The Basics of Options Trading

Options are a part of the Futures-And-Options (FNO) market and you can buy and sell options only for stocks traded in the FNO market (think medium and large caps).

The standard definition of options is that these give you the right but not the obligation to buy or sell a stock (referred to as the underlying) at a future date. No physical deliveries are involved, you just have to pay the options premium/margin and wait for your prediction to play out.

An example will clarify the concept, but before that you have to understand the Option terminology:

Option Trading Terms

CE – Call (Buy) Option (The E stands for European, but don’t let that bother you)

PE – Put (Sell) Option (The E stands for European, but don’t let that bother you)

Premium – The amount that you pay for the option.

Strike Price – The strike price is the price that you pay for the stock (at a later date).

Underlying – Underlying is the stock for which you are purchasing the option.

Expiration – Every option has an expiration period specified by the Exchange. Your option will expire and be squared off (in case you do not act on it earlier) by this date.

In the Money (ITM)

– (For Call options) When strike price is below the stock price. Example, if you buy Nifty 10200CE and the spot price is 10700.

– (For Put options) When strike price is above the stock price. Example, if you buy Nifty 10800PE and the spot price is 10700.

At the Money (ATM) – When strike price is equal to the stock price. Example, if you buy Nifty 10700CE or PE and the spot price is 10700.

Out of the Money (OTM)

– (For Call options) When strike price is above the stock price. Example, if you buy Nifty 10800CE and the spot price is 10700.

– (For Put options) When strike price is below the stock price. Example, if you buy Nifty 10500PE and the spot price is 10700.

Intrinsic value – The amount that an option is in the money. For example, if stock price is 1400 and strike price of CE is 1350, then the intrinsic value is 1400-1350 = 50.

Time value –  The price of an option less the intrinsic value. For example, if stock price is 1400 and strike price of CE is 1350, then the intrinsic value is 1400-1350 = 50. If the option is purchased at 68, then the time value is 68-50 =18.

Option Trading Example

It’s 2 May 2018, and let us suppose you are bullish on L& T (CMP 1400) and feel that it will appreciate 10% within a couple of weeks. The lot size is 750 units. So you buy a 1360CE 31-5-18 Expiry at 60 bucks.

So you now have 29 days for L&T to move per your expectations. If it appreciates to 1500 by 31 May 2018, here’s how your option will move.

Total cost of Strike price of 1360 (X 750 shares) = 10,20,000

CMP of stock by end-May (assuming you have not sold your option earlier) is 1500 (X 750 shares) = 11,25,000

Appreciation = 1,05,000 for 750 shares, therefore Rs 140 per share. This is the expected value of your CE when L&T touches 1500.

When you sell at this point, your gain is 140 less 60 (cost) = 80 X 750 shares = 60,000

Your intrinsic value is 1400 (CMP) – 1360 (Strike Price) = 40

Your time value is 60 (cost) – 40 (intrinsic value) = 20

You can play around with this data with different figures. You also can extrapolate it for put options to gain an understanding.

Now, this is basic information written for newbies. read and revise it because I will start writing option trading strategies from now on. There are more than 40 strategies and if you play it right, you can make money. Stay tuned for the next post.