All you want to know about Options trading – For beginner investors

POSTED BY manish ON June 16, 2008 COMMENTS (51)

What is an Option?

Option is a contract which gives buyer the right, but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date. An option has an Expiry date, when its automatically exercised if it has any intrinsic value left.

When you buy an option you have to pay some premium at the time of buying it.

options trading

You can buy or sell Options just like you buy or sell Shares. They are traded in real time. An option value depends on some underling, which can be a stock or an index or even interest rate, The scope of this article is restricted to Stock options or index options.

An example of index option is Nifty option, so its underlying is Nifty.

You must know that its a kind of Derivative : Derivatives are any instrument whose value are derived from some other thing, there value depends on some other thing, like In case of options in stock market, there value depend on either a stock or an index.

Futures are also a kind of Derivatives, The minimum money required for trade in Futures are much more than Options. You can trade in options with as little as 2,000 or 3,000 (depending on the option you are trading in).

Types of option: CALL and PUT

CALL option gives you the right to BUY something anytime before expiry at a predetermined price. The value of the CALL option increases as the Price of the underlying thing increases. The reason for this is because you can still buy it at the fixed price and the difference is your profit.

PUT option gives you the right to SELL something anytime before expiry at a predetermined price. The value of PUT option increases as the price of the underlying Decreases. The reason is that you still have the right to SELL it at fixed price and difference will be your profit.

SOME OPTION TERMS

Exercising an Option :exercise an Option means to Buy(CALL) or Sell(PUT) the stock on the expiry date if they are European style else Buy or sell anytime on or before Expiry if they are American Style.

Expiry Date : The date on which an option will expire and then it will be exercised automatically if it has any intrinsic value left.

Option Style : Options are of two styles, American style (It can be exercised any time before or on expiry date) and European Style (exercised on expiry only).

STRIKE Price : Strike rate is Stated Price for which the underlying stock can be purchased or sold on expiry date.

SPOT Price : The current price of the underlying at a particular time.

LOT : Options are traded in lot size, you can buy 1 lot, 2 lot or any number of lots, and a lot has a particular number of shares in a single lot, Like Nifty options have lot size of 50.

Premium : Every option has some premium which users have to pay when they purchase an Option. So for a CALL option, the premium increases when its underlying price increase and decreases when its underlying price decreased and just opposite of PUT option.

How does an OPTION look like?

Example : CHAFER 90 CE 1.95, EXPIRY 26th June

CHAFER is the symbol for a stock called CHAMBAL FERTILIZERS, so its a Stock option. The expiry date of this option is 26th June (current year).

90 CE means its a CALL (C) option, which is European Style (E, can be exercised on expiry date only) and the Strike rate is 90, means that you have right to buy 1 lot (3450 shares, it depends on the option how many shares a lot has) of chambal fertilizers shares at Rs 90 on the date of expiry if you want.

What are the Profit and Losses you can make?

The Losses are always limited to the extent of premium you pay (in worst case you do not exercise the option and you let your premium go), On the other hand the profits are theoretically unlimited, because the option price can keeps increasing when underlying increases or decreases depending on the type of option.

What is time value and option value ?

The Premium you pay for the option has two components
– Time Value
– Intrinsic value

Premium = Time value + Intrinsic Value

Intrinsic value is the true worth of the option (premium) and Time value is the value which is there because of the time left for the expiry, because as the Expiry time comes near the risk of loosing the money is high. So time value keeps decreasing as the expiry comes closer.

There fore you will see that even if STRIKE price is closer to SPOT price, the option price will be very high if the expiry is after many days.

For CALL option price moves towards 0 if SPOT is less then STRIKE price and expiry comes closer.
For PUT option price moves towards 0 id SPOT is higher than STRIKE and expiry comes closer.

Watch this video to learn more details about Options trading:

How does it works?

You can either sell it at the profit or still hold it.

Case 2: If market does not fall as per your expectation and still is at 4400 before 10 days of expiry and the current price of premium is suppose 10, you can sell it at loss, because you don’t want it to become 0.

Suppose you didn’t sell it and market really closed above 4300 on expiry date, then you loose whole your premium (as SPOT Options used for Hedging

Example 1:

Suppose you buy CHAFER 90 CE EXPIRY 26th June, at a premium of 1.95 (you will have to pay Rs 1.95 * 3450 to buy this option), and the SPOT is 78, means currently price of Chambal fertilizer share is Rs. 78, now the price of option will follow the price of the share price.

If price increases to say 85, then the option may increase to 4.5 (depending on demand and supply), and at this point you can sell the option and earn a profit of 4.5-1.95 = 2.55 Per share, profit of 130%.

Now suppose on 26th June (Expiry day), the price of Chambal Fertilizer is Rs 100, then the option will be exercised and who ever has the option at that time will receive the profit of Rs 10 (total 10 * 3450) and the option will not be exercised if the SPOT (current price) of share is below 90, because then he will make loss if exercised.

(Remember, its not your obligation to exercises the option (you exercise if its in profit, or you loose your premium)

When do you buy Options?

Example 1 :

Suppose Infosys is at 2000 today (1st June) and you are optimistic that its price will go further go up 10% or 15% (2200 or 2300). so you buy a CALL option of Infosys which is going to Expire in approx 1 month, say INFOSYS 2200 CE 10.5 26th June is available and lot size is 1000, so you pay 1000 * 10.5 = Rs 10,500 for this option.

Now option price will move the same way as the price of Infosys share. At the end of the Expiry date if Price of Infosys share will be more than the 2200 then the option will be called “In the Money” as it will be in profit when exercised Else it will be out of money.

So suppose Price of Infosys share is 2280 at the end of Expiry then you exercise the option and get 1000 * 80 = Rs 80,000, you can also sell the option anytime before Expiry date if you want to make profit and convinced that the option price has reached at a good point.

Example 2:

You think that Economy is not doing well and markets as whole will fall because of high inflation news and political issues (or for any reason), Suppose Nifty is at 4600 and you believe that it will fall to 4300 in 2-3 months, Suppose current date is 1st June then you can buy NIFTY PE 4300 AUG , assume premium is Rs 15.

Case 1: If markets fall badly and reaches 4500 in 1 month and the premium increase to 330. You can either sell it at the profit or still hold it.

Case 2: If market does not fall as per your expectation and still is at 4400 before 10 days of expiry and the current price of premium is suppose 10, you can sell it at loss, because you don’t want it to become 0.

Suppose you didn’t sell it and market really closed above 4300 on expiry date, then you loose whole your premium (as SPOT Options used for Hedging)

The main use of Options is for hedging, So if you have bought some 1000 shares of company ABC at Rs 20 , and think that price may fall to 15 in one month ,you can ABC PE 20 or 19, and pay a small premium, Now you are covered for the loss you will make on shares, because you have right to sell the shares at 20 or 19 (depends on the price you bought the options at).

Some other important points

1. Options are very risky and very rewarding, it can give returns of even 100% or 200% in day, or can give negative returns of 50% or 80% in a day.

2. Options are very volatile, so its a good idea to be patient with options.

3. Buying Options near its Expiry dates are highly risky, because if they go in wrong direction they don’t have time to come back.

4. Its not a good idea to buy a option with strike price very far from the SPOT price unless there is some good reason for it. Options with more gap between between STRIKE and SPOT have less premium, but very risky (and can be very rewarding too).

5. Its not a good idea to put a Stop loss for your option very near to the current price, because its highly probable that it will come to Stop loss point and then again bounce back because of there high volatility.

6. Its a good idea to set a target to book profits and get out, rather than trying to get maximum out of option. If you don’t exit at a good point, the chances are that value will again bounce back to normal price and you will miss a chance.

(I sold Chambal Fertilizer CALL 90 option when it price went up to 6.5 though 8-9 looked achievable target next day, but i thought its a great return and didn’t miss the chance of booking 250% return in 2 days, Buy price was 1.95).

I would be happy to read your comments or disagreement on any topic. Please leave a comment.

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51 replies on this article “All you want to know about Options trading – For beginner investors”

  1. Naveen says:

    Very nice article sir. I read on various articles about options trading. Mostly explained about near expiry or action on expiry date. From thisarticles, my all doubts cleared easily.
    Thanks

  2. Rajib says:

    SIR, can we buy unlimited number of lots of stock options(call/ put) of any script or is there any limit set by NSE ? { Suppose if i want to buy multiple lot of SBI then, 1 LOT of SBI = 1000*10000 times= 10000000} can we execute in single order?

    1. Hi Rajib

      This is very specific query which you should follow up with the concerned authority only. We wont be able to comment on that

      Manish

  3. varinder says:

    Can a person sell a call option or buy a put. Like in shares we short sell

    1. Yes, you can do that

  4. vivek says:

    i have 8000 rs. i want to do nifty options trading. how much quantity i can buy in 8000. pls give a simple clear example to elaborate how much i could gain and how much i could loose if its a loss, can you?

    1. Vivek

      8k is a very less amount. You will be able to buy 1 lot of NIFTY options, but chances of your making a lot of money in long term is almost ZERO . you should start atleast with 1 lac of capital or more

      Manish

  5. Gaureesh says:

    Hi Manish,

    Just a doubt about the point of Exercising the Option

    Say I have ICICI Call Options expiring at the month End. Strike Price is 350 and lot size is 1000. So at the time of expiry, if ICICI is trading at Rs 360, do I need to actually buy 1000 shares of ICICI at 350 and then sell at 360? Or is it just a cash settlement of the difference?

    1. Its going to be just a settlement of difference. You dont need to do anything !

  6. Manish says:

    When one should sell call option ideally before expiry ? 3,5,6,7 or 8 days before expiry ?

    1. Whenever it makes sense to sell it as per market conditions . One cant give a number !

  7. Vani Ranjan says:

    Hello
    Truly a nice article .Got to know important things for options market .
    I have a question what does it mean premium is greater than spot price or vice versa in call as well as put option .Please Elaborate .

    1. Premiums has no relation to Spot Price . Premium can be any number higher than the spot price depending on the anticipation , but generally its a small amount !

  8. Gautam says:

    Hi Manish,

    Nice article. I need your email ID.

    Regards.

    Gautam

  9. prasad says:

    Hi Manish,

    Very good article, thank you…
    I have a small question..

    Can we make the profit from difference in premium values ir-respective of strike price?
    Suppose the below is the security

    Current value of NIFTY 5900
    NIFTY13DEC5800PE
    Buy put, thought that it will decrease..
    Say premium 5rs so total premium = 250

    After some time..NIFTY has decreased to say 5950
    say preimum has increased to 10rs..

    Here i can book the profit… 10-5=5*50=250rs?
    ir-respective of Strike price..?

    1. Yes, you can definately do that 🙂 .

  10. Chetan Ambi says:

    Manish,

    This is very good article on OPTIONS. You have clearly explained about it with examples. Though derivatives are complex but anybody with little market knowledge can understand OPTIONS from this article. Tnx Manish !!

  11. Dear Manish Chauhan
    I really appreciate your “Some other important points”
    Also I read all the replies you have given to the people who have commented on your post. I really like your concern to them.
    Keep up the good work.
    All the best and Thanks.
    Regards
    Piyush

  12. tarun mohan says:

    hi. Manish,

    thanks for this presentation ,
    1-at the start of the option contract how to select the strike price to buy an option ?
    2- often near the expiry why some itm options have premium less than its intrensic value?
    3- why in near the expiry there are lots of seller than buyer?

    1. 1. The distant the STRIKE PRICE, the higher risk you are taking and lower the price of the option. Its totally your call which one you want to take . If the nifty is at 5000 , then if you buy a NIFTY 5500 PUT/CALL , then it does not make much sense because in next 1-2 months, the chances of NIFTY crossing 5500 is very less. If you take 5100 or 4900 , then there is high probability that it will .. So its your call , how optimistic/pessimistic you are about the movement of markets

      2. Give me an example , it can not happen .. The premium is less, because now the time is less and movement is limited.

      3. Because those OPTIONS were WRITTEN by someone (who took the premium from you) , so now they have to settle things up ! .. so they have to sell it off !

      I think you should still learn a bit about options .. you are not clear about the whole process I can see 🙂

      Manish

      1. mr says:

        Option writer and Option seller are same person. When someone sells option contract in market we say he has written Option Contract. When option writer Squares up his position he buys option contract and not sell it again.
        I think you should still learn a bit about options .. you are not clear about the whole process I can see

  13. manjunath says:

    i understand the options, but in case of profit at the expiry say in the above example where one buys call option of 90 the spot price becomes 100 at the expiry, will the rs. 10 profit will be automatically put in my account or will i have to exercise the option.and if so, how should i exercise the option

    1. It will automatically come to your account, in India , the excercising happens on its own on the maturity

  14. Indrajit says:

    hi Manish,
    suppose today(1st jan) nifty is at 4700
    i buy a call 4800 at premium rs.50(50*50=2500rs)
    now supose on 15th jan nifty is at 4750 and premium is goin on rs 90.
    let i dnt want to wait upto last thursday,
    1)can i sell the lot whch i buyed at 50rs premium?? if yes do i get any profit??
    2) nw let at expiry date nifty is at 4850,i hav already sold my premium what is my loss and profit at the end?

    1. Indrajit

      1. Definately.. you can sell your option at 90 and make a profit of Rs 40 (90-50)
      2. If you have sold the call option , then you are out of the option and now whatever happens in expiry has nothing to do anything with you . But suppose you have not sold your option , then at the end of the expiry , whatever is the option value at the end will be your worth – like if its worth 4850 , then its worth is Rs 50 , then you have no profit no loss .. but suppose the nifty was at 5000 , then your option worth is Rs 200 (5000 – 4800) .

      Manish

  15. Jsan says:

    Hi Manish,
    The article is intro to Options. I have done Options trading and have lost some money in it but I still want to learn it because I know it also has potential to earn a lot of return for you. Can you guide me on how to speculate in a better or a better strategy for Options.

    1. Jsan

      I am not that proficient in options . The main thing you have to learn is how to control your emotions , greed and fear .

      Manish

  16. Sanjay says:

    Hi Manish,
    I am a long term investor. I am not interested in buying or selling options. I am interested in executing them. Is there a way to buy options smaller than lot size? lot size 50 is too big for me to execute the options.
    What I want to do is this….
    I am a long term investor (buy-and-hold kind of investor). Sometimes market falls down a lot but I don’t have money to buy. But I can arrange the money in next 2 or 3 months. So I would like buy At-the-money call option when market has fallen. But I would like to execute the option in next 2 or 3 months. Nifty has current value around 5000Rs. With lot size 50, executing the option requires investment of 2.5 lacks. I don’t want to invest so much. I am fine with investment of 40000 Rs or so.
    Is there any way to implement this investment strategy?

    1. Sanjay

      At the moment in India , you dont have execution facility in options , you can only buy and sell and settle the money

      Manish

      1. Sanjay Singhaniya says:

        First comment itself talks about the execution of options (it talks about execution of options which have intrinsic value – in other words in-the-money options). What use an option will have if the last buyer is not able to execute/exercise it?

        Another question : if I buy a call-option of 50 nifty shares (which is one lot size), can i decide to exercise only 10 of them? I am fine with letting go the premium of other 40 shares.

        1. No you cant exercise it in parts , its one whole lot

          Manish

  17. Sreenivasa Gurani says:

    Hi ,

    Its very good presentation on Derivative Options. I am fresher to Share market and interested in Option Trading. If you could explain ,how best we can use Option Calculator to predict the STRIKE price of the script will be very help full to us.

    Thanks
    Sreenivasa Gurani

    1. Sreenivassa

      I am not sure on that , I suggest you read more on options and get more knowledge by practice 🙂

      Manish

  18. raj says:

    Excellent Article

  19. vijay says:

    hello Manish,

    can we buy and sell commodities like wheat, rice, sugar, haldi etc. like shares or there is any change in commodities trading.

    Thanks

    1. Vijay

      Dont have much idea on this in detail , but AFAIK you can buy/sell , commodities are for that only , just that the lot price would not be very small, you might need money in range from 30-50k minimum and also you need to have much knowledge about the subject

      Manish

  20. Geeta says:

    thanks for the very nice written article , i t really helped me to understand derivatives, options and related stuff. thanks

    1. Geeta

      Thanks , good to know you are interested in these topics 🙂

      Manish

  21. Manish Chauhan says:

    @Anonymous

    Yeah .. generally the initial sellers are the "big people" in stock market .

    Its not the question of "if you win , what happens to premium" . The correct question is "When do you win ? " , so the answer is , you win when your options go upto , STRIKE + PREMIUM . thats where you break even and when prices move about that , you win .

    So if you buy ICICI 600 CA at Rs 45 . now your break even price is 645 . Only when prices reach above that you say that you win .

    You dont win when prices just more up . Bcause it can happen that ICICI is at 600 and its 600 CA is selling at 60 . Now it can happen that prices move "UP" and go upto 630 at the end . but still you will be in loss of Rs 30 , because at the end the option value will just be Rs 30 .

    However if you are short term trader , then it might happen that prices move up from 60 to 70 because of increase in ICICI prices , where you can book your profits and take the profit of 10 .

    There is too much into options . the best you can learn is mock trade for some time just to see how prices behave . Life is waiting for you in that case 🙂

    good luck .
    Manish

  22. Anonymous says:

    Was just googling to find more about this – the initial sellers are 'market makers' like Goldman etc in the US.

    The other question I had was – What happens to the premium in case you 'win' i.e your call option stock goes up. Is the premium lost in both cases i.e up and down?

    In other words
    Gain = (closing – opening)*N – premium*N ??

  23. Manish Chauhan says:

    @Mk

    Who sets the premium price ?

    The price is set by the sellers of the options in the start . If someone wants to buy it , they buy else , seller has to lower the premiums .. its just like any other market .

    Who gets paid ?

    Sellers in the start get paid .

    Manish

  24. Anonymous says:

    Interesting article. Just wondering, who sets the premium prices, and who is it actually paid to?

    Mk

  25. Manish Chauhan says:

    Mark

    Thanks for pointing out the mistakes .. I have corrected them ..

    thanks a lot
    Manish

  26. Srinivas Patnaik says:

    Here is another good link on options trading:
    http://www.optiontradingpedia.com/stock_options.htm

  27. Mark Wolfinger says:

    I’d like to correct some mis-statements:

    1) “An option has an Expiry date, when its automatically exercised.”

    Only options that have an intrinsic value are automatically exercised. The others expire worthless.

    2)”Exercising an Option: To exercise an Option means to Buy(CALL) or Sell(PUT) the stock on the expiry date.:

    To exercise an option means to buy or sell the stock AT THE STRIKE PRICE at ANY TIME (if American style option) before it expires.

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