What is options trading? Types of options, Pros & Cons of options trading, example of call option & put option

Derivatives trading can be done through futures and options. Futures trading requires high capital and involves high risk, whereas options buying requires limited capital and entails limited risk.

Stock options trading: What every stock investor should know about?

Within the derivatives segment, a trader can trade in two instruments: futures and options. In this article, we will focus on how to do options trading.

What is an option?

An option is a contract that gives the buyer the right but not the obligation to buy or sell a specified quantity of an asset (shares of a company or index) at a specified price by a specified date. For example, on 7 July 2021, Karan (a trader) buys an option that gives him the right to buy 250 shares of Reliance Industries Limited (RIL) at Rs 2100 per share by 29 July 2021 by paying a premium of Rs 50 per share.

Types of options

A trader can buy two types of options depending on whether they feel the stock price will go up or down.

Call option

If a trader feels that the price of a particular stock will go up in the near future, they will buy a call option. This gives the buyer a right but not the obligation to buy a specified number of shares of a specified company by a specified date by paying a specified premium.

Case Scenario 1: Call option payout

For example, on 7 July 2021, Shirin (a trader) buys a call option that gave her the right to buy 250 shares of Reliance Industries Limited (RIL) at Rs 2100 per share by 29 July 2021 by paying a premium of Rs 50 per share. The current market price of RIL is Rs 2100 per share. 

From the next day, the RIL shares start rallying and suppose it reaches Rs 2300 by 29 July 2021. On 29 July, which is the expiry date of the contract, Shirin (the call option buyer) needs to decide whether she would like to exercise her option.

Chart 1: Call option payout

Call Option Payout.png

In this case, it makes sense for Shirin to exercise the option as she will get 250 RIL shares for Rs 2100 per share, and the market price of RIL shares is Rs 2300 per share. After exercising the option, she can sell them in the open market and make a gross profit of Rs 200 per share (Current market price Rs 2300 – Strike price Rs 2100). 

After deducting the Rs 50 premium per share, Shirin’s net profit will be Rs 150 per share x 250 shares. In this scenario, we can see how a trader can make a profit when the current market price (Rs 2300) of RIL shares is above the call option strike price (Rs 2100) on the expiry day.

Put option

If a trader feels that the price of a particular stock will go down in the near future, they can buy a put option. This gives the buyer a right but not the obligation to sell a specified number of shares of a specified company by a specified date by paying a specified premium.

Case Scenario 2: Put option payout

For example, on 7 July 2021, Anita (a trader) buys a put option that gives her the right to sell 250 shares of Reliance Industries Limited (RIL) at Rs 2100 per share by 29 July 2021 by paying a premium of Rs 50 per share. The current market price of RIL is Rs 2100 per share. 

From the next day, the RIL shares enter a weak phase and start falling. Suppose the RIL shares reach Rs 1950 by 29 July 2021. On 29 July, the expiry date of the contract, Anita (put option buyer) needs to decide whether she would like to exercise her option. 

Put Option Payout.png

In this case, it makes sense for Anita to exercise the option as she will get to sell 250 RIL shares for Rs 2100 per share even though the current market price of RIL shares is lower at Rs 1950 per share. When exercising the put option, she can buy RIL shares from the open market at the current market price of Rs 1950 and sell them to the put option seller for Rs 2100 per share and make a gross profit of Rs 150 per share (Selling price Rs 2100 – Buying price Rs 1,950). 

After deducting the Rs 50 premium per share, Anita’s net profit will be Rs 100/share x 250 shares.

Unlimited profit, limited loss – or vice versa?

In the above scenarios, we saw that the payouts for option (call and put) buyers depend on the stock’s price behaviour. However, for the option buyer, while the profits can be unlimited, the losses are always limited to the extent of the premium paid. For the option seller, it is the other way round – while the profits are always limited to the extent of the premiums received, the losses can be unlimited.

Merits of options trading

  • Lower capital requirement: To purchase an option, the trader needs to pay only the premium rather than the entire contract value. For example, as we saw above, to buy a RIL call option with a strike price of 2100, the trader needs to pay only Rs 50 per share rather than Rs 2100 per share
  • Potential for unlimited profit: When a trader buys either a call or put option, there is potential for unlimited profit if the share price moves in the right direction. However, the losses are always limited to the premium paid.

Demerits of options trading

  • Non-availability of options: Not all stocks are traded in the derivatives segment. Options trading is available for only those stocks that are included in the derivatives segment from time to time.
  • Liquidity: The stock options of some individual companies don’t have much trading volume. Even within individual companies, some strikes may have liquidity, while other strikes may not have much liquidity.

Where to trade options?

All stockbrokers provide trading in options. However, for a trader who trades on wafer-thin margins, the cost is a big deciding factor. Discount brokers like Zerodha, Upstox, etc., provide options trading at a low cost of Rs 10-20 per contract.

Last words

Options buying requires less capital and involves less risk. But it has the potential to give unlimited profits, provided the stock price moves in your direction. So, if you are a trader, trading options is a better choice than trading futures.

 

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