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February 08Basics of option trading and How it is exercised?
Basics
of options and How it is exercised
Basically there are two types of options -
Call options and Put options
Call options are a form of derivative trading contracts in which the option buyer gets the right to purchase underlying
assets. Vice Versa Put options gives the owner the right to sell the underlying
assets. These underlying assets may include a stock, bond, commodity, or any
other instrument.
In Call option trading, buyer can buy these
underlying assets at a specified price within a specific period of time. InCall
optiontrading ,buyer will gain if the price
of underlying asset rises and Put option buyer will gain if the price of
underlying asset falls.
Another good thing about the optionsis that
it doesn’t obligate the buyer to buy/sell these assets or stocks. A buyer can
exercise or deny the option on its expiration date.
Options can be categorized as ITM (In the
Money Option),ATM (At the Money Option) andOTM (Out Of Money Option).
In Case Of Call Option
ITM = When Spot price > Strike Price
ATM = When Spot Price = Strike Price
OTM = When Spot Price < Strike Price
In Case Of Put Option
ITM = When Spot price < Strike Price
ATM = When Spot Price = Strike Price
OTM = When Spot Price > Strike Price
Index and Stock Options
Index options give you the right to buy/sell
an index such as Nifty,Bank Nifty. Your profit or loss would depend on the
movement in the index value.
On the other hand, Stock options are options
on individual stocks such as that of the Reliance Industries, Infosys, and Tata
Steel. You can earn profits when the stock price rises or falls depending upon
whether you a call buyer or a put buyer.
European and American Call
Options
Option buyers can either reverse a call
option in the market or exercise the call option in exchanges.
A European option can only be exercised on
the expiration date whereas an American option can be exercised on or before
the expiration date.
How to Trade in Options
In case of a bullish market, you should buy
the call option by paying a specified amount called Premium. But when the
market is bearish, you should buy the put option.
Suppose Nifty is around 10,000 points today.
If you are bullish about the market and foresee that the index will reach 10,100
within the next one month, you may buy call option of Nifty at 10,000
Let''''''''''''''''s call for 10,000are available at a
premium of Rest 60 per share. Since the current contract or lot size of the
Nifty is 75 units, you will have to pay a total premium of Rest 4,500 to
purchase 1 lot(75*60=4500) of call option of the index.
If the Index remains below 10,000 points
until the contract expires, one certainly will not exercise the option and
purchase the call at 10,000. Your loss is the premium of Rest 4,500 that you
have paid.
On the other hand, say the Index crosses 10,000
points as you expected and closes on 10,100 on expiry day.On Expiry , Remember that one will earn profits if the Index
closes above 10,060 levels, since you must add the cost incurred due to payment
of the premium to the cost of the index. If index closes @ 10,100 levels, your
profit will be
10,100-(10,000(strike price)+60(premium paid))=
40 * 75 = 3000 profit
In case you are bearish on market and you see
index going down from the current levels then you buy put option. For eg. Suppose
index is trading at 10,000 levels and index put of 9,900 strike price is
trading at Rs.50. So when you buy a put option, you will pay a premium of Rs.50
which will be your cost and your maximum loss.
If on Expiry,
Index closes above 9,900 levels then your
loss is the premium paid by you
i.e.Rest.
50*75 = 3750
Suppose Index closes on levels of 9875, then
price of your put will be 25 on Expiry Day. So your loss will be (50-25) * 75 =
1875
You will be in profit only if on expiry day
index closes below 9,850 levels, Let’s assume it closes on the levels of 9,815.
So the price of put will be Rest. 85 which you have purchased atRest. 50. Your
Profit will be (85-50)*75 = 2625
If you are unsure about trading in call
options, connect with our financial experts at helpdesk@myfindoc.com.