Basics of Options for Beginners
Investment and Risk Management
12 April, 2020 by
Basics of Options for Beginners
Rohan Trivedi

This article is intended to give some basic understanding of options in the stock market. In this article, we are going to understand some basic terminologies used in options and some grass-root level understanding of positions to make in option trading depending on market sentiments.

INTRODUCTION

Before we jump onto the option contracts we must first understand the meaning and use of “Derivative” in the context of the stock market. The dictionary meaning of “Derivative” is “something based on another source”. In the financial market “Derivative Contract” is a contract whose value is derived from the value of an underlying asset. These derivative contracts are mainly used for the purpose of “Risk Management”. So the question arises: What kind of risk can be managed by a derivative contract in the financial market? and the answer is “Price Risk” which means the volatility of the stock market. There are basically four types of derivative contracts available like the Forward contract, Future contracts, Options, and Swaps. Without going much into details we are now going to understand options as derivative contracts.

        OPTION CONTRACTS

        As the name suggests “Option Contract” gives an Option; either to Buy or Sell the underlying asset. 
        Options are basically of 2 types (1) Call Options (2) Put Options.

        (1) Call Option:
        • Investors can take two positions in call options either: Buy (Long position)” call option or “Sell (Short Position)” call options.
        • The buyer of the Call option has a Right to Buy an underlying asset. E.g You “CAN” buy 1000 shares of ABC Limited at Rs.10 per share after 2 months. Here you have an option to exercise your right to buy the shares after 2 months but you are not compelled to buy.
        • Seller of the Call option has an Obligation to Sell an underlying asset .E.g You “UNDERTAKE” to sell 1000 shares of ABC Limited at Rs.10 per share after 2 months. Here you are compelled to sell the shares after 2 months but you do not have an option to sell.
        • Investors can take any position in call option i.e Buy or Sell; depending on the market expectation of the investor. (Discussed in detail later in this article)

        (2) Put Option:
        • Investors can take two positions in put options either: Buy (Long position)” put option or “Sell (Short Position)” put options.
        • The buyer of the put option has a Right to sell an underlying asset. E.g You “CAN” sell 500 shares of ABC Limited at Rs.20 per share after 2 months. Here you have an option to exercise your right to sell the shares after 2 months but you are not compelled to sell.
        • Seller of the put option has an obligation to buy an underlying asset .E.g You “UNDERTAKE” to buy 500 shares of ABC Limited at Rs.20 per share after 2 months. Here you are compelled to buy the shares after 2 months but you do not have an option to buy.
        • Investors can take any position in the put option i.e Buy or Sell; depending on the market expectation of the investor. (Discussed in detail later in this article).

        So rather than buying or selling the shares investor can buy or sell options and can get income out of it. So what is the difference between buying shares and buying an option? In case if you want to buy shares you have to pay the market price of shares whereas in case you buy an option you have to pay the premium amount only which is far less than the market price of shares. So the liquidity increases in case of options; because an investment is limited to the premium amount only.
        Based on the above basic knowledge we shall now understand the position to take in option contracts based on market sentiments.

        Basic Terminologies in options:

        • Strike Price: It is the price at which Buyer of an option can exercise his Right at the time of the expiration of the option period.
        • Expiry date: It is the date on which the Buyer can exercise his right. 
        • Premium: For Buyer of Option it is the amount to be paid to purchase the options.
          For Seller of Option, it is the amount to be received to sell the options.

              

        Basically, there are three types of trends in the market.

        1. Bullish Trend i.e Increase in price of shares

        2. Bearish Trend i.e Decrease in price of shares

        3. Stability in the market.

        The Decision regarding the position (Buy or sell) of option and type of option (call or put) depends on the trend in the market that Investor expects.

        (A) BULLISH TREND

        If the investors expect to have a “BULLISH TREND” ( increase in price) then it is suitable to either “BUY CALL OPTION” OR “SELL PUT OPTION”.


          (1)  Buy Call Option:
        • Buying call option gives “RIGHT” to purchase the underlying asset.
        • Buyer of the call option has to pay a premium which is the cost of the call option for the buyer.
        • Buyer of the call option will exercise his right only if Market price is more than the strike price at the time of expiry of option as he can buy at low price (strike price) and sell at high price (market price).
        • It could result in unlimited profit (due to increase in price) and limited loss in case of bearish trend (to the extent of premium paid)


        E.g An investor purchases a 2 month call option on shares of ABC Limited with a strike price of Rs.120 at premium of Rs. 10.Now lets see the effect on expiry of option with different market price.

        From the above it is clear that the buyer will not exercise his right until the market price exceeds strike price. When market price exceeds strike price then the buyer of the call option exercises his right and buys the shares(underlying asset) at strike price and sells at market price which results in profit. Now if we put Market price on X axis and Net Profit/(Loss) on Y axis we get the following.


        As from the above we can see that there is a possibility of earning unlimited profit as the market goes Bullish. Against that if the market tends to Bearish then loss is capped to premium paid which is the maximum possible loss.

        (2)  Sell a Put Option:

        • Selling the put option gives an “obligation” to purchase the underlying asset.
        • Seller of the put option receives a premium which is income to the seller of the option.
        • Here we have to think from the viewpoint of buyer of put option as he has right to sell; buyer of Put option will exercise his right only if Market price is less than the strike price as he can sell at high price (strike price) and purchase at low price (market price).
        • It could result in limited profit (to the extent in premium received) and loss to the extent to difference between strike price and market price at the time of expiry of option.
        • Here seller of put option gives right to exercise option to the buyer of put option, so if market price is MORE than strike price then buyer of put option will not exercise his RIGHT TO SELL at strike which gives seller of put option a guaranteed profit as premium income.

        E.g An investor sells a 2 month PUT option on shares of ABC Limited with a strike price of Rs.130 at a premium of Rs. 20. Now let's see the effect on the expiry of option with the different market price.


        From the above it is clear that the buyer of the put option will not exercise his right if the market price exceeds strike price, where seller of put option earns premium income as guaranteed profit.Now if we put Market price on X axis and Net Profit/(Loss) on Y axis we get the following,

        As from the above we can see that there is a possibility of earning guaranteed profit as the market goes Bullish. Against that if the market tends to Bearish then maximum loss is capped to the difference between strike price and  market price less premium received.

        (B) BEARISH TREND

        If the market tends to have a “BEARISH TREND” (decrease in price) then it is suitable to either “BUY PUT OPTION” OR “SELL CALL OPTION”.


          (1)  Buy a Put Option:
        • Buying put option gives “RIGHT” to sell the underlying asset.
        • Buyer of the put option has to pay a premium which is the cost of the option for the buyer.
        • Buyer of the put option will exercise his right only if Market price is less than strike price of the option as he can sell at high price (strike price) and buy at low price (market price).
        • It could result in profit to the extent of difference between strike price and market price in bearish trend and limited loss in case of bullish trend (to the extent of premium paid). 


        E.g An investor buys a 2 month PUT option on shares of ABC Limited with a strike price of Rs.110 at premium of Rs. 12.Now lets see the effect on expiry of option with different market price.

        From the above it is clear that the buyer will exercise his right if the market price decreases below the strike price. When the market price decreases below the strike price then the buyer of the put option exercises his right and sells the shares (underlying asset) at strike price and buy at market price which results in profit. Now if we put Market price on X axis and Net Profit/(Loss) on Y axis we get the following,


        As from the above we can see that there is a possibility of earning profit as the market goes Bearish. Against that if the market tends to Bullish then maximum loss is capped to the Premium paid on purchase of the options.

        (2)  Sell a Call Option:

        • Selling the call option gives an “obligation” to sell the underlying asset.
        • Seller of the call option receives a premium which is income to the seller of the option.
        • Here we have to think from the viewpoint of the buyer of call option as he has right to buy;so buyer of the call option will exercise his right only if the Market price is more than the strike price as he can buy at low price (strike price) and sell at high price (market price).
        • It could result in limited profit (to the extent of premium received) and unlimited loss (difference between strike price and market price at the time of expiry of option less premium income.)
        • Here seller of call option gives right to exercise option to the buyer of call option, so if market price is LESS than strike price then buyer of call option will not exercise his RIGHT TO BUY at strike which gives seller of call option a guaranteed profit as premium income.


        E.g An investor sells a 3 month call option on shares of ABC Limited with a strike price of Rs.90 at premium of Rs. 15.Now lets see the effect on expiry of option with different market price.


        From the above it is clear that the buyer will exercise his right if the market price exceeds the strike price. When the market price exceeds the strike price then the buyer of the call option exercises his right and buy the shares (underlying asset) at strike price and sells at market price which results in profit. Now if we put Market price on X axis and Net Profit/(Loss) on Y axis we get the following,

        As from the above we can see that there is a possibility of earning profit as the market goes Bearish. Against that if the market tends to Bullish then maximum loss is uncapped.

        CONCLUSION

        From the above discussion we understand that Option contracts are derivative products used for the purpose of risk management; risk in terms of price variation in the stock market. Type of option and position in option highly depend on the investors expectation about the market sentiment. So it becomes very important that there shall be high probability of the investors' expectation about the market.These were the basic four strategies that we have discussed there could be many strategies which can be applied.

        These four strategies can be very well be applied depending to market sentiment as follows

        STRATEGY

        MARKET TREND

        Buy Call Option

        Bullish

        Sell Put Option

        Bullish

        Buy Call Option

        Bearish

        Sell Put Option

        Bearish

        DISCLAIMER

        This article is intended for the basic understanding of the options and the author will not be responsible for any loss incurred based on this article.This article is not intended to be a form of solicitation or advertising. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. No person should act on such information without appropriate professional advice based on the circumstances of a particular situation. This update is intended for knowledge sharing only.

        Share

        Basics of Options for Beginners
        Rohan Trivedi 12 April, 2020
        Share this post
        Archive