Derivative : Option Trading Basic

“Derivatives: Option Trade”

 

Definition:

A stock option is a contract between two parties in which the stock option buyer purchases the right, and not the obligation to buy/sell shares of an underlying stock at a predetermined price from or to the option seller within a fixed pre determined period of time.

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Option Contract Features:

Option Class

The two classes of stock options are puts and calls.

1.       Call Option: gives the buyer the right to buy the underlying stock.

2.       Put Option: gives buyer the rights to sell the underlying stock.

Strike Price

The Strike Price is the price at which the underlying asset is to be bought or sold when the option is traded or exercised.

Expiry date

The expiration month is specified for each option contract. Once the stock option expires, the right to exercise no longer exists for option holder, and the stock option value becomes zero. The specific date on which expiration occurs depends on the different types of market, country. For e.g.  Stock options listed in the India expire on the last Thursday of the month.

Option Style

An option contract can be of two styles.

1.       American style.

2.       European style.

American style options can be exercised anytime before expiry date.

European style options can only be exercise on expiry date itself.

All of the stock options currently traded in Indian Stock Market are American-style options.And Nifty options are European style options.

Underlying security

The underlying security is the security which the option seller has the obligation to deliver or purchase on option expiry date. In the case of stock options, the underlying asset means shares of a specific corporate.

Premium

The option buyers have to pay the option seller a premium for carrying on the risk that comes with the obligation, for the right option buyer is enjoying by option trading. The option premium depends on the strike price of security, volatility of market, as well as the time remaining to expiration o that contract.

Lot size

Lot size states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For nifty option lot size is fixed 50. For stock options, each contract covers different number of shares, same as its future lot size.

Call Option

Definition:
A call option is a type of option trade where the holder of the call option (buyer) has the right (only right and not the obligation) to purchase a specified quantity (lot size) of a security at strike price before expiry day. If option writer writes (sell) a call option, it is an obligation for the writer to sell the underlying security at the strike price if the option is exercised before expiry date. For stock options or index options, each contract has pre determined quantity of shares.

Call option buying is generally used to hedge short position too. When traders have fear of some uncontrollable elements which can raise risk level of his/her short position in market, at that time he can use call buying. Call buying is popular in traders as trading mechanism too. We will try to understand the same with following example.

Example:

Suppose the stock of Reliance Company is trading at Rs 2200/-. A call option contract with a strike price of Rs.2200/- expiring in a month’s time is being priced at Rs.100. You strongly believe that Reliance stock will rise sharply in the coming weeks after their earnings report. So you paid Rs 15000 to purchase a single Rs.2200 Reliance call option covering 150 shares. If the price of Reliance stock rallies to Rs.2400 after the some days, with this sharp rise in the underlying stock price, your call buying strategy will give you a profit of Rs 15000/-. As you have call option of 2200/- you can buy the stock from market at 2200/- and at current situation you can sell the call option at 2400/- rate. And 15000 Rs were paid for buying the right of call option. So net profit is 100 Rs for 150 share lot. That will be 15000 Rs profit net.

Call writing:

Sometimes traders in stock exchange, sell call options instead of buying them. It is known as selling call option or writing call options. They do it generally with the prediction of premium reduction. They can get profit of reduced premium and reduced worthiness of that call option. Traders can make good profit if call writing is done properly.

Traders can sell option with hedged position of stocks (having stock buy position) it is called Covered Call Selling. If traders are selling the call option without any hedged position then it is called Naked Call Selling. Naked call selling is highly risky. Risk is unlimited and return is limited in this case.

Call Spreads

Call spread is a strategy where equal numbers of same security option contracts are bought and sold simultaneously in such way that can reduce risk and maximise return. This option trades can be of different strike price or different expiry date.

Put option

Definition:

A Put option is a type of option trade where the holder of the [ut option (buyer) has the right (only right and not the obligation) to sell a specified quantity (lot size) of a security at strike price before expiry day. If option writer writes (sell) a put option, it is an obligation for the writer to purchase the underlying security at the strike price if the option is exercised before expiry date. For stock options or index options, each contract has pre determined quantity of shares

Put option buying is generally used to hedge long position in stock market. When traders have fear of some uncontrollable elements which can raise risk level of his/her long position in market, at that time he can use put buying. Put buying is the simplest way to trade put options. Put buying is popular in traders as trading mechanism too. We will try to understand the same with following example.

Example

Suppose Reliance company is trading at 2200/- . Strike price of 2200/- put option rate, expiring in a month’s time is being priced at Rs 100. You strongly believe that XYZ stock will drop in the coming days. So you paid Rs 15000 to purchase a single rs 2200/- Reliance put option with lot size of 150 shares.

As  you expected the price of Reliance  stock plunges to 2000/- after a few days.

When you buy the put option, you invoke your right to sell 150 shares of Reliance stock at 2200/- each. Although you don’t own any share of XYZ Company at this time, now the rate is 2000/- so can buy it from market and sell it at your rate 2200/- . Per share profit of 200 Rs. Lot size is 150, the total amount you will get 30,000. As you had paid 15000 to purchase this put option, your net profit for the entire trade is 15000/- .

Put writing:

Sometimes traders in stock exchange, sell put options instead of buying them. It is known as selling put option or writing put options. They do it generally with the prediction of premium reduction. They can get profit of reduced premium and reduced worthiness of that call option. Traders can make good profit if put writing is done properly.

Traders can sell option with hedged position of stocks (having stock short position) it is called Covered Put Selling. If traders are selling the put option without any hedged position then it is called Naked Put Selling. Naked Put selling is highly risky. Risk is unlimited and return is limited in this case..

Put Spreads

Put spread is a strategy where equal numbers of same security option contracts are bought and sold simultaneously in such way that can reduce risk and maximise return. This option trades can be of different strike price or different expiry date.

Strike price

Definition:

Strike price is price at which option holder can buy or sell the  underlying stock or index at expiry date. This strike price is known as exercise price too.  The option price and its liquidity /money ness is depended on strike price.

Relation of Strike price and Option price, generally if the strike price is nearer to market price of the security, the option price will be higher. Some exceptional cases are always there too.

Strike Price Intervals

Strike price interval can be different for each and every stocks. For example Reliance strike price difference is 20 Rs . and Nifty strike price difference is 50 Rs.

Type of strike price:

In-The-Money (ITM):

When Call option strike price is below its current trading price of that particular security it is called in the money (ITM) call option.

When Put option strike price is above its current trading price of that particular security it is called in the money (ITM) put option

Out-of-the-Money (OTM)

When Call option strike price is above its current trading price of that particular security it is called Out of the Money (OTM) call option.

When Put option strike price is below its current trading price of that particular security it is called Out of  the Money (OTM) put option.

At-the-Money (ATM)

When any call or put has same strike price as its current trading  price this option is called At the money (ATM) call / put option. It does not have any intrinsic value. Only time value decides its premium. Generally ATM has good volume compared to ITM and OTM.

Option premium

Option premium is one of the most important terms. It is the higher price we are paying to buy or sell the option in market. It is depended on market condition, events, time frame and many other factors. One should be very careful while deciding the option premium. Two important factors are explained below.

Intrinsic Value

The intrinsic value of option trade can be calculated by the difference of strike price and current trading price. In the money options will have intrinsic value; out of the money options will not have intrinsic value.

Time Value

Time value is nothing but the loss of worthiness of any option contract as expiry time declines. As expiry date period declines, liquidity in the option also reduces. And this value is called time value. Time value will rise with uncertainty rise in any security.

For In the money options or Out of money option time value is Option Price – Intrinsic Value.

Options Expiry /assignment /excercise

Option expiry:

All option contracts has pre decided life time. Option expiry date is the date when right of option holder will expire. In other word the right for particular option is valid only till expiry date. In Indian stock market expiry day is last Thursday of every month.

Option Exercise:

To exercise the option means to use the right to buy (in case of call option) or to sell (in case of put option) the underlying stock or index or other security. It can be exercise in following ways:

American Style Or European Style

In American style of exercise option holder can exercise his right any time before expiry date. And in European style of exercise option holder can exercise on expiry date only. Stocks traded in Indian stock market are American option example and Indices traded in Indian stock market are European option example.

I have tried my best to provide you basic information of option trading.

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