Traditional trading on the stock exchange (or currencies, real estate, or bonds) typically involves the buying and selling of an asset or an underlying asset to make a profit. These tend to be simpler instruments to deal with and will appreciate or depreciate based on the asset itself. However, a certain class of financial instruments called ‘derivatives’ has been made to function a little differently. Derivatives are financial agreements that change their value based on the underlying asset it is based on. In the stock market, the two most prominent types of financial derivatives are futures and options, commonly called F&O.
An options contract gives the buyer/seller a right, but not the obligation to buy/sell the underlying at a specific price at a specified later date. A futures contract, on the other hand, has to fulfil the obligation of buying/selling the underlying asset at the specified price at a specified later date.
In this article, we will explain the fundamentals behind the options contracts, the volatility behind the contracts, and a few widely implemented strategies to make money from this volatility. For simplicity, we will be explaining only the bullish cases.
You will learn the following terms:
- Call Option
- Put Option
- Strike Price
- Expiry Date
- Lot size
- In the Money
- At the Money
- Out of the Money
Call and Put Options
There are two types of options that are traded in the stock market - the call option and the put option. The call option is a bullish (price moving upwards) bet on the underlying while the put option (price moving downwards) is a bearish bet on the underlying.
For example, the value of the Nifty 50 index is 15,600 today, and you are expecting the value of the index to rise to 16,000 by the expiry date of the current monthly contract. In this case, you can buy a Nifty call option. You will be buying this by paying an amount called the ‘premium’.
(The expiry date of a monthly contract is the last Thursday of the month. If the last Thursday of the month is an exchange holiday, then Wednesday is the expiry date.)
Now, you will find that the contracts will come at multiple ‘strike prices’, which refer to the price of expiry. If a Nifty call option has a strike price of 16,000, it means you will likely make money if the value of Nifty crosses the sum of the strike price and the premium. If the value of Nifty does not cross the strike price at expiry, it will go down to zero, losing all your money.
Considering the same scenario, if the premium value of the Nifty 16000 CE (call option) is at ₹30 per contract, then you will need the value of Nifty to cross 16000 + 30 = 16030 at expiry to turn net profitable.
However, you cannot buy an individual contract; you can only buy these options contracts in lots, i.e. a collection of contracts. The lot size will vary depending on the underlying and is set by the stock exchange in question. The lot size of a single Nifty contract is 50, i.e. 50 Nifty contracts in one lot.
Moneyness of a contract
Note that the amount of profit you make at the expiry depends on the current price you are buying the contract, the strike price of the contract you are buying, and the price at expiry. All these are best explained in a concept called moneyness, in which we use three terms to explain:
In the money option:
The value of Nifty is 15,600 today and you buy an option contract with the strike price of 15,300. These options are more expensive but relatively safer.
At the money:
The value of Nifty is 15,600 today and you buy an option contract with the strike price of 15,600. These options are medium-priced, but have a higher likelihood to be profitable at expiry as long as the value of Nifty moves past 15,600 + premium price.
Out of the money:
The value of Nifty is 15,600 today and you buy an option contract with the strike price of 16,000. These options are much cheaper than the former two types, but have a lesser likelihood to be profitable at expiry.
However, note that you don’t have to necessarily hold the option contract till the expiry, and as a result traders prefer out of the money options as they are cheaper, move faster and can potentially produce higher returns. They don’t need to hold out of the money options till expiry and risk losing all their money.
A personal example I’ve encountered, as the value of ITC dropped 8% in three days, the value of the Out of the Money put option of ITC went up by 2200%. Another surprising fact is that these returns are not uncommon in the options world.
We have covered this entire article from the perspective of the option buyer. Logically speaking, however, the option sellers are the ones who are more likely to get away with a profit, as almost 80% of all active contracts tend to expire at zero. Option sellers, therefore, aim to profit from this statistical probability and make money comfortably as the option prices fall to zero.
Let’s say you are an option seller that is bullish on the Nifty. Instead of buying call options at a lower strike price and hoping for Nifty value to rise, you will be selling put options at a lower strike price and hope the Nifty value doesn’t fall. For example, if you are confident that Nifty will not fall below 15,500, you can sell put options on 15,400.
This may sound very easy and comfortable but there is a massive catch. Since brokers understand that selling options can potentially have infinite losses, you are required to have a margin amount with the broker. On the contrary, you can buy options with all of your money.
For example, if you want to sell the 15600 Nifty call option, you will need a margin of almost ₹76,000 for intraday selling and nearly double that amount for the overnight short position. This high-capital level of entry makes option selling nearly impossible for beginners. Professional option sellers mention the requirement to have a capital of at least ₹10-15 lakh to consistently make good income from selling options.
Whether it's buying or selling options, traders employ different option trading strategies to maximise their gains and reduce their risks. These option trading strategies usually involve purchasing and/or selling more than one type of contract.