Options are a part of larger securities group known as derivatives. In simple terms, derivatives imply that the prices are derived from an underlying asset.
Options are derivatives of financial securities, such as shares and indices. You might be wondering what is options trading. It means entering into a contract that offers a right (without an obligation) to buy or sell the underlying security on or prior to a fixed date at a pre-determined price. Contracts that provide you with the right to buy are known as call options and those that offer selling rights are termed as put options.
Call and put options
Call options offer you the right to buy the underlying asset at a pre-determined (strike) price on or before the fixed date. When you procure a call option, you pay an upfront premium to the seller. Generally, the value of call options increases when the value of the underlying asset rises.
Put options provide you with the right to sell the underlying asset at a pre-determined price on or before the expiry date of the contract. You pay the premium upfront when you acquire a put option. Because you are able to sell the put option any time before the expiry date, you are protected in case the price of the underlying asset decreases. Therefore, put options gain value when the underlying asset price goes down.
Here are two examples related to call and put options:
Exercising a call option
Assume that you purchase one lot of XYZ share June 2017 call option at INR 3,000 per share when the spot price is INR 2,900 per share. Furthermore, assume that you pay a premium of INR 250 per share. If the price of the XYZ share increases over INR 3,250 per share, you may exercise the option. However, if the spot price remains below INR 3250 per share on the expiry date, you do not have to exercise your option and let it expire.
Exercising a put option
Now assume that the XYZ share is overpriced at the current spot rate and the price will reduce during the next few trading sessions. In this situation, you may use a put option to secure your price. Suppose you buy 1000 shares of XYZ at put option of INR 1,070 per share when the spot price is INR 1,040 per share. You pay a premium of INR 30 per share. If the price falls below INR 1,040 on or before expiry, you may exercise the put option. In case the spot price remains higher than INR 1,040, do not to exercise your put option and let it expire.
Earning profits through options trading
Now that you know how to trade in options, let us understand how you earn profits from such trades.
Let us consider the first example where you purchased one lot (1000 shares) of shares with a call option at INR 3,000 per share when spot price was INR 2,900. If the price of the XYZ share increases during the contract period to INR 3200, you may consider exercising your option. In this case, you will earn INR 200 per share as your strike price was INR 3000 per share. However, you must consider that you paid INR 250 per share as the premium. Therefore, even if the price is INR 3200 per share, you will make a notional loss and should not exercise the option. If the price reaches INR 3300 during the contract period, you will make a profit of INR 50 per share by exercising the option. In this case, the profit will be INR 50,000 in this trade.
In the second example, you buy 1000 shares with a put option at INR 1070 per share and pay a premium of INR 30 per share. If the spot price reduces to INR 1020, you make a profit of INR 50 with a net profit of INR 20,000 after deducting the premium of INR 30,000.