Have you ever wondered what ‘options’ are and wondered what they are and how to trade in options? Let us explain what options in the share market are. It is a form of derivative, its value is determined by the price of the underlying instrument which may be stock but it can also be an index, a currency, a commodity, or some other security. An option, like a stock or a bond, is a security that represents a legally binding contract with specific terms and assets or regulations.
An options contract is a financial contract that gives the investor the right, but not the obligation to sell or buy an underlying asset at a specific or predetermined price on or before a certain date. In India, the National Stock Exchange (NSE) introduced trading in index options on June 4, 2001.
First, let us understand the main difference between a call option and a put option under option trading. In simple terms, a call option is a contract that allows the buyer to buy a stock, commodity, bond, or other assets whereas a put option allows the owner the right to sell any underlying security.
Now that we’ve understood a security price rises, the holder can sell the stock at a higher price to make profits since they’re allowed to buy it at a lower price.
A put option is a contract that gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at the strike price within a specified time frame. When you purchase a put option, you want the price to drop below the strike price because the seller will have to buy shares from you at the strike price, which is higher than the market price. If the market price goes up rather than down, you can simply let the option expire because all you’ll lose is the cost of the premium you paid for the put since your shares will have increased in value.
Now let’s look at an example to understand put options clearly. If an investor buys a put option of ABC company on a specific date with the term that he can sell the security any time before the expiration date for Rs 100 and if the price of the share falls anywhere below Rs 100, the investor can still sell the stock at Rs 100. In case the share price rises to Rs 120, the holder of the put option is under no obligation to exercise it.
If the price of a security is falling, the seller is allowed to sell the underlying securities at the strike price and therefore, minimizes his risk.
Advantages of options:
Now that we have understood what options are, we are going to look into what the advantages of options are.
- Low cost of entry: The first benefit of options is that, unlike stock trades, they allow an investor or trader to take a position with a small amount of money. If you want to buy actual stocks, you’ll need a large amount of money equal to the price of each stock multiplied by the number of stocks you want to buy. Another option would be to buy call options of the same stock and will cost much lower but, the share prices are expected to go up as you have predicted, then you would benefit just as much as you would have in percentages if you had invested money to buy the actual stock. You would pay lesser but reap the same benefits.
- Flexibility: The versatility of options allows the investor to exchange for any possible change in the underlying security. An investor can use an options strategy as long as he can predict how a security price can shift in the future. If an investor believes the price of a security will increase, he may purchase a call option to lock in the price at a certain amount. If the underlying security’s price rises, he will buy the security at the strike price and then sell it at the market price to gain profits. If an investor believes the price of a particular security will decline, he may purchase a put option with a specific strike price. Even if the security’s price drops below the strike price, he can still sell it at the strike price and lock in a specific price for selling it. As a result, options can be used in a variety of market conditions.
- Hedging against risks: Options are a great way to safeguard the investment portfolio. Purchasing options are similar to purchasing insurance for your stock portfolio, therefore, reducing your risk exposure. If the price of the underlying security for a call option does not rise above the strike price until the option expires, your option becomes worthless, and you lose all of the money you invested. However, the premium that you pay is the maximum limit of your risk.
Many choice strategies are extremely complex and risky and as a result, not all options strategies are appropriate for all investors. The writing of puts or uncovered calls will be unsuitable for almost all investors, except for high net worth individuals who can afford and are willing to suffer significant losses. Brokers do, however, sometimes engage in inappropriate options trading on behalf of customers who are unaware of the risks.