Derivatives: All you want to know about Options

With flexibility, limited risk hedging and leveraging, Options is indeed a good too for trading in the markets

Are you amongst the ever-increasing group of investors who feel that there is somebody in the market who is specially appointed to monitor your specific trades and force the market to do exactly the opposite of what you have traded?

Are you amongst the thousands who have burnt their fingers after investing enthusiastically when the Sensex was at the 22,000 level and saw an erosion of almost 12,000 points on the Sensex, (courtesy the sub-prime crisis in the United States); missed out on investing when the Sensex was at 8,000 points and failed to capitalize on the 7,000-point rally within a span of two months (courtesy 2009 elections); and to rub salt into the wound, got in again when the Sensex was at 15,800 and saw a washout of almost 2,000 points in a single week itself (courtesy Budget 2009)?

Sorry if this has brought back painful memories to anyone, but sadly this holds true for most investors. You enter and the markets crash, you exit and the markets soar! Fret no more, worry no more; you have got Options…literally.

What if you were told that there is a product out there wherein even if you have a bearish view on this market and the markets fall, you can still invest in it and make money. Have a neutral view on the markets and still invest and make money. Sounds like a con scheme in the brewing, doesn’t it?

The magic word here is Options. Relax, before you pick up that dial and frantically ring your brokers. First you need to understand the nitty gritties of Options trading. Let us start with the basics of Options trading and then take it further from there. Options trading form an integral part of a market called Derivatives.

What is an Option? An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (it may be any index or a particular stock) at a specific price on or before a certain date.

An illustration will help you understand this better. Suppose you are an art collector and you happen to find a beautiful painting at an art exhibition and you simply want to buy the irresistible masterpiece. The price tag on the painting is a whooping Rs 1 lakh. Since you do not have the funds necessary to buy the painting right away, you talk to the art dealer and convince him that you would have the cash ready within the next one month but he would have to sell it to you at the current rate of Rs 1 lakh only even in the future.
As against this the seller sells you the option to buy the painting after charging you a token amount of Rs 5,000 as an option to buy the painting after one month at today’s rate. You have struck a deal!

Now imagine two different scenarios that can arise after one month.

A prominent art scholar who visited the exhibition from abroad saw the very same painting that you booked and instantly recognized it as a classical work of Pablo Picasso. Overnight the price of the painting soared to Rs 10 crore.
But because the art dealer has already sold you the option of selling the painting for Rs 1 lakh, he is obligated to keep his part of the bargain, albeit grudgingly. You in turn stand to earn a profit of Rs 9.99 crores right away. What a deal!

Now consider the second scenario, a rat entered the exhibition hall one night and gnawed at the painting, leaving huge holes on the canvas. The painting is ruined. It is now not worth even a single rupee and lost all the value it could possibly have.

But since you have bought the Option of buying after paying a token amount of Rs 5,000, you are not obligated to buy the painting. You consider yourself unlucky, forfeit your Rs 5000 that was paid earlier and go home contented with the fact that your loss could have been much more.

Options trading in the stock market works on more or less the same premise. The buyer of an option has the right but not the obligation to fulfil a contract whereas the seller of an option has the obligation but not the right to fulfil a contract. An option buyer can only lose what he has paid for the option contract while the option seller’s loss can be unlimited.

There are basically two types of Options in the derivatives markets. They are Call Options and Put Options. These are not acronyms. But that is exactly what these innovative derivatives are called.

Call Option: Gives the buyer/holder the right to buy the underlying asset at a fixed pre-determined price within a certain fixed period of time.

Put Option: Gives the buyer/holder the right to sell the underlying asset at a fixed pre-determined price within a certain fixed period of time. 

Before understanding how you can trade in the options markets it is imperative that we learn about the basic terminologies involved in the course of options trading.

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Basic terms in Options Trading
Index Options: These Options have the index as the underlying. In India, these are Nifty options, Mini Nifty options, and Bank Nifty options.

Stock Options: Stock options are options of individual stocks.

Underlying: A particular asset on which the options contract is issued. Example index, stock, etc.

Option Buyer/Options Holder: An Option buyer is one who has the right but not the obligation to exercise his option. The buyer is the one who pays the premium amount to the options seller. The buyer of an option has limited risk with the possibility of unlimited profit.

Option Seller/Option Writer: The seller or the writer of an option is one who has the obligation to sell option but not the right. The seller or writer receives the premium amount from the options buyer. The seller of an option has limited profit with the possibility of incurring an unlimited loss.

Option Premium: The price paid by the buyer of an option to the seller of an option is called option premium.

Expiration Date: The date on which the option expires and ceases to exist.
Exercise: The right of the option buyer.

Strike Price or Exercise Price: The strike price or the exercise price is the specified price of an option at which the contract may be exercised.

Exercise Date: The date on which the option gets exercised by the option buyer or holder.

Lot Size/Contract Size: The number of underlying assets in a contract. For example the lot size of a Nifty contract is 50.

Options cost only a fraction of the amount that one would have had to shell out if he had bought the entire quantity of the underlying asset in the equity market. This is called leveraging your position wherein you can get a much larger exposure by paying a very small premium for the same. This is mainly reason why more people are getting attracted towards Options every now and then.

You can buy and sell options in the markets just like stocks during markets hours. Contrary to popular belief you don’t need a huge corpus to begin trading in options. You can start trading in options with as little as Rs 1,000 or sometimes even lesser depending on the value of the underlying asset.
The enchanting world of Options is vast and we have just begun our first leg of this magical journeY.

Source: Nirmal Bang