Introduction to Options

This module kickstarts our journey into the world of one of the most popular types of derivatives known as options.

In this chapter, we will learn what options are and how they are used. We will also try to understand the terminologies and jargons of the options world in detail in subsequent sections.

In Indian equity markets we have two types of derivatives contracts- futures and options. Buyer of an option has the right but not the obligation to sell or buy the underlying security at a predetermined price. The seller of the option has to deliver the security if the option buyer exercises the option. Seller of the option is also termed as the writer of the option.

Put simply, in case of futures, both the buyer and seller have the obligation as per the terms of the futures contract. However, in case options, the buyers do not have the obligation. Only the seller of the option is bound to perform.

Stocks, currencies, commodities and indices thereof can be the underlying securities for option contracts. For example, options contracts are traded on stocks such as Reliance, ICICI Bank, HDFC Bank, as well as on indices such as Nifty, Bank Nifty. Traders can also transact in options with underlying like gold and USD:INR.

As per the Futures Industry Association (FIA), Nifty Bank Index options traded on the National Stock Exchange of India (NSE) is the largest traded options contract in the world in CY2021, closely followed by CNX Nifty Index options, by volume.

Like futures contracts, options contracts in the derivatives market for each month expire on the last Thursday of the month. Some indices such as Nifty and Bank Nifty have weekly options contracts as well, which expire on Thursday.

Depending on the way the options are exercised, they have two types. European option and American option. While European options can be exercised only on the expiration date (specified date as per option contract), the buyer of the American option can exercise the option any time on or

before the day of expiration (specified date as per the option contract). In India all options that are traded on the stock exchanges are European options.

That is why you get to see ‘CE’ and ‘PE’ written in the options contract data. E stands for European. Now let’s see what C and P stands for.

Options can be of two types if we consider the right they give to the buyer of the option: call option and put option. While C represents the former, P represents the later.

Call Option:

A call option gives the option buyer the right but not the obligation to buy the underlying at a predetermined price from the option writer. This predetermined price is also known as strike price (or just strike) in markets.

RELIANCE 29SEP2022 CE 2700 PRICE RS 75

This is how a typical call option is mentioned on a trading terminal. Let’s use this example to understand what it means. In the above case, the buyer of this option has the right to buy a stipulated quantity of Reliance Industries’ stock on the date of expiry (29 Sep 2022, in this case), at Rs 2700 per share, from the seller of this option. This call option is bought by paying a price – technically known as option premium of Rs 75. This right can be exercised irrespective of what price the stock quoted at the time of purchase of this call option or at the time of settlement (expiry) of the call option.

Put Option:

A put option, on the other hand, gives the option buyer the right but not the obligation to sell the underlying at a predetermined price to the option writer. This predetermined price is also known as strike price (or just strike) in markets.

RELIANCE 29SEP2022 PE 2660 PRICE RS 91

Let’s understand the put option with this example. In the above case, the buyer of this option has the right to sell a stipulated quantity of Reliance stock on the date of expiry (29 Sep 2022, in this case), at Rs 2660 per share, to the seller of this option. This put option is bought by paying a price – technically

known as option premium of Rs 91. This right can be exercised irrespective of what price the stock quoted at the time of purchase of this put option or at the time of settlement (expiry) of the put option.

To sum it up, Call means to buy the underlying and Put means to sell the underlying.

Now let’s quickly look at the various participants in the options markets.

Buyer (or holder) of Call Options:

The buyer (or holder) of call options is an individual/entity who buys the option and expects the price of the underlying asset to rise.

Writer of Call Options:

The writer of call options is an individual/entity who sells the option and expects the price of the underlying asset to drop.

Buyer (or holder) of Put Options:

The buyer (or holder) of put options is an individual/entity who buys the options and expects the price of the underlying asset to fall.

Writer/Seller of Put Options:

The writer of put options is an individual/entity who is the seller of the option and expects the price of the underlying to rise.

Unlike the option holder, the writer of the option has an obligation to buy/sell the underlying should the holder decide to exercise the option.

In order to give the option holder this right to exercise at will, the option writer charges an amount called premium from the buyer of the option.

Uses of Options

Options are widely used for purposes of risk management as they act like an insurance policy in case something goes wrong.

Let’s try to understand this with an example.

Let’s say you hold 250 shares of RELIANCE in your portfolio that is currently trading at Rs 2650. But you expect the price to drop down to Rs 2500 in the coming month. In this case, you stand to lose Rs 37,500 after the price drops (Rs 2,650-2,500 = 150 x 250 shares), if you leave your position unprotected. So, to shield your downside risk in such situations, you can go for a 1-month put option for a strike price of Rs 2660. (Remember the put option we saw earlier)

If after a month the price drops to Rs 2500 as per your expectation, you can exercise your option to sell the shares for a price of Rs 2660 per share. In this case your put option will fetch you Rs 17,250, assuming there is no cost of trading such as brokerage.

Strike Price for put Rs 2660

• Market price of the stock Rs 2500
• Premium Paid Rs 91

Net Profit Rs 69 * Number of shares 250 = Rs 17,250

This way you can reduce your losses.

Options can also be used for speculation and cost reduction purposes.

Let’s look at the Call option example for this purpose. You expect the stock of Reliance to touch Rs 3000 next month. Stock is now trading at Rs 2660. If you buy the call option by paying the premium of Rs 75, then the total outgo today is Rs 18,750. Next month at the time of expiry if the stock closes at Rs 3000, assuming no brokerage, you will end up making Rs 56,250. The calculation is as follows

Market price Rs 3000

• Strike price Rs 2700
• Premium paid Rs 75

Net Profit Rs 225 * Number of shares 250 = Rs 56,250

In both above cases, if the expectation does not materialise, then the maximum loss for the option buyer is the premium paid.

The maximum loss for the option writer can be unlimited.

In the coming chapters, we will learn a lot more about the various options including various strategies that will help you trade options like a professional trader. Also, don’t forget to watch our video series on all the chapters from the trading and investing modules.