What are the Options?
Options are like a choice you have, but not an obligation. They are financial contracts that give you the right to buy or sell an underlying asset at a predetermined price on or before a specific date. There are two types of options: call options, which give you the right to buy the underlying asset, and put options, which give you the right to sell the underlying asset. In other words, options give you the power to choose whether or not to enter into a transaction for an asset.
Here is an example of options trading in the Indian market:
Imagine that Ravi is a trader who thinks that the price of gold is going to go up soon. However, he doesn’t have enough money to buy a large quantity of gold bullion outright. So instead, he buys call options on gold. This gives him the right to buy gold at a predetermined price, known as the strike price, anytime before the option expiry date.
- What is the Expiration Day of Options?
- What is the Strike Price of an Option?
How do Options Work?
Let’s say that the current market price of gold is Rs. 50,000 per 10 grams, and Ravi buys a call option on gold with a strike price of Rs. 55,000 per 10 grams. This means he has the right to buy gold for Rs. 55,000 per 10 grams anytime before the option expires. If the price of gold goes up to Rs. 60,000 per 10 grams before the option expires, Ravi can exercise his option to buy gold at the lower price of Rs. 55,000 per 10 grams. He can then sell the gold at the higher market price of Rs. 60,000 per 10 grams, making a profit. On the other hand, if the price of gold stays the same or goes down, Ravi can let the option expire and avoid making a loss.
Information on Different Types of Options
- Call Options: These entail the right to buy the underlying asset at a predetermined price on or before a certain date, but not the obligation to do so.
For example, a call option on shares of XYZ Company gives the holder the right to purchase shares of XYZ Company at a certain price, known as the strike price, anytime before the option expires. If the market price of the shares is higher than the strike price, the holder can exercise the option and buy the shares at a discounted price, then sell them for a profit. If the market price is lower than the strike price, the holder can let the option expire and avoid making a loss.
- Put Options: They allow the holder to sell an underlying asset at a predetermined price on or before a specified date, but they do not obligate them to do so.
For example, a put option on shares of ABC Company gives the holder the right to sell shares of ABC Company at a certain price, known as the strike price, anytime before the option expires. If the market price of the shares is lower than the strike price, the holder can exercise the option and sell the shares at a higher price, making a profit. If the market price is higher than the strike price, the holder can let the option expire and avoid making a loss.
- European Options: These can only be exercised at the expiration date of the option. For example, a European call option on gold can only be exercised on the expiration date, at which point the holder has the right to buy gold at the predetermined strike price.
- American Options: You can exercise them at any time before the option’s expiration date. For example, an American call option on oil gives the holder the right to buy oil at the predetermined strike price anytime before the option expires. This type of option is more flexible than European options, which can only be exercised at the expiration date.
If you wish to know about these Options Trading in India: read them in detail.
- What are Naked Options?
- What is an American Option?
- What is a European Option?
What are the Covered Options?
Covered options are options that are backed by a corresponding position in the underlying asset. This means that the option holder has a stake in the underlying asset and can better manage the risks associated with the option.
Covered option example: For example, if an investor owns 100 shares of XYZ Company and writes a covered call option on those shares, they agree to sell the shares at the strike price if the option is exercised. The investor is “covered” by the underlying position in the shares, which reduces their risk.
If the stock price goes up, the investor may be able to sell the shares for a profit. If the stock price goes down, the investor can keep the shares and the option premium as a consolation prize.
Futures and Options in Share Market- How to Trade in F&O?
Futures and options (FnO) are financial derivatives that are used to hedge against or speculate on the future price movements of a particular asset, such as a stock or commodity. FnO contracts are traded on a stock exchange and can be used by investors to manage risk, generate income, and profit from changes in the price of the underlying asset. FnO contracts have expiration dates, and the underlying asset’s price determines the contract’s price at the time the contract is settled. FnO trading is a popular way for investors to participate in the stock market, as it allows them to take market positions without buying or selling the underlying asset.
Trading in futures and options (F&O) involves the following steps:
- Open a brokerage account: To trade F&O, you will need to open a brokerage account with a registered broker.
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- Choose an exchange: F&O contracts are traded on various exchanges, such as the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) in India.
- Select a contract: Each F&O contract has a specific underlying asset, expiration date, and other terms. Choose a contract that meets your investment objectives and risk tolerance.
- Place an order: Once you have chosen a contract, you can place an order through your brokerage account. You will need to specify the type of order (e.g. market order, limit order), the quantity of contracts you want to trade, and the price at which you want to trade.
- Monitor your position: After you have placed your order, you will need to monitor your position and make any necessary adjustments as the market moves.
- Close your position: This will typically involve offsetting your original trade by taking the opposite position (e.g. buying if you originally sold or selling if you originally bought).
Futures vs Options——-
Futures and options are both financial contracts that allow investors to speculate on an asset’s future price and hedge their investments.
Options vs Futures which is better?
Each has its own unique characteristics and uses, and which one is better for you will depend on your investment objectives, risk tolerance, and financial situation.
Options are generally used for speculation and hedging, as they give the holder the flexibility to choose whether or not to exercise their option.
Futures are typically used for speculation and hedging, as they allow the holder to lock in a price for an asset they expect to either appreciate or depreciate in value.
Both options and futures can be complex and carry a high level of risk, and it may be advisable to seek the advice of a financial professional/financial advisor before making any investment decisions.
How are the Options Contracts Settled?
Options contracts are typically settled in one of two ways: by cash or by delivery of the underlying asset.
- If the option is settled in cash, the option holder receives or pays the difference between the strike price and the market price of the underlying asset at the time the option is exercised.
- If the option is settled by delivery of the underlying asset, the option holder receives or delivers the underlying asset at the strike price.
Investing in Options: Additional Information
How to decide on whether to buy or sell call or put options?
The decision to buy or sell call or put options depends on the investor’s expectations for the price of the underlying asset. If the investor expects the price to go up, they might buy call options or sell put options. If the investor expects the price to go down, they might sell call options or buy put options.
What is the time value of an option?
The time value of an option is the amount by which the price of the option exceeds the intrinsic value. The intrinsic value of an option is the difference between the market price of the underlying asset and the option’s strike price for options that are in the money. The time value reflects the uncertainty of the future price of the underlying asset and the time remaining until the option expires.
Moving average strategy
A moving average strategy is a technical analysis tool that involves plotting the average price of an asset over a certain time period and using that data to identify trends and make investment decisions. For example, an investor might plot the 50-day moving average of a stock and use it to decide whether to buy or sell the stock based on whether the current price is above or below the moving average.
What is an assignment in options?
Assignment in options refers to the process of exercising an option and transferring the underlying asset from the seller to the buyer. When an option is exercised, the buyer has the right to buy or sell the underlying asset at the strike price. The seller of the option is then “assigned” the obligation to sell or buy the underlying asset at the strike price. Assignment can occur anytime before the option expires, depending on the terms of the option.
Difference Between Option Buyers and Stock Buyers
Option buyers and stock buyers differ because option buyers purchase the right to buy or sell a stock at a certain price at some point in the future. In contrast, stock buyers actually purchase ownership in the company represented by the stock.
How are Options Settled?
Options are settled in one of three ways:
- Exercise: The option holder can exercise their option, which means they will buy or sell the underlying stock at the strike price.
- Assignment: If the option holder is writing (selling) an option and the option is exercised, they will be assigned and will be required to buy or sell the underlying stock at the strike price.
- Expiration: If the option is not exercised or assigned before the expiration date, it will expire worthless, and the option holder will not have any further obligations.
- Chen, J. (2003, November 24). What are options? Types, spreads, example, and risk metrics. Investopedia. https://www.investopedia.com/terms/o/option.asp
- Option trading: Overview, benefits and importance – IIFL. (2021, May 15).
- Wikipedia contributors. (2022, December 30). Options strategy. Wikipedia, The Free Encyclopedia. https://en.wikipedia.org/w/index.php?title=Options_strategy&oldid=1130534975