Option Trading

Options trading allows you to take a position on the price movement of an asset without directly buying or selling it at the beginning.

• A call option gives the buyer the right to buy the underlying asset.
• A put option gives the buyer the right to sell the underlying asset.
• The buyer pays a premium for this right.
• The seller receives the premium but must fulfil the contract if required.
• Options have a fixed strike price and expiry date.
• Buyers can lose the entire premium paid.
• Sellers may face much larger losses depending on the strategy.
• Options can be used for hedging, speculation and creating different market positions.
   

Option trading involves contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period.

A call option gives the buyer the right to buy the asset. A put option gives the buyer the right to sell it.

Options can be used to take a position on market movements or reduce the risk of an existing investment. However, they are complex instruments and may lead to significant losses.

An options contract is linked to an underlying asset such as a stock, index, commodity or currency. Its value changes according to the price of the underlying asset and other factors.

The main elements of an options contract are:

• Underlying asset: The stock, index, commodity or currency linked to the option.
• Strike price: The fixed price at which the underlying asset may be bought or sold.
• Expiry date: The date on which the options contract expires.
• Premium: The amount paid by the buyer to purchase the option.

An option’s premium can change based on the underlying asset’s price, market volatility and the time remaining until expiry.

In exchange-traded equity options in India, the contracts are European-style. This means they can be exercised only on the expiry date. However, you can generally sell an open options position in the market before expiry, subject to market conditions and liquidity.

If an option has no value at expiry, it expires worthless. In this situation, the buyer loses the premium paid.

Different option strategies may be used depending on whether you expect the market to rise, fall or remain within a range.

1. Long call strategy

A long call involves buying a call option. It gives you the right, but not the obligation, to buy the underlying asset at the strike price.
Traders may use this strategy when they expect the underlying asset’s price to rise. The buyer’s maximum loss is generally limited to the premium paid.

2. Short call strategy

A short call involves selling a call option. The seller receives the premium but takes on an obligation under the contract.
Traders may use this strategy when they expect the price to remain stable or fall. An uncovered short call can involve potentially unlimited losses if the underlying asset’s price rises sharply.

3. Short put strategy

A short put involves selling a put option. The seller receives the premium and may be required to buy the underlying asset at the strike price.
Traders may use this strategy when they expect the underlying asset’s price to remain stable or rise. Losses can be substantial if the asset’s price falls sharply.

4. Long straddle option strategy

A long straddle involves buying a call option and a put option with the same strike price and expiry date.
It may be used when you expect a large price movement but are unsure whether the price will rise or fall. The total cost is the combined premium paid for both options.

5. Short straddle strategy

A short straddle involves selling a call option and a put option with the same strike price and expiry date.
Traders may use it when they expect the underlying asset’s price to remain close to the strike price. However, this strategy can result in substantial losses if the market moves sharply in either direction.

6. Long put strategy

A long put involves buying a put option. It gives you the right, but not the obligation, to sell the underlying asset at the strike price.
Traders may use this strategy when they expect the underlying asset’s price to fall. The buyer’s maximum loss is generally limited to the premium paid.
Each strategy has a different risk and return profile. The result also depends on the premium, strike price, market movement, volatility and time remaining until expiry.
 

The main participants in options trading are buyers and sellers.

• Option buyer: The buyer pays a premium to receive the right to buy or sell the underlying asset. The buyer is not required to exercise the option.
• Option writer or seller: The seller receives the premium and accepts the obligation created by the contract.
• Call option buyer: The buyer receives the right to buy the underlying asset at the strike price.
• Put option buyer: The buyer receives the right to sell the underlying asset at the strike price.

A call or put option is a type of contract rather than a separate category of market participant.
 

Understanding the main terms can make options trading easier to follow.

• American option: An American-style option may be exercised at any time up to and including its expiry date.
• European option: A European-style option may be exercised only on its expiry date. Exchange-traded equity options in India are European-style.
• Strike price: The strike price, also called the exercise price, is the fixed price at which the underlying asset may be bought or sold.
• Premium: The premium is the amount the option buyer pays to the option seller.
• Expiry date: The expiry date is the date on which the options contract ends.

To trade exchange-listed options in India, you generally need a trading account with a SEBI-registered broker. A demat account may also be required, particularly where securities must be delivered or received during physical settlement.
 

Options are described as in-the-money, at-the-money or out-of-the-money based on the relationship between the underlying asset’s market price and the strike price.

• In-the-money: A call option is ITM when the underlying asset’s price is above the strike price. A put option is ITM when the underlying asset’s price is below the strike price.
• At-the-money: An option is ATM when the underlying asset’s price is equal or very close to the strike price.
• Out-of-the-money: A call option is OTM when the underlying asset’s price is below the strike price. A put option is OTM when the underlying asset’s price is above the strike price.

ITM, ATM and OTM describe an option’s moneyness and intrinsic value. They do not directly indicate the trader’s final profit or loss because the premium and other charges must also be considered.
Options may be used for hedging, speculation or taking leveraged positions. However, they can result in significant losses. Buyers may lose the full premium, while option sellers may face much larger losses.
 

Options offer certain features that may be useful in different market situations. However, these features do not guarantee profits.

1. Cost efficiency
Buying an option may require a lower initial amount than directly purchasing the same quantity of the underlying asset.
However, the option buyer can lose the entire premium if the expected price movement does not occur before expiry.

2. Risk management
Options may be used to hedge an existing investment against an unfavourable market movement.
The effectiveness of the hedge depends on factors such as the strike price, premium, expiry date and position size.

3. Potential percentage returns
Options provide leverage because their value is linked to an underlying asset while the buyer initially pays only the premium.
This may increase percentage gains when the market moves as expected. It can also increase the possibility of losing the entire premium.

4. Flexibility
Options can be combined to create strategies for rising, falling, volatile or range-bound markets.
The risks and possible outcomes depend on the structure of the strategy. More complex strategies may also be harder to understand and manage.
 

Options give the buyer a right without creating an obligation to exercise the contract. In comparison, futures contracts create an obligation for both parties to complete the transaction according to the contract terms.
Options also allow traders to select different strike prices and expiry dates. This makes it possible to create strategies based on different market expectations.
For an option buyer, the maximum loss is generally limited to the premium paid. However, this limited-risk feature does not apply in the same way to an option seller. Selling uncovered options can lead to substantial or potentially unlimited losses.
Options trading can be more complex than directly buying shares. The result may depend on the direction and size of the market movement, volatility, time decay, premium and expiry date.
Successful options trading is not based only on predicting whether prices will rise or fall. The market movement must also be sufficient to cover the premium and other trading costs.
 

Options trading allows you to take positions based on expected market movements through call and put contracts. It can also be used for hedging and creating different trading strategies. However, options involve leverage, time decay and fixed expiry dates, which can lead to significant losses. Buyers may lose the full premium, while sellers can face much larger risks. Understanding the contract terms, settlement process and possible outcomes is essential before trading in options.