Option Trading

What is the definition of an Option?

Options are the financial instruments that DERIVE their value from the value of the underlying securities such as Stocks. An option gives the buyer a choice on whether to buy or sell (depending upon the type of option) the security. Unlike Futures the option buyer has choice whether he/she wants to exercise his/right of buying and selling of the security. In futures the person is obligated to exercise the right.

What is an option in lay man’s language?

Options are contract between a buyer and seller of the security. They agree to make the transaction on a future date for a predetermined price. The buyer has the option of not buying the security on the date of transaction. For this the buyer pays a premium to the seller.

For e.g. if a Ram wants to buy shares of X ltd. Now Ram has heard the speculation of investments by big firms in X ltd. This means the share prices will increase. But the news is not yet confirmed and the Ram does not want to block a huge amount of the capital on it. So, Ram and Shyam comes into a contract that Ram will buy the shares at current trading price 2 months from now. The trading price of X ltd today is Rs 1,000 and if the news gets confirmed then the prices will increase to Rs 1,500. Therefore, Ram agrees to pay Rs 10 per share extra to Shyam. This is called premium and is not refundable. This is a one-time payment to Shyam to block those shares. Its not necessary for Shyam to hold the shares on the date of option selling, he can purchase the shares on the date of the expiry at the market price and then sell it to Ram. If in two months the news gets confirmed then Ram will buy the shares of X ltd from Shyam at Rs 1,000. The share prices will increase to Rs 1,500 and Ram enjoys a profit of Rs 490 (1,500-(1,000+10)) per share. The profit of buyer will be equal to the loss to the seller and vice versa. But if the news turns out to be a fake news then the share prices will fall down. In such situation the prices will fall to down Rs 800. Now since Ram had the option of either to buy the share or not, therefore Ram won’t buy the share and restricting the loss to Rs 10 per share. 

Pros and Cons from option buyer’s perspective:

1.    The buyer can only earn profit if the share prices is more than Rs 1,010. The price agreed upon is Rs 1,000 and he paid a premium of Rs 10 for the price. Therefore, the buyer will only exercise the right when the trading price of the share is above Rs 1,010 on the date of expiry of the contract.

2.    The maximum loss the buyer can occur is of Rs 10 per share. If the price is below Rs 1,010 then the buyer will not exercise the right.

3.    The buyer has the benefit of unlimited profit. The more the prices will increase the more profit the buyer will enjoy.

4.    The probability of buyer earning profit is 33.33%. There are 3 possible situations the prices of shares will increase; they will stay the same or they can decrease. The buyer will only profit when the price increases. A rational buyer only exercises the right when the price increases. 

5.    The premium is one-time payment and cannot ask for refundable if he/she does not buy the shares.

Pros and Cons from option Seller’s perspective:

1.    The seller will earn profit if the share prices is less than Rs 1,010. The buyer won’t exercise the right if the price is less than that and the seller enjoys the profit from the premium.

2.    The maximum profit the seller can enjoy is Rs 10 i.e. the premium paid by the buyer.

3.    The seller has the liability of unlimited loss. The more the price will increase more will the loss to the seller because the seller has to sell the share worth Rs 1,500 for Rs 1,000.

4.    The probability is in the favor of the seller. The seller has the probability of 66.67% of earning profit in his/her favor. The only scenario where he/she losses money is when the price of the share increases more than Rs 1,010.

Important options terminology:

1.    Strike Price: The pre-determined price at which the buying and selling of security will take place.

2.    Spot Price: The current market price of the security.

3.    Expiry Date: The date at which the exchange of securities will take place.

4.    Premium: The extra money that the buyer is willing to give to the seller for the contract.

5.    Long Position: It means the person has bought the option.

6.    Short Position: It means the person has sold the option.

There are 2 types of options- Call Option and Put Option. 

What is a Call Option?

Call option is the option where the option buyer feels that the prices of the security will increase whereas the option seller believes that the price of security will decrease. The above example is of a call option. Here Ram felt that the price of X will increase and Shyam felt that the price will either remain same or decrease. On the date of expiry if Ram exercises the rights then Shyam needs to SELL the security to Ram on the predetermined price.

What is Put Option?

Put option is the option where the option buyer feels that the prices of security will decrease whereas the option seller believes that the price of the security will increase. It’s the exact opposite of the above example. Here the option buyer is the owner of the security. Earlier the Shyam was the owner of the security here it’s completely opposite. On the date of expiry if the Ram exercises the right then Shyam must BUY the security from him. For example, if Ram feels that the price of X ltd which Rs 1,000 today will fall to Rs 950 in one month. So, Ram will buy a put option of Rs 950 by paying a premium of Rs 10 therefore effective price should be below Rs 940. Here Shyam feels that the share price will not fall and thereby earn a profit on the premium as the probability is in his favor. On the date of expiry if the share price is Rs 900 then Ram will sell that share to Shyam at Rs 950 by exercising his right. Hereby making a profit of Rs 40 per share. If the share price is not below Rs 940 he won’t exercise his right.

The pros and cons remain the same in both the options.

Option Market in India

India now follows only the European way of option trading, which states that the buyer can only exercise his/her right on the date of the expiry. Earlier we used to follow both American and European way of option trading. In American system the option buyer can exercise the right whenever he/she wants within the time of the expiry i.e. if the there is a sudden spike in price of X ltd the option buyer would exercise his/her call option. Here the risk for the option seller was huge. Therefore, this system was completely eliminated and only European system is now being followed. Now everyone does not wait for the expiry to realize their profit/loss. In India majority people trade on premium. They may buy options on intraday basis or short-term basis. The difference in the premium is their profit or loss. The premium depends upon various factors like the price of the security, time left for the expiry, demand and supply and various other factors.