What is Options Trading?

Options trading allows you buy and sell stocks, ETFs, etc. You can buy or sell stocks, ETFs, and other securities at a specified price, within a certain time period. This trading allows buyers to choose not to purchase the security at the given price or date.
Options trading is more complicated than stock trading but can make you much bigger profits if the security’s price goes up. Options contracts don’t require you to pay full price for security. Options trading, also known as a hedge, can limit your losses if security prices drop.

The right to purchase a security is called “Call”, while the right of selling is called “Put”.

These can be used as:

  • Options Trading: Leverage allows you to profit from fluctuations in share prices without having to lower the share price. You can have control of the shares but not buy them.
  • Hedging: These can be used to hedge against fluctuations in share prices and allow you to buy or sell shares at a fixed price for a specific period. Financial planning is an integral part of protecting yourself from market fluctuations. 

Options trading has its advantages but is more complicated than regular trading. To protect against losses, it requires a solid understanding of investment and trading strategies as well as continuous monitoring of market fluctuations.

ABOUT

Futures contracts reduce risks by setting a price for the underlying asset in the future. Options contracts do the exact same thing but without the obligation to purchase the futures contract.

An option contract seller is known as the “options writer”. Contrary to the buyer of an option contract, the seller does not have any rights and must sell assets at the agreed price if the buyer decides to execute the options contract before or on the agreed date. In exchange, the seller will pay an upfront payment.

At the time of an option contract being entered into, there is no physical exchange. Transactions are only recorded on the stock exchange through whom they are routed.

You have VIX Futures if you trade in NSE. This can help you measure volatility. Read more.

OPTION RELATED TO TERMS

Many terms can seem foreign to traders who trade in the derivatives section. These are some Options-related terms you need to be familiar with.

  • Premium An upfront payment by the buyer to the seller in order to receive the benefits of an option contract.
  • Strike price / Exercise price: Pre-decided price at the asset can either be purchased or sold.
  • Strike price intervals: These indicate the different strike prices at each option contract. These are determined by which exchange the assets are traded.
    There are usually at least 11 strike price declarations for each type of option in any given month: 5 above the spot, 5 below the spot and 1 equivalent to the spot.

The following strike parameter is currently in effect for options contracts on individual securities in NSE Derivative section:

The strike-price interval would be:

The Basis
Closing price
Strike Price
Interval
No. No.
Money-
At the money-Out of the money
No. Additional strikes may be taken
Intraday access may be possible
Either direction
Not less than or equal to Rs.502.55-1-55
From Rs.50 up to Rs.10055-1-55
From Rs.100 up to Rs.250105-1-55
From Rs.250 up to Rs.500205-1-55
From Rs.500 up to Rs.10002010-1-1010
> Rs.10005010-1-1010

STRIKE PRICE INTERVALS – NIFTY INDEX

The number of options on index contracts is determined by the closing value of the index in the previous day. This table applies to the following:

Index LevelStrike IntervalScheme of Strike to Be Introduced
Up to 2000504-1-4
From 2001 to 40001006-1-6
From 4001 to 60001006-1-6
>60001007-1-7
  • EXPIRATION DATE

    An option contract that can be executed at a future date or earlier. You have three options contracts that you can choose from:
    • Nearly a month (1 month).
    • Mid Month (2 months).
    • Far Month (3 months).*Please note that Nifty index offers long term options. Futures & Options Contracts typically expire on Thursday of each month. After that date, they are deemed null.
  • AMERICAN and EUROPEAN OPTIONS

    The terms “American” and “European” refer to the type and time of execution for an option contract. American options are Options that can be executed anytime before or after their expiration date. European options are Options that cannot be executed after the expiration date.
    Please be aware that only European options are available in India for trading.
  • LOT SIZE

    A lot size is a number of units of an underlying asset that are part of one F&O contract. Stock exchanges determine the standard lot size. It varies for each stock.
    E.g. Options contracts for Reliance Industries can have 250 shares in a lot.
  • OPEN INTEREST

    Open Interest is the sum of all outstanding positions in a particular option contract among all market participants at any one time. After the expiration date of a contract, Open Interest is null.

    Let’s look at an example:
    When trader A purchases 100 Nifty options from traderB, where both traders A-B are new to the market, the open interest is 100 futures or two contracts.
    The next day, Trader A makes a sale to Trader C. A’s position in the market for this asset is reduced by C’s.
    If trader A purchases 100 Nifty Futures more from trader D, then the open interest in Nifty Futures contract will become 200 futures, or 4contracts.

TYPES OPTIONS

As mentioned earlier, there are two types of options: the ‘Call Option’ and the Put Option.

  • CALL

    In return for a premium to the seller, the call option holder has the right to purchase a specific asset at strike price. As the asset’s value increases, call options become more valuable. Online quotes will abbreviate call options as “C”
  • PUT:

    In return for a premium, the Put Option allows the holder to sell an asset at the strike price at any time before or on the expiration date. The strike price is pre-set so that you are protected against any fall in stock price. Put options are more valuable if the stock price falls.

    The seller does not lose the entire asset price if the stock price rises during the contract term. Online quotes will abbreviate put options as “P”

HOW TO TRADE IN OPTIONS

Rajesh can buy 100 Infosys shares for Rs 3000 per share at any time during the contract period, from now until May. He also paid Rs 250 premium per share. To enjoy the right to sell, he has to pay Rs 25,000.

If Infosys shares rise to Rs 3,000-Rs 3200, Rajesh could consider buying Rs 3,000 per share. This would save him Rs 200 per share, which can be considered a tentative loss. After taking the premium amount into account, Rajesh still has a nominal net loss of Rs 50 per shares. Rajesh might decide to exercise the option when the share price reaches Rs 3,250. He can also choose to let his option expire and not exercise it.

Rajesh believes the shares of Company X have been overpriced at the moment and is betting on them falling in the coming months. He puts his money down on Company X shares in order to protect his position.

HERE ARE THE QOTES FOR STOCKX:

MonthPricePremium
February (Current Month)Spot Rs 1040NA
MayPut Rs 1050Rs 10
MayRs 1070 PutRs 30

Rajesh purchases 1000 shares of Company X at a strike price 1070 and pays
Premium: Rs 30 per share His premium total is Rs 30,000

Rajesh could sell his put option if the spot price of Company X drops below. He will earn Rs 50 per share (Rs1070 minus Rs1020 on the trade), making a net profit Rs 20,000 (Rs50 x 1000 shares – Rs30,000 paid as premium).

Alternately: If the spot price of Company X rises more than his Put option, say Rs1080, he would lose his right to exercise the option at Rs 1070. In this instance, he will opt to not exercise his put option. He loses Rs.30,000, which is less than if he exercised his option.

WHAT ARE THE PRICES OF OPTIONS CONTRACTS?

Options can be purchased for an underlying asset for a fraction than the actual asset’s spot market price by paying an upfront premium. This is the cost of entering an option contract.

Understanding the basic terms At-The–Money, Out–Of–The-Money and In-The–Money will help you understand how this premium amount is calculated.

Let’s look at what you might face in any of these situations while trading in options.

  • In the money: You can make a profit by using this option.
  • No money: By exercising this option, you will not make any money.
  • At the-money If you exercise this option, it will be a no-profit, non-loss situation.

If the spot price for the asset is lower than the strike price, a Call Option is considered ‘in-the-money’. A Put Option, on the other hand, is ‘In the money’ when the spot value of the asset exceeds the strike price.

HOW IS PREMIUM PRICING ARRIVED AT :

Two factors control the price of an Option Premium: intrinsic value and time value.

  • Intrinsic Value
    The difference between the cash spot price and strike price for an option is called the intrinsic value. It can be either positive (if you’re in-the money) or negative (if it is out-of the-money). A negative intrinsic value cannot be attached to an asset.
  • Time value basically places a premium on how long it takes to exercise an option contract. Contract A is considered to have a higher Time Value if it takes longer time between Contract A’s current date and Contract B’s expiration date.

Contracts with longer expiration dates allow for greater flexibility in when the option can be exercised. The contract holder is less likely to be in a difficult spot due to the longer expiration period.

The contract’s time value is high at the beginning of a contract term. The option price will rise if the option is still in-the-money. The intrinsic value of the option will be affected if it is out-of-money, or remains at-the-money. This affects the intrinsic value which then becomes zero. In such cases, the option price drops and only the time value is taken into account.

The time value of the contract decreases as the expiration date approaches. This negatively affects the option price.