Option Trading - A Free Style Of Trading

By Author: Renuka Peshwani
Total Articles: 3
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General traders don’t have much information about the derivative market; they generally got confused in future and option contracts. Future contract focused on both right and obligations for both the buy to buy and seller to sell at some point in time in future. Option contracts provide the rights but not the obligation of buying and selling of financial instruments at a fixed price or on or before a future date which is mutually fixed by both the parties. You buy the right to honors the contract for a price called premium. Options have a power of versatility and enable you to adapt/adjust your positioning according to market situations.
Stock Options are not suitable for everyone they are risky; this can be speculative in nature and carry a substantial risk of loss. Future requires high margin payment than option and also future were preferred by speculators and arbitrageurs and get unlimited profit with loss potentials, But option was preferred by only with hedger and earn an unlimited profit with unlimited loss potential.
Terms in option contract are-
Premium- also called Token, the payment given by the ...
... buyer to the seller to enjoy the privileges of an option.
Strike price/Exercise Price- A price is fixed between seller and buyer of the asset which can be bought or sold in future.
Strike Price Internal- these are different strike prices on which option contract is traded. Generally, these are 11 types, 5 are above the strike price and 5 are below the strike price.
Lots sizes- This is fixed size of a commodity on which they are traded.
Ex. Reliance industries have a lot size of 250 shares per contract.
Options are of two types through which we can buy or sell share/index in derivative markets are- call options and the put options.
CALL OPTION- It provides the right to buy a certain amount of share/index from the derivative market, strike/exercise price on or before a specific data in the future expiry data. For this option, you have to pay an option premium to the seller/writer of the option. This is because the writer of the call option assumes the risk of loss due to rise in market price of that share/index beyond its strike price on or before the expiry date. Here, the seller is obligated to sell share/index at the strike price even through it means making a loss. Below some key feature are discussed call option-
• Specifics-you will have to specify how much you are ready to pay for the call option for this you have to place a buy order with your broker specifying the strike price and the expiry date.
• Fixed price-also known as exercise price, this is fixed amount of buying the underlying assets in the future.
• Option premium- this is first paid to the exchange, which then passes it on to the option seller and when you buy the call option, you must pay the option writer a premium.
• Margins- when you sell a call option by paying an initial margin not the entire sum, once you pay the margin you have to maintain a minimum amount in your trading account or with your broker.

Let’s understand call option with this example- A land developer may want the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws are put into place. The developer can buy a call option from the landowner to buy the lot at say Rs 2, 50,000 at any point in the next 3 years. Here, the land owner will not grant for free option, the land developer need to contribute a premium/down payment to lock its right. Here the premium might be Rs 6000 that the developer pays the landowner. When 2 years passed the zoning had been approved they exercised and developed his option and they bought the land for $250,000 and it has doubled the market value of plot. In alternative case the zoning approval doesn’t came, and the one year passed the option has expired. The developer will pay the market price in the cash form and the landowner will kept the $6,000.
Put Option- Market is full of buyer and seller; there can’t be a buyer without there being a seller. In the same way, option market without having put option you cannot have call option. Put are the option which provide the right to sell of underlying stock or index at a pre determined price before or on a specified date in the future. Here, the strike price and expiry date is pre-defined by the stock exchange. Call and Put options share the similar traits but in opposite nature. The following are key features of put options.
• Specifics-you will have to specify how much you are ready to pay for the call option for this you have to place a buy order with your broker specifying the strike price and the expiry date.
• Fixed / Exercise price- It is a strike price which is fixed for buy the underlying assets in the future. It is fixed by mutual consent of both the parties.
• Option premium- This is the first amount paid for the exchange to the option writer known as a premium or token.
• Margins- when you sell a call option you have to pay an initial margin not the entire amount and also you have to maintain a minimum amount in the trading account or with your broker.
• Seller’s premium- you can sell off the call option to the another buyer before your expiry date of call option, on this new transaction you get a premium price which may be earn profit or loss for you.
Let’s see an example for put option- you have a share of ABC Company and you expect the down fall in price of your share which hold the current price of Rs 850/share. To make the most of a fall in the price, you could buy a put option on ABC at the strike price of Rs 830 at a market- determined premium of say Rs 10/share. Suppose the contract lot is 500 shares. This means, you have to pay a premium of Rs 5,000 (500share* Rs 10/share). Now you need to monitor the stock movement carefully, it could happen that the stock does fall, but gains back right before expiry .this would mean you lost the opportunity to make profit. If the stock falls to Rs 830 you can exercise the put option, but this could not cover your premium price of Rs 10/share. Then you have to wait until the share price falls to at least Rs 820. If there is an indication that the share could fall further to Rs 810 or 800 levels, wait until it does so. If not, jump at the opportunity and exercise the option right away. You would thus earn a profit of Rs 10 per share once you have deducted the premium costs.
However, if the stock price actually rises and not falls as you had expected, you can ignore the option. You loss would be limited to Rs 10 per share or Rs 5,000.
The major difference between a call and put options is when you buy the two options. The simple rule to maximize profits is that you buy at lows and sell at highs. A put option helps you fix the selling price. These indicate you are expecting a possible decline in the price of the underline assets. So, you would rather protect yourself by paying a small premium than make losses.