What is Option Trading ? A Beginners Guide

In very layman terms Option Trading involves buying and selling options contracts on the public exchanges (NSE ,BSE) . Roughly speaking, it’s quite similar to stock trading. A normal stock trader or investor goal is to make profits through buying stocks and selling them at a higher price. Likewise options traders can make profits through buying options contracts and selling them at a higher price. Similarly stock traders can take a short position on stock that they think will go down, options traders can do the same with options contracts.

We will try to touch every basic aspect of Option Trading. However before we begun i would request to keep patience and concentrate more as options trading is a much more complicated subject than stock trading. For beginners it may seem overwhelming. However i will try my best to explain it in simple terms.

In India nearly 80% of the derivatives traded are options and the rest is credited to the futures market. An Option Trader can use options to speculate on the price movement of individual stocks, indices, currencies, commodities. Moreover In options trading, there’s more possibility & ways to make money.

 History of the Indian Options Market:

  • June 4th 2001 –Index options were commenced
  • July 2nd 2001 – Stock options started
  • November 9th 2001 – Single stock futures were launched.

Options are not the same thing as stocks because they do not represent ownership in a company. Ownership comes when you buy a stock in normal equity (cash) segment and take delivery of tha stock in your demat. One of the benefit of option trading is you can close your position at any point until the expiration date.

How Option Trading Works?

There are two types of options – The Call option and the Put option. You can be a buyer or seller of these options. Let us understand them one by one with example.

What is Call option?

Book definition of call option is “The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (underlying) from the seller of the option at a certain time (expiration date) for a certain price (strike price). The seller (or writer) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (known as premium) for this right”.

In other words If you’re buying a call option, it means you want the stock (or other security) to go up in price so that you can make a profit from your contract by exercising your right to buy those stocks (so that you can sell them to cash in on the profit).when you buy options you can either hold the option till expiry and let the exchange do the settlement for you this is called Exercising a contract or you can close the position before expiry and book profits/loss.

What is Option Trading ?

As an illustration let us take an example of an stock option YES BANK. Few basic concepts you need to clear while trading options and futures are given below.

What is Lot Size?

In Option contracts the minimum number or quantity you would be transacting is known as lot size. It depends on different securities and are predetermined. You can not choose it by yourself how many shares you want to buy. As you can see in the image above market lot quantity for YES BANK Option contract is 2200. This is the minimum quantity you need to buy or sell in order to get the option contract for this particular share.

What is Strike price?

It represents the price at which the stock can be bought on the expiry day. As in above image we choose Rs.85 as strike price , which means on expiry or before whenever the price of Yes bank in spot market goes above Rs.85 you can exercise you right to buy it (premium goes higher when the spot price of any stock, index go high except in some cases). There is a reason why your strike price should be lower than current market price in case of call option if you want to make profit . We have discussed that below.

What is Contract worth?

As we know now the quantity is predetermined, contract value or worth would be multiplying quantity with current value of securities. So ,Lot Size x Price = Contract total worth in case of above image we are buying call option and hence to buy we need to pay the premium showing Rs. 5.95, Multiply 5.95×2200 = 13090 is the total premium you need to pay in order to get the call option contract. So this amount would be the total contract value.

How option contract get Exercised in Share market?

Let us suppose you have bought a call option at strike price for Rs.85. Exercising of an option contract means your right to buy the options contract at the end of the expiry. “Exercise the option contract” in the context of a call option simply means that one is claiming the right to buy the stock at the agreed strike price(Rs.85). Definitely he or she would do it only if the stock is trading above the strike.

NoteYou can exercise the option only on the day of the expiry and not anytime before the expiry. Please understand exercising contract and squaring off your position is 2 different thing.

You buy an option at a premium today, you can sell it anytime, including the very next second. The profit or loss you make is the difference between premium. On the other hand, you can buy the option today and hold it to expiry. If you do so, the profit or loss is dependent on the value of the option upon expiry aka the settlement price.

when you buy options you can either hold the option till expiry and let the exchange do the settlement for you this is called “Exercising a contract “or you can close the position before expiry and book profits/loss.

What is Expiry?

In the image above you can see expiry date showing 25 JULY 2019. Likewise every Option Contract is bound to time known as expiry . So if you purchase the contract for month of July, after 25 it will get expired. Expiry happens on last Thursday of every month for every contract. After this new contracts will be introduced by exchanges. Similar to futures contracts, option contracts also have the concept of current month, mid month, and far month. However the premium is not the same across different expiries. Premium is never a fixed it keeps on changing depending up on time, news or any events occurring in market.

What is Margin Requirement?

As we know now the contract value ,Margin is the minimum amount need to be deposited for purchasing a option contracts . It is certain %(percentage) of the total contract value, need to be deposited to your broker. Many of the brokers provide different margins for intraday and carryover. It’s different for every stock and index. You can know the minimum margin need to be deposited to trade a option contract by calling to your broker or it might be mentioned on there website as well. Asthatrade provides Margin calculator for easier calculation. A buyer of the call option need to pay the premium amount to get the contract .Where as the seller of the option contracts receives this premium but the margin get blocked for him till contract is settled.

Note: The margins charged for an option seller is similar to the margin requirement for a futures contract.

What is Instrument Type?

As you can see the image Above instrument type is Stock Option, underlying asset is the stock of a company as we want to buy YES BANK Call Option, we will select stock Option there.

What is a Symbol?

Symbol represents the name of the stock or Index. In the case above its Yes Bank .

What is Underlying Value?

Derivative contract derives its value from an underlying asset. The underlying price is the price at which the underlying asset trades in the spot market. This is current market price at which stock is trading in spot market. Spot market is the regular equity market, you would see the price difference in spot market and futures price. You might ask why is there difference in prices? Spot prices are for immediate buying and selling, while options contracts delay payment and delivery.

How to Buy Call Option in stock market?

As an illustration for Option Trading ,suppose a stock is currently trading at Rs.50/-today. As an offer You are given a option today to buy the same one month later, at say Rs. 58/-, but only if the share price on that day is more than Rs. 58, would you buy it? Think about it for a while ,its not a bad deal in case you know what you are buying .Undoubtedly you would buy, it means to say that after 1 month even if the share is trading at 80, you can still get to buy it at Rs.58.

Now in order to get this right you are obliged to pay a small amount today (known as premium), say Rs.4.0/-. If the share price moves above Rs. 58, you can exercise your right and buy the shares at Rs. 58/-(Known as Strike Price ). If the share price stays at or below Rs. 58/- you do not exercise your right because there won’t be any benefit. However, you will lose Rs. 4/- paid as premium to take the contract in this case. This is called Option Contract, a ‘Call Option’ .

After you get into this Call option agreement, there are only three probabilities that can happen.

  1. In case stock price go up, suppose Rs.80/-
  2. Stock price goes down, Rs.55/-
  3. The stock price can stay at Rs.58/-

Scenario 1 – In case stock price goes up, it would make sense in exercising your right and buy the stock at Rs.58/-.

The Profit & Loss statement –

Price at which stock is bought = Rs.58 (strike price)

Premium paid to buy call option contract =Rs. 4

Total Expense incurred = Rs.62 (58+4)

Current Market Price = Rs.80

Profit = 80 – 62 = Rs.18/-

Scenario 2 – If the stock price goes down to say Rs.55/- essentially it does not makes any sense to buy it at Rs.58/- as you would spending Rs.62/- (58+4) for a stock that’s available at Rs.55/- in open market.

Scenario 3 – Similarly if the stock remains flat at Rs.58/- it simply means you are spending Rs.62/- to buy a stock which is available at Rs.55/-, hence you would not exercise your right to buy the stock at Rs.55/-.

Conclusion of Option Trading:

  • You buy call option when you expect the underlying price(spot market price of any instrument) to increase .
  • In case underlying price remains flat or goes down, buyer of the call option will loses money .
  • Only loss for buyer of the call option is premium (agreement fees) that he pays to the seller/writer of the call option. Whereas potential to make an unlimited profit .
  • Buying a call option sometime also referred as  ‘Long on a Call Option’ or simply ‘Long Call’.
  • To calculate Profit Loss , P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
  • The price at which the buyer of a call option will start making profit is called as Breakeven point = Strike Price + Premium Paid
  • Call option is abbreviated as ‘CE’ .CE is an abbreviation for ‘European Call Option’ .
  • In India all options are European in nature

Given these points above i hope you have understood the basic logic behind call option.

How call option writing/selling works?

Option selling is just opposite to option buying. Hence whatever happens to the option seller in terms of the Profit & Loss, the exact opposite happens to option buyer. For example if the option writer is making Rs.10/- in profits, this naturally means the option buyer is losing Rs.10/-.

Below are specific points you need to keep in mind while writing(selling) Options Contracts :

  • We have learnt option buyer has unlimited profit potential as the stock price can go high as much as it can .This means the option seller potentially has unlimited risk.
  • The option buyer has limited risk (only to the extent of premium paid), on the other hand option seller has limited profit (the extent of the premium he receives from buyer).
  • The option buyer want the market price to increase (above the strike price of his contract). However the option seller would be of the opinion that the market should stay at or below the strike price.
  • When an option seller sells options he receives a premium (for example Rs.4/). He would be in a loss only after he loses the entire premium. Meaning after receiving a premium of Rs.4, if he loses Rs.3/- it means he is still in profit of Rs.1/-. Therefore option seller to experience a loss he has to first lose the entire premium he has received, any money he loses over and above the premium received, that will be his real loss.
  •  The same logic applies to option buyer. Since the option buyer pays a premium, he first needs to recover the premium he has paid. Hence he would be profitable over and above the premium amount he has received. As an illustration ,suppose he received the payed the premium of Rs. 5000 to buy a call option, his target would be to first recover the premium .You have already learnt about the breakeven point above.
  • Selling a call option is also known as ‘Shorting a call option’ or  ‘Short Call
  • P&L = Premium – Max [0, (Spot Price – Strike Price)]
  • Breakdown point = Strike Price + Premium Received
  • Selling(writing) a call option requires you to deposit a margin.

 

The risk Involves for a writer(seller) in Option Trading:

You might be thinking if seller have so much risk involved, than why would one sell at all. Comparatively to buyer it does not have that muck risk, let us check how :

  • Suppose the price of the stock move up (Good for option buyer).
  • In case if price stays flat (good for option seller) as the buyer will only make money once recovered the premium paid.
  • However If price moves lower (good for option seller) as we short when you believe that upon expiry, the underlying asset will not increase beyond the strike price.

So out of three possibilities 2 are with seller. Yes he has unlimited risk potential but the probability for a situation favours him. Stock exchange manages the risk for a seller, the risk exposure of an option seller may be unlimited. What if the loss becomes so high that the option seller decides to default?

To avoid this situation to happen the stock exchange made mandatory for the option seller to have some money as margins. The margins charged for an option seller is similar to the margin requirement for a futures contract. You can check the margin requirement for a seller on your broker website . 

Conclusion :

Just opposite to call option buying and selling, option trading also involves put option buying & selling. Put Option referred as (P.E). Likewise call option buying ,put option buyer thinks the securities will fall and he buy put option to benefit from fall.

Where as put option seller do writing to benefit from rising in securities. At the end of this blog i would say this is the just the basic information for option trading in market. We have to learn lot more things like different strategies involved in Option Trading.

One last thing on option chain i forgot to inform above. Option chain gives you all the specific data you need.

What is Option Trading ?

You can view this by going to NSE website .Select stock or index you want to look. To begin with in maroon (Strike Price) been specified. In blue details for premiums are given. In left you can see all call option data. Whereas at right side Put Option. At the top in orange is the current market price(spot) of a security is given.

For now just have the basic information and try to implement them in market. Check if you have understood it properly. If you have any doubt or question in mind, please leave a comment below.

Important NoteAsthatrade is the leading broker who provides Highest Intraday Margin In Option Writing .You can trade Nifty and Banknifty only with Rs.2500.

This Post Has 4 Comments

  1. Thanks a lot for sharing this wonderful article because it is very helpful for me however, good work and very useful information is given in this blog.

    1. Thanks, Marry for your kind words.

    2. Delighted to know about your experience, thanks for your comment.

  2. Thanks for sharing the post. The way you narrated the post is good and understanding. After reading this post I learned a lot of new things about optional trading. Please let me know for the upcoming posts.

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