Basics of options

What is an Option?

An option is a contract that gives the holder of the option the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a predetermined price.

Example - Imagine you want to buy a flat that costs you 50 lakh. The owner says: "Pay me 50,000 Rs. today, and I'll hold this price for you for the next 1 month. If you wanted to buy the flat, you pay the rest of the amount but If you don't buy the flat, you lose only the 50,000 Rs. Here you buy the option by paying 50,000rs as premium.

Here -

• The 50,000rs. advance = premium (the price of the option)

• The 50-lakh price         = strike price (the fixed price you locked in)

• The 1 month                 = expiry (the time limit to decide)

That's the key difference between a regular stock buying and an option buying – here you're not committing fully, you're just holding a choice (Option).

The option buyer or holder has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, the option buyer will exercise his option only when the situation is favorable to him. On the other hand, the option writer is legally bound to honor the contract whenever the option buyer decides to exercise his option. For that the buyer of the option pays the premium to option seller.

Types of Options -

Options can be categorized into two types -

·         Call option

·         Put option

Call option –

An option, which gives the buyer/holder a right to buy the underlying asset, is called a call option. Here the thinking of the buyer is that the price of underlying asset will go up in future.

Example: Currently the Nifty is trading at 24,000. You believe that the price of the nifty will rise to 24,500 in next few days. To lock the price today you buy a call option of strike price of 24,000 by paying a small premium of rs.100.

• If the Nifty rises to 24,500 - your Call option becomes profitable, and you booked the profit of 400 (Gross profit500 minus the ₹100 premium you paid for buying the option).

• In case the Nifty remains flat or falls - you simply don't use the option. Your loss was the only 100 rupees that you have paid as a premium.

In short: Buy a Call when you expect the price to go up.

Put Option -

An option which gives the buyer/holder a right to sell the underlying asset in future at predetermined price, is called a ’put option’.

Example: Suppose the Nifty is currently traded at 24,000. You believe that the price will fall to Rs. 23,500. To lock the price today you buy a Put option with a strike price of 24,000, paying a premium of 100.

• If the Nifty falls to 23,500 - put option became valuable, and you make profit.

• In case Nifty rises or stays flat - you will not use your option.  In this case you lose only 100rs. That have you paid as premium.

In short: Buy a Put when you expect the price to go down.

A short comparison -

Benefit of buying options instead of buying stocks directly -

1.    Protection -

If you hold shares and you are worried about the sudden fall in the price of shares, to safeguard yourself you can buy a Put option on that stock. If the price falls, the Put option gains value and offsets the loss on your shares. If the price doesn't fall, you only lose the small premium you paid. This practice is called hedging, and big institutions and mutual funds use this to protect their portfolio.

Suppose you hold 100 shares of a company worth 5 lakhs. You're worried the market might fall sharply next week due to some news event, but you don't want to sell your shares.

To protect your portfolio, you can buy a Put option on that stock.

• If the stock falls, your Put option gains value and offsets your loss on the shares.

• If the stock doesn't fall, you only lose the small premium.

2. Leverage -

Options give you give chance to control a large position with the smaller amount compared to buying the stock. This is called leverage. Leverage increases both potential profit and potential loss percentage wise.

Example: Buying 100 shares of 2,000 stock needs 2,00,000. But controlling the same exposure through options might cost you only 8,000–10,000 in premium.

3. Defined risk -

If you buy the option, your maximum loss is limited to the premium paid. You can never loss more than that. But in case you buy the stock directly, a sudden crash can wipe out a much larger portion of your capital. This defined risk nature make options attractive.

4. Flexibility Across Market Conditions -

With stocks, you generally only make money when the price rises. With options, you have tools to potentially profit whether the market goes up, down, or even stays flat - through different combinations of options.