What are the options?
The options buyer gets a right to buy/sell that underlying asset at a particular time and price.
Buying of options
There are two types of options-
A call is an option that gives the right to buy the underlying assets at a particular time and price.
For example, We have Stock A whose CMP is 200 and I feel that it will go to 220-230 and want to buy in a month. But want to buy on 205, for that, I will a call option at a strike price of 205. But for that, I would have to pay a premium, which guarantees that I will get the stock after a month. Normally call option is bought when you know that the price would go up in the coming times.
Similarly, the put option gives the right to the buyer to sell at a particular time and price.
For example, I have 500 shares of Stock A whose lot size is also 500. Its CMP is 200 and I feel news can make its price go down. So to hedge my selling price, I will buy a put option at a strike price of 200 with a date after one month. Meaning I can Sell my Stock at 200 for which I will have to pay a premium.
One question is that if the price doesn’t go down and stays at 205.
Now you bought the put option so you can sell it at 200 after one month. Here you will not use your put option rather sell it at an open market price at 205 meaning the put value becomes 0.
To summarise, whenever you feel a price will go up, you buy the call option. And if you feel the price will go down, you buy a put option. So this was the strategy during the buying time.
Let’s try to understand what can be the maximum loss if you buy/sell a call option. And what can be the maximum loss/profit when you sell an option. So whenever you buy a call option, you pay a premium for it. Assuming that the premium is Rs 10 per share of the call option at a strike price of 200. Its lot size was 1000. Hence you paid a premium of 10000. Now if the price rises, your profit is unlimited.
Like you paid a premium of 10 and when it expires its price is 210. You will have no profit no loss. And if this price goes to 250, you will have a profit of 40 per share. So the maximum loss is the amount of the premium because on the expiry the lowest value can be 0. So your profit is unlimited and your loss is limited which is the amount of premium paid.
The lot size of an option is 100 and a trader buys its call option at a strike price of 25 and pays a premium of 150. Now assume the stock price goes from 25 to 35 on expiry. Meaning the one who bought the call option will be able to buy at 25 on expiry day. So he has the right to buy 100 shares of 25 each which amounts to 2500. And the current price amounts to 3500, hence he makes a profit of 1000. But he paid a premium of 150, which makes his profit of 1000-150 = 850. Similarly, when you buy a put option. The more the price falls, you make an unlimited profit and can happen till it goes to 0. But the loss is limited which is the premium paid for it.
Selling of options
You might have heard people say that the ones who sell options make money and the people who buy options take higher risk. So whenever you sell an option, your profit is the premium collected from the other person. And loss can be unlimited in that case, as we discussed in the case of the call option that you buy the right. But the option seller has sold his obligation to the other so that they can buy the stock at 200.
So the example wherein the stock price went to 35, the option seller would have to sell at the rate of 25 only. So the profit in option selling is the premium and the loss is unlimited. To summarize, in option buying your loss is limited and profit is unlimited. And the call is to buy when you think it might go up. Here you can either buy a call option or short a put option. Similarly, when you feel the price might go down. You can either buy a put option or short the call option. So you can make your position based on the market.
From what the value of options is derived?
The option doesn’t have its own value but derives from an underlying asset.
The first is the current price. Whatever the assets may be, they can derive their value from the current price. Now you bought a call option assuming the price would go up. The next day it does so by 10%, so your call option would also go up 10%. So any fluctuation in the underlying assets price will directly affect your option’s price.
The second is the time before expiry. Assuming today and the expiry after 15 days. More the gap, the more the price. Options are like insurance. For example, You buy an option in May with expiry in June, you would have to pay more premium. And if you buy with expiry in July, you would have to pay more premium. There are weekly expiries too wherein the least premium is required. So due to the time value, the value of options increases with time.
The third is volatility. The more volatile the markets, the more prices of options. And when volatility is there, the prices either shoot up or fall drastically down hence the prices are higher.
The fourth is the dividend. If the company announces a dividend, the prices of put options go up, their premium goes up. Because normally, when a dividend is announced the share price goes down and the put options go up. So anything that impacts the underlying assets will affect the options prices.
Lastly, I will talk about interest rates. Whenever interest rates rise, the call option prices go up and when they decrease, put option prices go up.
OBjectives of options
The main objective of options is for hedging. Assume you have a lot of shares of stock. But you feel its stock price may go down and your portfolio may suffer. So for that, you can buy put options as if the price goes down, you will benefit. So if you buy the put option equivalent to the stocks. your value in Demat would decrease but the put option will hedge it. Hence it can beautifully use for hedging.
One more thing that you get when your trade-in options are exposure. You can take a higher exposure in options by buying them and paying less for more. Which has the advantage of, that if you catch the momentum, you can profit a lot. But if you fail to do so, you can a huge loss due to the higher exposure. And many people use it for speculative purposes to gain more profit. So you should access your risk and then invest in call and put options.