If you’re new to finance and investing, the word options might sound complicated or even risky. You may ask:
- What exactly are options?
- How do people make money trading options?
- Is options trading only for experts or big investors?
- Can a small business owner or freelancer in India benefit from understanding options?
These are very natural questions. The truth is, options can be a powerful tool when you understand their basics well.
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 call options and put 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.
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.
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
An option is a financial contract that gives you the right, but not the obligation, to buy or sell an asset at a specific price before a certain date.
The two basic types are:
- Call Option: Right to buy
- Put Option: Right to sell
From these two, there are four important ways traders interact with options:
- Buying a Call Option
- Selling a Call Option
- Buying a Put Option
- Selling a Put Option
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.
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.
The Four Option Variants: Building Blocks of Trading
Think of these four variants as the primary colors on an artist’s palette. With these, traders create complex strategies. But before we get to the complex part, let’s understand each variant carefully.
1. Buying a Call Option (Long Call)
You pay a premium upfront to buy the right to purchase the asset at a set price.
- You expect the price to go up.
- Your risk is limited to the premium you paid.
- Your profit potential is unlimited (the price can rise endlessly).
- Example: A freelancer buying a call option on a stock they believe will rise sharply.
2. Selling a Call Option (Short Call)
You receive a premium upfront for selling the right to someone else.
- You expect the price to stay flat or go down.
- Your profit is limited to the premium received.
- Your risk is unlimited if the price rises too much.
- Example: A bakery owner selling call options to earn steady income but must be careful about sudden price spikes.
3. Buying a Put Option (Long Put)
You pay a premium to buy the right to sell the asset at a set price.
- You expect the price to go down.
- Your risk is limited to the premium.
- Profit potential is high if the price falls sharply.
- Example: A small manufacturer buys a put option to protect against falling raw material prices.
4. Selling a Put Option (Short Put)
You receive a premium for selling the right to sell the asset to you.
- You expect the price to stay flat or go up.
- Profit is limited to the premium.
- Risk is significant if prices fall sharply.
- Example: An online seller sells put options anticipating prices will hold steady.
Why Understanding Payoff Diagrams Matters
Payoff diagrams help visualize how profits and losses behave for each option variant. Here are some key insights:
- Buying and selling call options are mirror images in terms of risk and reward. The buyer’s maximum loss is the seller’s maximum profit, and vice versa.
- Buying a call and selling puts both profit when the market goes up. So don’t buy calls or sell puts if you expect prices to fall.
- Buying and selling put options are also mirror images, with opposite risk and profit potentials.
How to Use These Variants in Real Trading
Traders often combine these four variants to build sophisticated strategies, but it’s important to first master each one’s basic behavior.
Market Views and Option Positions Summary
| Market View | Option Type | Position Name | Other Alternatives | Premium Impact |
|---|---|---|---|---|
| Bullish | Call Option (Buy) | Long Call | Buy Futures or Buy Spot | Pay Premium |
| Flat/Bullish | Put Option (Sell) | Short Put | Buy Futures or Buy Spot | Receive Premium |
| Flat/Bearish | Call Option (Sell) | Short Call | Sell Futures | Receive Premium |
| Bearish | Put Option (Buy) | Long Put | Sell Futures | Pay Premium |
Note:
- Buying an option is called taking a long position.
- Selling an option is called taking a short position.
Important: Buying and Selling Options Can Mean Two Things
Buying:
- To open a new position (fresh buy).
- To close an existing short position (square off).
Selling:
- To open a new short position (fresh sell).
- To close an existing long position (square off).
This distinction helps you understand your position clearly.
Option Buyer: Limited Risk, Unlimited Potential
If you buy a call or put option, you pay a premium upfront. Your maximum loss is limited to this premium if the market doesn’t move as you expected. But if the market moves strongly in your favor, your profit can be very high.
How to calculate your profit/loss on expiry:
- Long Call: Profit = Max[0, (Spot Price – Strike Price)] – Premium Paid
- Long Put: Profit = Max[0, (Strike Price – Spot Price)] – Premium Paid
This is only if you hold the option till expiry.
Option Seller: Steady Small Gains, Big Risk
Sellers collect premium upfront but face much higher risk. For example, a call option seller’s loss can be unlimited if the asset price rises sharply.
How to calculate seller’s profit/loss on expiry:
- Short Call: Profit = Premium Received – Max[0, (Spot Price – Strike Price)]
- Short Put: Profit = Premium Received – Max[0, (Strike Price – Spot Price)]
Remember, margins are blocked when you write options to protect against big losses.
Why Do Option Premiums Change?
Option premiums don’t just depend on whether the market price moves above or below the strike price. Several other forces affect premiums, known as Option Greeks — factors like time decay, volatility, and price changes all influence premium size.
Think of premiums like a ship sailing on the sea — its speed depends on wind, sea conditions, and engine power. Similarly, option premiums move due to multiple forces acting simultaneously.
Most option traders do not hold contracts till expiry. Instead, they focus on capturing movements in the option premium over short periods—sometimes just minutes or days.
Why Do Traders Prefer Buying Options?
Options allow traders to potentially earn high returns with a lower initial investment.
For example:
- If Mr. Kumar wants to invest Rs 10,000 in ABC Limited, currently trading at Rs 1,000 per share, he could buy 10 shares.
- If the stock price rises to Rs 1,100, his profit would be Rs 1,000 (10 shares * Rs 100 profit per share).
Alternatively, with Rs 10,000, Mr. Kumar could buy call options for ABC Limited at a strike price of Rs 1,000 (Rs 50 per share for 100 shares). He could buy 2 lots (200 shares) for Rs 10,000 and, if the stock price rises to Rs 1,100, his call options could be worth Rs 20,000.
In this case, Mr. Kumar would make a 100% return on his capital, which is far greater than the 10% return he would have made by simply buying the stock.
The Risk and Reward of Options Trading
The main advantage of buying options is that your potential loss is limited to the premium you paid for the option. If the market moves against you, that’s all you lose. But if the market moves in your favor, your profit can be substantial.
The potential downside is that options can expire worthless, and if the asset price doesn’t move in the direction you expected, you could lose the premium you paid for the option.
For option sellers, the profit is limited to the premium received, but the risk is higher since losses can be much larger if the market moves against them.
What’s Next in Your Options Journey?
Understanding these basics sets you up to dive deeper into:
- Moneyness of options (how close the strike price is to the market price)
- Option pricing models (how premiums are calculated)
- Option Greeks (which influence premium changes)
- Strike price selection (choosing the right strike for your trade)
Mastering these will help you trade options with more confidence and professionalism.
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.
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!
Frequently asked questions (FAQs)
What is the strike price?
Strike price is set by the seller or writer of the option contract.
When you buy a call option, strike price is the price at which you are agreed to buy the underlying asset if the contract is exercised. Strike price also determines whether the option contract is a At the money (ATM), In the money (ITM) or out of the money (OTM).
What is the option premium?
Premium is the amount of fee paid by the buyer for buying an options contract. Premiums vary based on how the option contract is traded in the market and the value of the underlying asset.
The Buyer pays the premium and the seller receives the premium.
Buyer has liberty to sell the right on option contract to another buyer in stock exchange for higher or lower premium based on how the contract is traded in the market. The new buyer will become the holder of the option contract.
What is implied volatility?
Implied volatility is known as IV. You don’t need to calculate it.
You can find Implied Volatility (IV) in the option chain. Implied volatility is a prediction of how much the price of the security will move over a given period of time.
What is the Expiration date in Option contract?
All option contracts must have an expiration date after which they will become worthless. An European option can only be exercised at expiry but an American option can be exercised at any time before expiry.
Different option contracts can have different expiry dates.
What is the European Option?
European option is a type of option contracts in which the buyer or holder is allowed to exercise the contract at expiry. The buyer can not exercise his or her rights on the option contract before expiry.
The holder or buyer has the right to exercise the option but are not obliged to do so. They can even let the option expire worthless without exercising it.
What is the American Option?
American option is a type of option contract in which the buyer can exercise his or her rights at any time before the expiry. Which means he or she can exercise rights at any time between the day they purchase the contract and the expiry date.
What is theta in options?
Option value decreases as it nears expiration date. This change in value is measured by Theta. Theta is also known as time decay.
What is delta in options?
Delta measures the change in option price with respect to change in the price of the underlying asset.
All at the money (ATM) option contracts are considered as 0.5 Delta. Which means if the price of the underlying asset moves 2 points then option price will move 1 point.
In the money (ITM) option contracts have high delta and out of the money (OTM) option contracts have negative delta.
What is In the money (ITM), At the money (ATM) and Out of the money (OTM) options?
A call option will be considered as In the money (ITM) if the current market price of the underlying asset is higher than the strike price.
A put option contract is considered as In the Money (ITM) when the price of the underlying asset is lower than the strike price.
When the strike price of a call option contract is higher than the current market price of the underlying asset, the contract is considered as Out of the money (OTM).
A put option contract will be considered as out of the money (OTM), if the price of the underlying asset is higher than the strike price.
If the strike price and price of the underlying asset is same, then the option contract is considered as At the money (ATM).
What are spreads in option trading?
Naked trading in options is very risky as the trader may have unlimited loss. To minimize losses and protect profit, traders use different strategies.
Spreads are hedging strategies used in option trading to minimize risk. In spreads, traders buy and sell a combination of different option contracts for the same underlying asset.
Spreads are categorized as credit and debit spreads based on net premium credited or debited based on the strategy used. We have debit spread, credit spread, straddle, strangle and Butterfly as a spread strategy used by option traders.
What is a covered call?
Covered call is a hedging strategy used when you are holding shares of a particular stock and you have a bearish view on the same stock for a short period of time.
In a covered call, the owner of the stock writes a call option at a strike price which is the same as current market price or above it to collect premium from the buyers.
When market price moves down and expires below the strike price, then the seller earns the premium as the buyer will not exercise his rights. Instead if the market moves up and closes at or above the strike price, then the buyer will exercise their rights by which the seller will sell the shares at the strike price and retain the premium.
Covered calls are executed when the traders think that the market price of the underlying will not close at or above the strike price. They are not even expecting a drastic fall in price.
What is a protective put?
Protective put is a hedging strategy in which the trader is expecting a downside in the stock’s price that they own. In a protective put, the trader buys a put option by paying premium for the stock which he is holding in his or her portfolio.
Protective put acts like an insurance policy for the investor against losses.
If the price of the stock expires above the strike price, then the put option expires worthless. Buyer’s loss in this case is the premium amount paid.
Instead of moving up, if the stock closes far below the strike price, the put option premium increases to cover the losses of the portfolio. The buyer can either exercise by selling their holdings at the strike price to make profit or the put option contract before expiry can be sold to another buyer to pocket the profit arising from the rise in option premium price.
Instead of buying a lower strike price put option, if you have decided to buy an at-the-money (ATM) put option to cover the downside of your existing long position, then the strategy used is referred to as married put.
What are long straddles?
When a trader does not know in which direction the market or stock price will move, they prefer to use long straddles. In this hedging strategy, they buy both a call option and put option at the same strike price and expiration on the same underlying asset.
In long straddles, maximum loss is restricted to the premium paid on buying both call and put options. Traders will make money if prices break out either way.
What are long strangles?
Long strangles are similar to long straddles.
In long strangles, the trader buys an out-of-the-money (OTM) call option and a put option at the same time having the same expiry date. Put strike price should be below the call strike price.
Traders will be paying less premium but in order to make profit, the market should make a strong move to close at or above either side of the strike price.
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
