Welcome traders today we are going to kick start a new series, Options Trading for Beginners. Here you learn all you need to know about options.
Wikipedia defines options as, “a contract where the buyer of the option has the right, but not the obligation to purchase or sell an underlying asset at a fixed price on or before the expiry date of that contract.”
With this definition, a lot of questions come to mind as in…
So an underlying can be a stock and index, interest rates, currencies or commodities.
The price at which the buyer of the option wishes to buy or sell that particular underlying.
It is the date on which the contract expires. Any dues are settled on this date based on the price of the underlying with respect to the strike price of the option and options premiums paid at the time of buying that option.
For options trading you need to understand how you can classify options. You can do it in two ways.
Secondly, you can classify the options based on whether you are betting on the upside or the downside of the market. For example, if you believe that the markets are going to go up, you are likely to buy a call option. If you believe that the market is likely to go down, you are likely to buy a put option. So for upside, you buy call options and for the downside, you buy put options.
Obviously, it is not as simple as it sounds, but we will go into more details as we proceed in this series.
Call Option – A call option gives Buyer the right to buy a particular stock index commodity at a particular price on or before the expiry of that option.
Put Option – Consequently, a put option gives the option buyer a right to sell a particular stock index or commodity at a particular price. That is the strike price on or before the expiry of that option.
Let me give you an example. Let’s say you want to trade NIFTY option and NIFTY is trading at 12000.
You believe that NIFTY is going to go up from here. So you buy a call option of twelve thousand strike price at, let’s say, 100 rupees. If you are buying this call, you have the right to buy NIFTY at the rate of 12000 on or before the expiry. The expiry, as we discussed, is on every Thursday of the week. So let’s say you buy this option on Monday. So you have four days Monday, Tuesday, Wednesday and Thursday for this option to move higher and make you some profits.
Let’s say it’s the expiry day and the market closes at twelve thousand two hundred. No, we had the right to buy the option at 12000, but we paid 100 rupees for it. So our break, even in this case, is twelve thousand one hundred. So unless prices move above whatever breakeven, we are not going to make a profit. So basically above 12100, this is our profit zone and below this is our loss zone. So when the market closes at 12100, our call option will be worth two hundred.
Subtract the initial buying price from that and you get 100 rupees as your profit. So that is how a call option works.
And the put option works in an exactly opposite manner. Let’s say you bought a put option of the 12000 strike price at 150 rupees and you expect the market to go down now you bought it on Monday. You have four days of expiry left. Let’s say the market closes at 11800. Now, based on our calculations for the call option, in this case, the option will be worth 200 again.
But if you reduce the purchase. That is 150 from what you are left with is up 50 rupees profit.
Now, let us go back to our call option example and see what if the market does not move and closes at 12000 itself. So here the market does not go to 12200 or 12100 but closes 12000. In this case, our option will be worth “0” and you reduce the cost or the purchase price of 100 from which you’re left with a loss of one hundred rupees.
So not only does the market has to move, but it has to go beyond your break-even point in case of options for you to make money. If you compare this with simple futures example and you bought the futures at 12000 and if it goes higher than 12000, then you make a profit. If it goes below 12000, you make a loss, but not in case of options. In the case of options, things are a little different. And here your underlying price has to move beyond your breakeven price.
So for the call option, your breakeven is the strike price plus the call option premium. And in case of put option, your breakeven is the strike price minus the put option premium.
As I said, one of the option classifications was whether you are betting on the upside or downside.
So if you’re betting on upside, obviously you need to buy a call option and if you’re betting on a downside, you need to buy a put option.
Markets likely to go up = buy a call option…
Marketr likely to go down = buy a put option…
But whether it is that simple, we will find out when we move deeper into the series on options trading in our future videos. When you start trading options, you realize one thing, that for a given set of conditions like let’s say the market is at 12000, that is NIFTY is at 12000. And if you compare the premiums of call option of the 12000 strike price and put option of 12000 strike price you will find out that the put option premiums are always greater than the call option premiums, all other things remaining constant.
Why is it there is no technical reason for it but a psychological one. Just recall the last instance that you were long and the market fell sharply. Remember the feelings and emotions that rushed through your mind when that was happening?
You would agree that traders fear downside more than they like the upsides. The market gaps up 100 points, nobody is worried as much as when it gaps down 100 points. So the emotions and fears are stronger to the downside than to the upside.
And that is why when an option seller is pricing an option higher than a call option. Obviously we will learn more about pricing options further down in the series. But the option seller when he is pricing option, he will add more premium for the downside possibilities than to the upside possibilities.
That is why a call option is not always as expensive as the put option, because traders fear the downside more the option. Sellers will factor in more risk into the premiums of put options than they will in the premiums of call options.
And that is why a put option all of the things remaining constant a put option will always be slightly costlier than a call option.
As we said, an option depends on many things. First is the underlying lets say that is in our case, NIFTY which is sitting at 12000.
Then we select a strike price. Let’s say we select strike price as 12000 we will talk about calls. So strike prices above the current market price of NIFTY in this case 12100, 12200 and so on are considered as out of the money strike prices.
Whereas if we go below that is 11900, 11800 and so on. Any strike price below the current market price for a call option is called in the money.
Put options are exactly opposite to that. So any strike price that is above the current market price for a put option will become in the money whereas any strike price that is below the current market price for a put option will become out of the money.
Now, when you talk about deep in the money options, whether it is a call or put, in case of a call, it will be way below the current market price. So let’s say someone is buying a call with the strike price of 11200. This is an deep in the call option.
Similarly, if someone is selling, let’s say, 12800 put option, this put option will be deep in the money. So the farther you go from the strike price, if you go lower the calls become deeper in the money, if you go higher the puts, become deeper in the money.
First and foremost, they have a very high delta. Now, what is Delta? Obviously, they’re going to see more about all these Greek letters associated with options very soon.
But for the time being, Delta tells you how much an option will move for a given movement in underlying so NIFTY moves by 100 points. What will the option premium change be? So for at the money options, the delta is always 0.5. What it means is that it will move half the amount of underlying. So at 12000 if NIFTY goes to 12100, the 12000 calls will increase roughly by 50 points.
So if it was trading at 100, it will become one hundred and fifty. when NIFTY reaches 12000. So that is how Delta is calculated.
For deep in the money options that Delta values are very, very close to 1. So let’s say NIFTY moves by one hundred point. The deep in the money option will move almost 100 points. So let’s say you don’t want to buy futures and if you deep in the money option, you can replicate the action of futures or stock by buying deep in the money options.
Second, the benefit of deep in the money option is lesser time value. Now, what is time value?
We discussed the underlying price, then we discussed the strike price. Then we saw the option premium. Let’s say we are talking about a call and option premium is 100. How you calculate time value is by finding out this formula…
Time Value = (Strike Price + Premium) – Current Market Price
Lets fill in the values…
(12000 + 100) – 12000 = 100 (is the time value)
Let’s say, as we say, that if this moves to 12100, the call option premium goes to 150. In this case, if you apply the same formula, what you will find out is that the time value comes to 50 rupees.
As your option goes deeper and deeper into the money, this time value will go on reducing further.
Now, why is it important? Because let’s say you bought an option of 12000 strike price hundred and at expiry if it closes at 12000, this 100 rupees time value will become “0”.
We will have to go much deeper into the discussion of options trading to understand this correctly. But this is what happens. And that is why if you want to replicate a stock or a future and don’t want to buy a lot of stocks or pay the margin on future, you can buy deep in the money options because.
You will be charged much, much less than what futures margin is or buying that much amount of stock will cost you. You have to pay much less and at the same time, this time, values also is less. So even if your stock does not move the time value loss is not that big.
Thirdly, as I said, you can replicate a long stock or a long future using this deep in the money option. So for these three reasons, there are advantages of buying deep, deep in the money call or put options.
So obviously call options you will buy if you are betting on the upside and put options you will buy if you’re betting on the downside. So for general purposes, put options are exactly opposite of call options.
These are some of the basics related to options trading. I know it gets confusing real fast, but obviously you’ll have to stay with me for this whole series and you will start understanding all these concepts one by one.
So thank you for reading the post till the end. And here are suggestions for the next post you should watch in the series and I’ll see you in the next one.
Read “How to trade options for beginners?” next…