The following post is by Sahaj Agarwal of Kotak Securities to educate first-time traders and investors with an easy-to-understand approach into the world of Options Trading.
Options Trading unfold a new world of opportunities for investors who understand the complexities of the market and have an appetite to take risks. Hence, Options – perceived as a fast money trade – have been successful in holding the interests of the investors. As the name suggests, Options give one the right and not the obligation to buy or sell a particular underlying asset at a particular price on or before the fixed date. It is a contract that binds both the buyer and the seller entailing strict conditions and terms. Options fall under the category of derivatives as it derives its value from something else.
A basic example of buying a house may illustrate the working of the Option market. You wish to buy a house but require a minimum of 6 months to amass money for the same. However, you are worried that the price may further rise by then. Option Contract allows you to crack a deal with the seller with the option to buy the house in the next six months for Rs.20, 00,000. However, the deal necessitates you to pay an amount of Rs.5000 to bring it into effect. We here consider two possible situations to help you understand its working. The price of the house suddenly surges to Rs.50, 00,000 with the reports of a railway station being built near it. However, the seller will be obligated to sell you the house at the preset price as he sold you the option. You can capitalize from the deal as you make a profit of Rs.29,95,000 (Rs. 50, 00,000- Rs.20, 00,000 –Rs.5, 000). Later, you discover that the house is prone to leakage problems with the walls seeming to be of poor quality. Hence, you change your mind and decide not to buy the house. Once again, you are in an advantageous position, as you are not under the obligation to buy the house. All that you will lose is Rs. 5000 which you have paid already as the price of the option.
The two types of options are calls and puts:
Call: Call allows the holder the right to buy a particular asset within the set period. Buyers of call embark upon the deal with the opinion that the stock value will swell within the expiry date. The buyer holds a position that is akin to having a long position on a stock.
Put: The holder has the right to sell an asset at a fixed price within the set period. They hope that the price will fall before the expiry of the contract. Here, one holds a position that is similar to being on a short position on the stock.
Holders are people who buy options and writers are people who sell options.
The Option Market has four types of traders that include Buyers of calls, Buyers of Puts, Buyers of Puts and Sellers of Puts.
Call Holders and Put Holders will have the whip hand to buy or sell but are not obligated to do the same.
Call Writers and Put Writers are obligated to buy or sell with the intention of making the most in the deal.
To trade in the Options Market, one needs to be aware of a few terminologies including the strike price, expiration date, premium, etc.
The price decided by the buyer and the seller at which an underlying stock can be sold or purchased is the strike price. It serves to be the target price with respect to which one measures the upward movement or downward movement of the stock.
The expiration date is the deadline set for the option contract. On this day, the option buyer will decide whether he wishes to go with the transaction or not.
When the share price is above the strike price with respect to the call option, the option is in-the money. Similarly, a put option is in-the-money when the strike price is above the share price. Intrinsic value is the amount by which an option is in-the-money.
The premium is the total cost of the option. While fixing the premium, one takes into consideration factors including the stock price, strike price, time remaining until expiration and volatility.
There are two main types of options- the American option and the European option. While the American option allows you to exercise your option at any point of time, i.e. even before the expiration date, the European option forbids you from the same and can only be implemented on the expiration date.
Option is a tool that investors use primarily to speculate and hedge. With respect to speculation, the beauty of it is that you can benefit both when the market moves upwards or downwards. The foresight to understand the direction of the stock, its magnitude, and its movement can help you gain ground in the bourse.
An investor can use the option of hedging to insure your products and limit losses during the downturns. You can already set the prices for products and insure them beforehand. With respect to Options Contract, it is merely the transfer of the ownership and not the product in itself.
The flexibility that Options endows you is what makes it a favorite among the traders. The best part is that one can use it to be both speculative and conservative, and capitalize from it.
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