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Basics of Option and Future Trading

What is an Option?

In a lay man words, an option is the right but not an obligation to buy the underlying asset ( stocks, bonds). There are two types of options - call or put. Lets discuss these further:

Types of Option

1. Call Options

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date.

The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Example : An investor buys One call option on RIL at the strike price of Rs. 1500 at a premium of Rs. 100. If the market price of RIL on the day of expiry is more than Rs. 1500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 1600 (Strike Price + Premium i.e. 1500+100.

In another scenario, if at the time of expiry stock price falls below Rs. 1500 say suppose it touches Rs. 1000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option.

So when would you buy a call option? You would buy calls when you were expecting prices to rise in the near future

2. Put option

On the other hand if you buy a put option contract you have right to sell the asset at a predetermined price by the expiration date. This is similar to 'shorting' a stock in that you are expecting the price of a share of stock to go down in the value in the near term (sometime before expiration).

In the case of a put the inverse of a call holds. If the market price goes below the strike price then you are 'in the money' otherwise you are said to be 'out of the money'. Whether you choose to trade options using calls or puts, you need to do your homework. Trading options is risky and slightly more complicated than trading stocks. But, if you study the underlying asset, the volatility and other factors that affect its value you will be able to make better investment decisions.

Example: An investor buys one Put option on Reliance at the strike price of Rs. 1500/-, at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 1500, the option can be exercised as it is 'in the money.

 Call OptionPut Option
Option buyer or option holderBuys the right to buy the underlying asset at the specified priceBuys the right to sell the underlying asset at the specified price

Glossary of Terms Used in Option Trading

Derivative - An instrument which derives its value from the value of an underlying instrument (such as shares, share price indices, fixed interest securities, commodities, currencies, etc.). Warrants and options are types of derivative.

Underlying - The specific security / asset on which an options contract is based.

Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell.

Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.

Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.

Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option).

Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.

Open Interest - The total number of options contracts outstanding in the market at any given point of time.

Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.

Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.

Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options.

Option Series - An option series consists of all the options of a given class with the same expiration date and strike price.

Expiration Day - The expiration date is the last day an option exists. If that Thursday is an exchange holiday, the last trading day will be one day earlier.

Exercise - If the holder of an option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock

Risks of an options buyer

The risk/ loss of an option buyer is limited to the premium that he has paid.

Stock Index Options

The Stock Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty Index / Options on BSE Sensex etc.

What is a Future ?

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. Futures Contracts have symmetric risk profile for both buyers as well as sellers.

How Options are different from Futures ?

In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.

The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset.

Time Tested Rules for Successful Trading

This is a list of classic trading rules You may correlate the list according the market trend.