What is Option Trading? Basics of Call and Put Option
Options Trading, Call Option Put Option, Option Buying, Option Selling, etc. are the common terms associated with Options Trading. But, what exactly is this options trading?
Here we have a complete guide to options trading. We have covered the basic details of options trading and a guide on whether options trading is good for you or not. First things first, all you need to understand is trading which means buying and selling for the purpose of profit maximization. So, the intention is very clear that we are not staying for a long-term perspective but making money in the very short term through options trading. Now, let us understand what does it mean when you say options trading.
What is Options Trading?
Options Trading is trading in options but what kind of options are we talking about. It’s an option to buy or sell a security. We will understand the concept of Options Trading with an example.
Let’s imagine the Share of Reliance Industries is trading at Rs 2539.00 and you are expecting that it will go up to Rs 2800 by this month’s end. So, the idea is that you can buy the stock of Reliance and you will get a profit by selling it. But, what if you don’t have money to buy the stock at this time. But, you are very sure about the stock price going to your target price. Imagine what if you can enter a contract to buy the stock at a price of Rs 2650 at month end but for this, you will have to pay a token of advance so that your contract is secure. Let us consider this token of advance as Rs 25 for our example.
In the market, you will find a lot of people who would be ready to sell the stock at a price of Rs 2650 as it is higher than CMP giving them a profit as well. Now at the end of this month, if the stock price goes to 2800 as you predicted, you have an option to buy the stock at a price of 2650 as you have the token and the seller will have to sell it compulsorily because of the contract. Here you paid Rs 2650 for the stock plus the price of token which was 25 so the total cost of 2675 against the Selling price of 2800 giving a profit of Rs 125. There is a possibility that the seller would request you to accept Rs 125 and not to exercise the right to buy.
What is Premium?
In this example, the price of the token that you paid is called Premium. It is the price for the right that you get in options. The above is a theoretical example where you have to wait till the month to exercise the right but in reality, as the price of the security increases your price of the premium will also increase which you can sell anytime as it will have demand, and this is called options trading. By paying the premium, you acquire a right to buy the security which can be transferred. And, this right gives you an option to exercise which only the buyer gets, the seller has to execute. Similarly, the same right is there for selling also.
What do you understand by CE & PE?
If you are thinking that the underlined security will go up then you can buy CE for that strike price (target price) but if you have a bear view on the market you can buy PE for your strike price on the lower side. CE gives you an option to buy and PE an option to sell. But, we are not interested in buying or selling the security. While writing they are written as CE & PE but we simply call them call option and put option respectively. And the prices of these options keep on changing based on the time value, expiry date, and the price of underlined security.
These options have an expiry date, they cannot be open forever. Every Thursday is the weekly expiry and the last Thursday of the month becomes the monthly expiry. Let’s say a call option is written as –
“RELIANCE MAR 2800 CE”
It means that this is a call option of Reliance for the strike price of 2800 with an expiry of March. Here it’s a monthly expiry for the last Thursday of March 31st this time. So, if in case the Reliance does not reach 2800 by 31st March the price for this call option would be zero on that day getting expired. The actual meaning of the option holder would be that on 31st March the holder would buy Reliance at a price of 2800 depending upon the number of calls.
ITM, ATM & OTM Options
ITM stands for in the money which means whatever the option is reading has already happened. So, if we are saying RELIANCE MAR 2800 CE is in the money, it means that Reliance is trading above the 2800 mark in the equity segment.
ATM means at the money which implies that the underlined security is about to cross the strike price mentioned.
OTM or Over the Money is the case where there is a huge difference between the strike price and the current price.
Why do people do Options Trading?
This is the question that arises as options trading comes with great risk. The biggest risk is the declining time value. The price of a call/put option is determined by two factors one is intrinsic value and the other one is time value. This time value becomes zero on the day of expiry which keeps on declining with the passing time. Another risk is the fluctuation being very high but why do people go for Options Trading?
One advantage with the Options trading is that you can trade on the INDEX also like Nifty/Bank Nifty and then it is in lot size. Yes, there is a lot of sizes fixed for options trading. For, Nifty 50 the lot size is 50 and for Bank Nifty it is 25. You can buy in multiples of these lot sizes only.
Let’s take an example where you have a capital of Rs Rs 1 lakh with which you are trading in reliance. The Reliance you are buying at CMP as of March 23rd, 2022 at Rs 2539 which you are expecting to go to 2600 by the 31st of March 2022. In this case, if it happens the way you are predicting the profit will be Rs 2379 where you are trading in 39 shares of Reliance.
In the same scenario, you can get 20 lots of Reliance for RELIANCE MAR 2600 CE which is trading at Rs 18 now and the lot size is 250 for Reliance. In this example, the call price would go up to at least Rs 30-50 if the Reliance close above 2600 before the expiry date. Taking the minimum target price of 3o giving a profit of Rs 10 multiplied with the lot size of 250 and 20 lots the amount comes to Rs 50,000. Imagine the difference, this is why people do Options trading but if not done properly the entire capital can become even zero in a matter of moments