An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.
Options are popular as the buyer has limited investment and potentially unlimited profits.
‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or walk away from the contract.
An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity). In the case of an index option, its value is based on the underlying index (equity).
Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.
To begin, there are two kinds of options: Call Options and Put Options.
Call Option: is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options: are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.
Bullish view: Sam is bullish on ABC and purchases a December CALL option at Rs 40 for a premium of Rs 15. That is he has purchased the right to BUY that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.
Bearish view: Sam is bearish on ABC and purchases a December PUT option at Rs 40 for a premium of Rs 15. That is he has purchased the right to SELL that share for Rs 40 in December. If the stock falls below Rs 35 (40-15) he will break even and he will start making a profit. Suppose the stock does not fall and instead rises he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.
Premium: is tradeable and can increase or decrease depending upon the price of the underlying. This is described in detail subsequently.
Duration: In India, option contracts (stock, index) are available for 1, 2 and 3 months duration. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.
Margins: Option buyers do NOT have to pay any margin except for the premium paid to initiate a contract.
Options sellers, however must pay a margin (as the liability is unlimited). The margin here is the futures margin less the premium collected from the buyer of the option.
Cash settlement: Since options is a type of derivatives contract, there is no concept of delivery (as in stocks). Settlement is always on cash basis and one does not need to have a demat account at all!
Trading in options: is extremely profitable provided you know the trend of the market. It is very easy to get returns of 100-200% within 4-5 days. Veteran option players get returns well in excess of 400%.
Options are popular with retail investors as the buyer has limited investment and potentially unlimited profits. For nifty options, the investment amount varies from Rs.2,000/- to Rs.10,000/-. You can also invest Rs.500/- but chances of earning anything here are very slim unless the market is poised to make a major move.