Basics 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.