You buy a call option with a strike price of ₹6,000 for a premium of ₹200 per share. The option expires in one month.
If the stock price rises to ₹7,000, you can make a profit.
Here’s how:
- You bought 100 shares at ₹6,000 each, but now the stock is worth ₹7,000.
- You can buy the stock for ₹6,000 using your option and then sell it for ₹7,000 in the market.
- Your profit is ₹1,00,000 (₹1,000 × 100 shares) minus the ₹20,000 you paid for the option. So, your total profit is ₹80,000.
If the stock price doesn’t rise above ₹6,000, your option will expire worthless, and you’ll lose the ₹20,000 you paid.
Conclusion
In simple terms, an options contract gives you the right to buy or sell an asset at a certain price before a specific date. There are two main types: call options (right to buy) and put options (right to sell).
Options can help you make money by predicting price changes, but they come with risks. You can lose the premium you paid if the price doesn’t move as you expected.
Also, remember that there are two main styles of options: American-style options, which can be exercised at any time before the expiration date, and European-style options, which can only be exercised on the expiration date.
Options are a powerful tool for investors, but they can be tricky if you don’t fully understand how they work. Always make sure to learn more and consider the risks before jumping into options trading.
Key Takeaways
- Options contracts give you the right, but not the obligation, to buy or sell an asset at a specific price before or on a certain date.
- Call options give you the right to buy, and put options give you the right to sell the asset.
- American-style options can be exercised at any time before the expiration date, while European-style options can only be exercised on the expiration date.
- Options can help you hedge, speculate, or generate income, but they come with risks like time decay and the chance of losing your entire investment.
Now that you understand the basics of options contracts, you can start exploring how to use them in your investment strategy. Just remember: like all investments, options carry risk, and it’s important to know what you’re doing before jumping in!
By mastering the basics of options trading, you can begin to use these tools to diversify your investment strategies and manage market risks more effectively. Happy trading!
