Skill Takeaways: What you will learn in this chapter
- What is an option contract?
- What is a call option and put option?
- Quantum of profit one can make in various market segments for a similar trade
- Why trade in Options?
Options, in the derivative market parlance, are contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a future date. Since there is no requirement for physical deliveries, the option buyer has to pay only the prevailing premium and, by doing so, indirectly participates in the price movement of the underlying asset. So, if the trader expects the price of the underlying asset to rise in the near future, he should buy a call option, and if he expects it to fall, then he should buy a put option.
There are two types of options, namely, European options and American options. European options are the ones where the buyer can exercise the option only on the maturity date. In the American options, the buyer can exercise the option on or before the maturity date. In India, we follow the European options method. That’s also the reason why traders see the terms CE and PE, which are the abbreviations for Call European, and Put European.
Another important point about options trading is that the lot sizes are pre-fixed. While in the cash market, traders can buy any quantity of shares, in options trading, which is applicable to futures trading too, the trader has to buy at least the minimum quantity, called the lot size, or in multiples of the lot size. The lot size varies from stock to stock. For instance, the lot size of Asian Paints is 200, while for GMR Infra is 22,500. Thus, when you buy 1 CE or PE of Asian Paints, you are indirectly buying or selling 200 shares of Asian Paints.
You can do options trading only in those stocks that are listed for F&O trading by the exchange. For example, National Stock Exchange at present allows about 175 stocks for F&O, and traders can do options trading only in these stocks.
The image above clearly illustrates the various investment avenues available and the possible returns under each avenue. Here, a live example of the stock of Asian Paints has been taken. Suppose the trader’s analysis showed that the Asian Paints stock is doing well in its business and the stock price is likely to go up; he would want to participate in the stock’s potential upward journey. Since Asian Paints is also an F&O stock, the trader has three options: buy the stock in the cash market, Futures market or Options market. Suppose he decides to take the plunge into all three markets just to understand them more clearly. Since the minimum lot size of Asian Paints in F&O is 200 shares, for convenience’s sake, we assume that the trader bought 200 shares of Asian Paints in the cash market and one lot each of the same stock in Futures, and in Options on the 8th July 2022 at the rates mentioned in the image. The fund requirement (in the case of F&O, its margin requirement) in each of the markets is also mentioned, which will be the amount invested for the purpose of calculating the returns. After nearly a month of staying invested in the stock, if the trader decides to sell the stock/futures/options, the return will be the same (in absolute terms) under cash and Futures market, but in relative terms, it will be higher under Futures market due to lesser fund requirements. In absolute terms, however, the returns will be the least in the Options market. Thus, in the Options market, the funds required will be the least, and also, the maximum risk involved in the Options market will be the initial funds required in the form of the premium. Another advantage of Options trading is that your maximum possible loss is pre-defined; in this example, it’s Rs 22,000.
Constituents of option trading
Of course, the main constituents of options trading are the buyers and sellers who come together on a platform provided by the stock exchange through their respective broking accounts. Here the seller of the option is also known as the option writer, who is supposed to be the market creator for options. Usually, option writers are high net-worth individuals (HNIs) who want to make money by taking home the premium from the options they write.
To be a successful option writer, one needs to be a good reader/judge of the prevailing trend. If the trend is bearish, the options trader benefits from writing call options, and if the trend is bullish, he gains by selling put options. While the maximum profit is the premium earned, the loss could be unlimited if the trend goes against the trader. Option writers also take into account the volatility factor, usually preferring less volatile stocks. Further, they write options for many stocks at a time – a method to spread the risk and improve the return.
Just like stock trading, for options trading too, you need to have an account with a broker. In case you have already opened an account with a broker, find out whether the account has a derivative trading option. If it doesn’t have that option, you would need to request your broker to activate that option, for which you may have to submit some minor additional information like 6 month bank transaction statement or IT return filing acknowledgement or some other details. Once the required details are submitted and sufficient margin money is deposited, you can start options trading on your account!
Though both Futures and Options are derivatives contracts and help traders to participate in the price moves without owning the underlying asset, there are many differences between the two. While in the case of a futures contract, a trader has to buy or sell the underlying on the expiry date (unless he has squared off his position before that), the buyer of an options contract gives the right, but not the obligation, to buy or sell the underlying at a specific price at any time before the expiry period. This is the major difference between Futures and Options and is also the major reason for the latter’s popularity.
In India, different margin requirement rules of the exchanges regarding Futures and Options also influence traders’ preferences. Usually, margin requirements for futures contracts are much higher than for options contracts. For example, if a trader wishes to buy an August (2022) futures contract of, say, Asian Paints, whose price is around Rs 3,485 (cash market), he will have to shell out margin money of Rs 1,36,000 for one lot (of 200 shares). On the other hand, if he buys an August options contract of, say, a 3,500 strike price, his margin requirements will be just Rs 14,700! In other words, the margin requirement in the case of the Futures contract is much higher (as much as 10 times in this example) than in the case of options contracts.
However, some traders prefer futures as it helps them to profit directly from the price movements in the underlying asset. On the other hand, in the case of options, he needs to be satisfied with the proportionate appreciation in the value of the premium of the underlying and not directly in its price variation. Options are also used by long-term investors and also institutional investors to hedge against short-term fluctuations in the prices of their long-term investments.
Things to remember
- Options are contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a future date.
- If the price of the underlying asset is expected to rise in the near future, then the trader should buy a call option, and if the price is expected to fall, then he should buy a put option.
- Of the three markets — cash, Futures and Option, the lowest amount of investment required for a trade is in options trading.
- Also, the loss that can happen in a trade will be the lowest in options trading. His maximum loss will be the premium paid.
- There are two types of options — European options and American options. India follows the European options.
- Options are used by long-term and institutional investors to hedge against short-term fluctuations in the prices of their long-term investments.