A quick look at option basics
Hi there. This is Sushant Reddy from Big Blind series on options trading.
In this first tutorial, I will go down to the absolute basics and talk about an options contract. I assume that you are a newbie to options trading and will break it down in a very easy way for you to understand — incase you already have a decent understanding of basics, you might as well skip this tutorial and move to next one.
By the end of this tutorial, you will learn
- basics of how options work
- how options are different from stocks
- why are the benefits of trading options
- what are the risks in options trading
What is an options contract?
Options are a legal contract between two parties to buy or sell an asset at a fixed time in future at a fixed price. An asset could be anything from a stock (eg. RIL), index (eg NIFTY, BANKNIFTY), a commodity (eg. Gold), currency (eg. USD INR) and so on.
Unlike a stock purchase where buyer and seller exchange an asset today at current market price, an option transaction allows an exchange of asset at a future date at a fixed price agreed today.
Why is it called an option?
So here is the catch — an option buyer need not necessarily buy or sell the asset on a future date at pre-agreed price. She has an option to back-off from the deal and let her contract expire worthless. Since she can choose to back-out from buying or selling the asset, it is called an ‘option’.
Option buyer has a right but not an obligation to buy or sell a stock at a future date and hence the term ‘option’
Had she not had that choice to back-out, such contract would be called a ‘future’.
A real life example
What is the closest real life example — Imagine that you are house hunting in a city like Mumbai and your broker shows you a nice looking apartment with a monthly rent of 25,000 rupees. You like it and give a token advance of 5000 to lock-in the rent & other terms for that apartment. A few days later you enter into a legal agreement and move into your new apartment.
What if another broker showed you a better looking apartment at a monthly rent of 22,000 . Your yearly savings would be 36,000 (3000 rent difference over 12 months). You let your earlier agreement expire and lose your token deposit. In effect, you bought an option that locks your rent at 25,000 (in options world, this is called a ‘Strike’) by paying an advance of 5000 (this is called ‘Premium’).
In our daily lives, we hold a number of ‘real’ options. It is always helpful to relate options theory to our real life decision making.
Why are the types of options?
There are 2 types of options — call & put. A call option gives a buyer a right to buy a stock at a fixed price on a future date but not an obligation. So its upto a call option buyer whether she chooses to buy a stock on a future date or simply pass the opportunity. Obviously, a call option buyer would choose to buy stock at a future date if pre-agreed price (‘strike’) is lower than the current market price.
A put option works the other way round. Put option gives a buyer a right to sell a stock at a fixed price on a future date but not an obligation. A put option buyer would choose to exercise the option by selling the sock at pre-agreed price (‘strike’) if that price is higher than current market price on the date of exercise.
An Example
To understand this better, let’s take a call option on Reliance Industries Limited that is currently trading on NSE.
A call option on Reliance Industries Limited with an expiry date of 30 May 19 and a strike of 1500 is trading at Rs 20 per option on 03 May 2019. What this means is that a person buying 1 option on Reliance Industries has to pay 20 rupees to have a choice of buying 1 share of Reliance for Rs 1500 on 30 May 2019.
Just so you know, on 3 May 19 Reliance Industries is trading at a price of 1408. So if your view is that RIL will breach 1800 by end of the month, you can go ahead an buy this option for 20 rupees. If RIL share goes to 2000 by 30 May 19, you make a profit of 180 rupees (a 10 to 1 return in a month…not bad at all)
Conclusion
Options seem complicated at first but trust me, they are very simple to understand. And as you understand options better, they start getting more intuitive. I hope this tutorial is a start of a wonderful journey in options trading.
If you have any questions, please let me know by commenting in the section below.
