If you want to know how option trading works in India or in general than read and understand this guide completely explaining step by step the basics of option trading with easy examples. The post will going to be long as need to cover everything one should know before thinking of trading options.
In very layman terms Option Trading involves buying and selling of options contracts on the public exchanges (NSE ,BSE). Roughly speaking, it’s quite similar to stock trading. A normal stock trader or investor goal is to make profits through buying stocks and selling them at a higher price or selling at higher and buying at lower price.
Likewise options traders can make profits through buying options contracts and selling them at a higher price. Similarly stock traders can take a short position on stock that they think will go down, options traders can do the same with options contracts.
We will try to touch every basic concept of Option Trading. However before we begun i would request to keep patience and concentrate more as options trading is a much more complicated subject than stock trading. For beginners it may seem overwhelming. However i will try my best to explain it in simple terms.
In India nearly 80% of the derivatives traded are options and the rest is credited to the futures trading. If you are not aware about derivatives, let me explain you in simple words, Options are part of derivatives market, so let us first know what is a derivative?
A derivative can be defined as a financial instrument whose value depends upon (or derives from) the values of other, more basic, underlying asset(variables). This can be stocks, commodities, metals, currencies, bonds, stocks indices, etc.
A derivative can be based upon any variable, for example the price of any pulses, wheat or the snow falling at a particular place. With the time now, derivatives are traded even to the, insurance, electricity, weather etc.
‘Derivatives’ as mentioned earlier derives its value from some other thing, that can be any other thing whether stocks ,commodities, metals, currencies, bonds, stocks indices, etc.
So as we know the price of a stock like Amazon, Apple, MRF may rise or fall, commodities like gold, silver , crude oil may fluctuate, currency prices can also increase or decrease. These changes which happens everyday can help investors or traders to get benefited.
Derivatives are convenient way to speculate future price and garner the profits. But remember the speculation has to be done with proper technical and fundamental research. It should be backed by strong logic and rationale rather than mere speculation it.
An Option Trader can use options to speculate on the price movement of individual stocks, indices, currencies, commodities. Moreover In options trading, there’s more possibility & ways to make money.
When Option Trading Started In India?
- June 4th 2001 –Index options were commenced
- July 2nd 2001 – Stock options started
- November 9th 2001 – Single stock futures were launched.
Options are not the same thing as stocks because they do not represent ownership in a company. Ownership comes when you buy a stock in normal equity (cash) segment and take delivery of that stock in your demat.
One of the benefit of option trading is you can close your position at any point until the expiration date. In simple words you can squareoff the position anytime in a day when market is opened till expiry.
How Option Trading Works In India?
There are two types of options – The Call Option and the Put Option. You can be a buyer or seller of these options. There are four types of participants in options markets:
- Buyers of calls
- Sellers of calls
- Buyers of puts
- Sellers of puts
Buyers are referred to as having long positions, sellers are referred to as having short positions. Selling an option is also known as writing the option.
Let us understand them one by one with example.
What is Call option?
Book definition of call option is “The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (underlying) from the seller of the option at a certain time (expiration date) for a certain price (strike price).
The seller (or writer) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (known as premium) for this right”.
In other words If you’re buying a call option, it means you want the stock (or other security) to go up in price so that you can make a profit from your contract by exercising your right to buy those stocks (so that you can sell them to cash in on the profit).
When you buy options you can either hold the option till expiry and let the exchange do the settlement for you this is called Exercising a contract or you can close the position before expiry and book profits/loss.
We will understand it later in this post how options gets settled at expiry. Below is a snapshot taken from NSE website. You just need to click on search box the name of the stock and than on next page click on Get derivatives quotes.
As an illustration let us take an example of an stock option derivative, SBI BANK. Few basic concepts you need to clear while trading options and futures are given below. Please keep an eye on things mentioned in green bracket only for time being.
What is Lot Size?
In Option contracts the minimum number or quantity you would be transacting is known as lot size. It depends on different securities and are predetermined. You can not choose it by yourself how many shares you want to buy.
As you can see in the image above market lot quantity for SBI BANK Option contract is 3000. This is the minimum quantity you need to buy or sell in order to get the option contract for this particular stock.
What is Strike price?
It represents the price at which the stock can be bought on the expiry day. As in above image we choose 192.50 as strike price , which means on expiry or before whenever the price of SBI bank in spot market goes above 192.50 you can exercise your right to buy it (premium goes higher when the spot price of any stock or index go high except in some cases).
There is a reason why your strike price should be lower than current market price in case of call option if you want to make profit . I have discussed that below.
What Is Contract Worth?
As we know now the quantity is predetermined, contract value or worth would be multiplying quantity with current value of securities. So, Lot Size x Price = Contract total worth in case of above image we are buying call option and hence to buy we need to pay the premium showing Rs. 5.95, Multiply 5.95 x 3000 = 17850 is the total premium you need to pay in order to get the call option contract. So this amount would be the total contract value for option buyer.
What is Expiry?
In the image above you can see expiry date showing 27 AUG 2020. Likewise every Option Contract is bound to time known as expiry. So if you purchase the contract for month of AUGUST, after 27 it will get expired. Expiry happens on last Thursday of every month for every contract whether stocks or index. (You can read more about index like Nifty here.)
After this new contracts will be introduced by exchanges. Similar to futures contracts, option contracts also have the concept of current month, mid month, and far month. However the premium is not the same across different expiries.
Premium of a stock or index option is never fixed it keeps on changing depending up on time, news or any events occurring in market affecting the stock price or index price.
What is Instrument Type?
As you can see the image Above instrument type is Stock Option, underlying asset is the stock of a company as we want to buy SBI BANK Call Option, we will select stock Option there.
What is a Symbol?
Symbol represents the name of the stock or Index. In the case above its SBI Bank .
What is Underlying Value?
Derivative contract derives its value from an underlying asset as we have discussed above. The underlying price is the price at which the underlying asset trades in the spot market. This is current market price at which stock is trading in spot or equity market.
Spot market is the regular equity market, you would see the price difference in spot market and futures price. You might ask why is there difference in prices? Spot prices are for immediate buying and selling, while options contracts delay payment and delivery.
What is Margin Requirement In Option Trading?
As we know now the contract value, Margin is the minimum amount need to be deposited for purchasing a option contracts. It is certain %(percentage) of the total contract value, need to be deposited to your broker. Many of the brokers provide different margins for intraday and carryover. It’s different for every stock and index.
You can know the minimum margin need to be deposited to trade a option contract by calling to your broker or it might be mentioned on there website as well.
A buyer of the call option need to pay the premium amount to get the contract .Whereas the seller of the option contracts receives this premium but the margin get blocked for him till contract is settled.
In futures and options Fyers offer different leverage depending upon the stock, however, its up to 18X time for stock and for index like nifty its 33X times and bank-nifty its 20x times, check out the image below i have calculated it from their margin calculator.
As you can see in above image SPAN + Exposure margins for 1 lot of Nifty futures or option, currently trading at 9987 is ₹1,41000(approx.).
A leverage (margin) of 6.5 times means that you will be able to take a position with just ₹22470 (22,470*6.3= 1,41,561). Similarly for bank-nifty and stocks.
To understand it better let me show you how margin works in options trade:
- At the time of initiating the options position, margins are blocked in your trading account
- The margins that get blocked is also called the “Initial Margin”
- The initial margin is made up of two components i.e. SPAN margin and the Exposure Margin
- Initial Margin = SPAN Margin + Exposure Margin
- Initial Margin will be blocked in your trading account for as many days you choose to hold the option contract, The value of initial margin varies daily as it depends on the futures price of the stock or index you are holding.
Note: The margins charged for an option seller is similar to the margin requirement for a futures contract.
How Options Contract Get Exercised In Stock market?
Let us suppose you have bought a call option at strike price for Rs.85. Exercising of an option contract means your right to buy the options contract at the end of the expiry.
“Exercise the option contract” in the context of a call option simply means that one is claiming the right to buy the stock at the agreed strike price(Rs.85). Definitely he or she would do it only if the stock is trading above the strike.
Note – You can exercise the option only on the day of the expiry and not anytime before the expiry. Please understand exercising contract and squaring off your position is 2 different thing.
You buy an option at a premium today, you can sell it anytime, including the very next second. The profit or loss you make is the difference between premium. On the other hand, you can buy the option today and hold it to expiry. If you do so, the profit or loss is dependent on the value of the option upon expiry aka the settlement price.
When you buy options you can either hold the option till expiry and let the exchange do the settlement for you this is called “Exercising a contract “or you can close the position before expiry and book profits/loss.
Before October 2019, settlement in stock derivatives, keep in mind i am only talking about stock options not index(nifty or bank nifty)stock option or stock futures were used to happen through cash only.
So suppose you hold a stock option contract and you forgot to square-off your position before the expiry, in that case you have to settle the position by giving the remaining money.
That means upon expiry of the contract, buyers or sellers settle their position in cash without taking delivery of the underlying(stock).
However from October 2019, SEBI bought this circular after which, if you trading in stocks derivatives, as an trader if you don’t close or rollover your position till expiry date, than you will be required to pay the remaining amount upon delivery of shares to your demat account as part of the settlement.
Let me explain this through an example:
Physical Settlement In Stock options from October 2019:
As a trader if you initiate a long (buy) trade on a security and you forget or did not closed your contract till expiry, than you have to compulsorily take delivery of shares against your derivative position. Hence need to pay the full contract value ( Strike Price * Lot Size * Number of lots).
So let say you bought SBI BANK strike price at 192.50, bought 1 lot of option contract, at the end of the expiry if you do not square-off your position than 192.50*3000(lots)* 1 (no. of lots) you bought = Rs. 5,77,500, so this amount will get debited from your trading account and the shares will get delivered to your demat account.
In Case of selling stock option if the position is not covered or rolled over till expiry, than you have to give delivery of shares. In above case of SBI bank you have to deliver 3000(lot size) shares.
Note: Only ITM (in the money) options will be physically settled, if the option expires OTM(out of the money), they expire worthlessly and there won’t be any delivery obligation. This is called moneyness of an option, you can read more about it here.
Another thing is suppose you sell any stock on T(trading) day, you are obligated to deliver the shares on T+2. However it may happen that you sell some stocks but these stocks are not present in your demat account and hence you would not be able to give delivery of these stocks on T+2 and you would end up defaulting.
This default is called “Short Delivery“. If a trader doesn’t own 3000 shares, he will have to pay the penalty by participating in the auction where he’ll have to purchase the shares from the market at a price higher than the current market price. This can be as much as 20% or more.
That is why it becomes very important to close your contract before expiry. Any Which ways after this circular brought by the SEBI, brokers aren’t allowing retail clients to take any position in stock derivatives in the expiry week to avoid any default until full margin is available.
If you don’t want your positions to be squared off by your broker, you will have to maintain an account balance which is equal to or more than the contract value of the derivative positions. Hence, it is advisable for a client to square off all positions on your own before expiry.
Incase of Index such as Nifty and BankNifty there is no such provision and it is still done through cash. So no physical settlement happens in Indexes. I hope you have understood this settlement procedure in FNO.
How To Buy Call Option In Stock market?
As an illustration for Option Trading, suppose a stock is currently trading at Rs.50/-today. As an offer you are given a option today to buy the same one month later, at say Rs. 58/-, but only if the share price on that day is more than Rs. 58, would you buy it?
Think about it for a while, it’s not a bad deal in case you know what you are buying. Undoubtedly you would buy, it means to say that after 1 month even if the share is trading at 80, you can still get to buy it at Rs.58.
Now in order to get this right you are obliged to pay a small amount today (known as premium), say Rs.4/-. If the share price moves above Rs. 58, you can exercise your right and buy the shares at Rs. 58/-(Known as Strike Price ).
If the share price stays at or below Rs. 58/- you do not exercise your right because there won’t be any benefit. However, you will lose Rs. 4/- paid as premium to take the contract in this case. This is called Option Contract, a ‘Call Option’ .
After you get into this Call option agreement, there are only three probabilities that can happen.
- In case stock price go up, suppose Rs.80/-
- Stock price goes down, Rs.55/-
- The stock price can stay at Rs.58/-
Scenario 1 – In case stock price goes up, it would make sense in exercising your right and buy the stock at Rs.58/-.
The Profit & Loss statement –
Price at which stock is bought = Rs.58 (strike price)
Premium paid to buy call option contract =Rs. 4
Total Expense incurred = Rs.62 (58+4)
Current Market Price = Rs.80
Profit = 80 – 62 = Rs.18/-
Scenario 2 – If the stock price goes down to say Rs.55/- essentially it does not makes any sense to buy it at Rs.58/- as you would spending Rs.62/- (58+4) for a stock that’s available at Rs.55/- in open market.
Scenario 3 – Similarly if the stock remains flat at Rs.58/- it simply means you are spending Rs.62/- to buy a stock which is available at Rs.55/-, hence you would not exercise your right to buy the stock at Rs.55/-.
Example Of Buying A Call Option:
Now before we do the math and P/L by taking an example, another important concept that you need to keep in mind is ‘Intrinsic value’. As you are the buyer of a call option, how much money you would receive upon expiry, if the call option you hold is profitable can be termed as IV.
Example of an Option’s Intrinsic Value:
Suppose you buy a call option at strike price of 30, and the underlying stock’s market price is Rs.38 per share. Than intrinsic value of the call option would be 8.
Intrinsic Value of a Call option = Spot Price – Strike Price Rs.38 stock price minus 30 strike price (38-30).
To put it differently the intrinsic value of an option is the money the option buyer would make from an options contract, If he has the right to exercise the options on a given day.
To understand this as an illustration we will be doing a little exercise.
|Option Type||Call Option (CE)|
Let us assume you bought Call Option for NIFTY 50 @ 11000CE and instead of waiting till expiry you had the right to exercise the option today.
It’s important to realize when you exercise a long option, the money you make is equal to the intrinsic value of an option minus(-) the premium paid.
To answer the above question we will be calculating the intrinsic value of an option:
Formula to calculate IV
Intrinsic Value of a Call option = Spot Price – Strike Price
= 11200 – 1100
So, if you were to exercise this option right now, you would be making Rs.100. You need to subtract this from premium paid to get net P&L.
Likewise for Put Option formula to know Intrinsic Value(IV) = Strike Price – Spot Price
Spot Value = 11000 and Option strike = 11500
Than, IV= 11500-11000 = 500
Important Note: Intrinsic value of an options contract can never be negative. It can be either positive number or Zero.
I know you might be thinking why IV is non-negative number?
To understand this let’s go through another example, Strike price is at 500, spot price is 480, option type is long call & the premium is Rs.10.
If you were to exercise this option, How much is the intrinsic value?
Intrinsic Value = 480 – 500 = -20.
Which means Rs.20 is going from out from our pocket. Now Let us assume this is true for a second, what will be the total loss? Adding premium paid with this value, 10 + 20 = Rs.30/-
But on the contrary we know the maximum loss for a call option buyer is limited to the extent of premium one pays, in this case it will be Rs.10/-.
This is termed as “non linear property of option payoff”, Hence in order to maintain this Intrinsic value can never be negative.
You can apply same argument to the put option intrinsic value calculation as well.
This is the concept of Intrinsic value, hope you have understood it completely now.
Coming back to the example of a call option, Let us take another example and try to understand when, how and why to buy a call option step by step.
Suppose you are tracking a stock named ICICI bank, did the technical analysis about it, please never speculate do some research before taking any trade.
Through research you come to conclusion that ICICI bank will go up in this week, below is the snapshot taken, take a look at all the major points in rectangle box.
As, you can see in the image above below details you need to keep in mind:
Strike Price – 370
Spot Price(underlying value) – Rs.371.30
Market lot – 1375
Expiry – 27 august 2020
Premium value – Rs.7.20
So, you are buying the call option because you think after your research the ICICI bank will go up. Let us see the three scenario that we have understood above.
- In case stock price go up, suppose Rs.385/-
- Stock price goes down, Rs.355/-
- The stock price can stay at Rs.370/-
But here is the question what about the rest of the strike prices falling in between this, for e.g what happens if the spot price of the stock when to 380 or 365 or any other point. To understand this please take a look at the table below.
Note – the negative sign before the premium paid represents a cash out flow from my yout trading account.
|Serial No.||Possible values of spot||Premium Paid||Intrinsic Value (IV)||P&L (IV + Premium)|
|01||360||(-) 7.20||360 – 370 = 0||= 0 + (– 7.20) = – 7.20|
|02||365||(-) 7.20||365 – 370 = 0||= 0 + (– 7.20) = – 7.20|
|03||370||(-) 7.20||370 – 370 = 0||= 0 + (– 7.20) = – 7.20|
|04||375||(-) 7.20||375 – 370 = 5||= 5+ (– 7.20) = – 2.20|
|05||380||(-) 7.20||380 – 370 = 10||= 10 + (– 7.20) = 2.80|
From the above table we can conclude following important things:
1.Even if the price of ICICI BANK goes down (below the strike price of 370), the maximum loss seems to be just Rs.7.20/-. Now, Icici bank lot size was 1375*7.20 = Rs.9900 is the maximum loss you will incur which you have already paid to get this call option contract.
Which means, For a call option buyer a loss occurs when the spot price moves below the strike price. However the loss to the call option buyer is restricted only to the extent of the premium he has paid to buy that option.
2. At 370 there is loss of the entire premium too.(by the way the premium you paid to get the contract goes to seller of the same contract, and this is how a seller of the contract makes profit).
3.The profit from this call option seems to increase when the ICICI bank moves above the strike price of 370, however here is the catch, even if the strike price moves above the 370 it will not make profit until the spot price goes beyond 377.20, because 7.20 is the already premium you have paid.
Now this is called the ‘Breakeven Point’, at the breakeven point you neither make money nor lose money. In other words, if the call option has to be profitable it not only has to move above the strike price but it has to move above the breakeven point.
The formula to identify the breakeven point for any call option is:
B.E = Strike Price + Premium Paid
4. At 380, you become profitable, 2.80 us the increased premium value so 1375*2.80= Rs.3850, is the profit you have garnered at this point. So keep in mind, the call option becomes profitable as and when the spot price moves over and above the strike price. The higher the spot price goes from the strike price, the higher the profit.
From the above points it is fair for us to say that the buyer of the call option has a limited risk and a potential to make an unlimited profit.
Here is a general formula that tells you the Call option P&L for a given spot price :
P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
Going by the above formula, let’s evaluate the P&L for a few possible spot values on expiry –
The solution is as follows –
= Max [0, (355 – 370)] – 7.20
= Max [0, (-15)] – 7.20
= 0 – 7.20
= – 7.20
The answer is in line as the loss restricted to the extent of premium paid.
= Max [0, (376 – 370)] – 7.20
= Max [0, (+6)] – 7.20
= 6 – 7.20
The loss is minimized as the spot value has crossed the strike price of 370 but the premium value you have paid is little more.
= Max [0, (385 – 370)] – 7.20
= Max [0, (+15)] – 7.20
= 15 – 7.20
The higher the spot value move above the strike price at which you bought the call option the unlimited profit.
Things To Remember For Call Option Buyer:
- You buy call option when you expect the underlying price (spot market price of any instrument) to increase .
- In case underlying price remains flat or goes down, buyer of the call option will loses money .
- Only loss for buyer of the call option is premium (agreement fees) that he pays to the seller/writer of the call option. Whereas potential to make an unlimited profit .
- Buying a call option sometime also referred as ‘Long on a Call Option’ or simply ‘Long Call’.
- To calculate Profit Loss , P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
- The price at which the buyer of a call option will start making profit is called as Breakeven point = Strike Price + Premium Paid
- Call option is abbreviated as ‘CE’. CE is an abbreviation for ‘European Call Option’ .
- In India all options are European in nature.
Given these points above i hope you have understood the basic logic behind call option. Another point is, the option buyer has a statistical disadvantage when he buys options it is because, only 1 possible scenario out of the three benefits the option buyer.
In other words 2 out of the 3 scenarios benefit the option seller. That is why you might have heard people make more money writing option than buying.
Although buying an option does not require much margin as you need to pay only the small premium value whereas for the option seller they have to pay the entire contract value. That is also one of the reason the option buyers interested in option buying, money is one also of the factor.
How call option writing/selling works?
Option selling is just opposite to option buying. Hence whatever happens to the option seller in terms of the Profit & Loss, the exact opposite happens to option buyer.
For example if the option writer is making Rs.10/- in profits, this naturally means the option buyer is losing Rs.10/-.
Below are specific points you need to keep in mind while writing (selling) Options Contracts:
1.We have learnt option buyer has unlimited profit potential as the stock price can go high as much as it can. This means the option seller potentially has unlimited risk.
2.The option buyer has limited risk (only to the extent of premium paid), on the other hand option seller has limited profit (the extent of the premium he receives from buyer).
3.The option buyer want the market price to increase (above the strike price of his contract). However the option seller would be of the opinion that the market should stay at or below the strike price.
4.When an option seller sells options he receives a premium (for example Rs.4/). He would be in a loss only after he loses the entire premium. Meaning after receiving a premium of Rs.4, if he loses Rs.3/- it means he is still in profit of Rs.1/-.
Therefore option seller to experience a loss he has to first lose the entire premium he has received, any money he loses over and above the premium received, that will be his real loss.
5.The same logic applies to option buyer. Since the option buyer pays a premium, he first needs to recover the premium he has paid. Hence he would be profitable over and above the premium amount he has received.
As an illustration, suppose he received the payed the premium of Rs. 5000 to buy a call option, his target would be to first recover the premium. You have already learnt about the breakeven point above.
6.Selling a call option is also known as ‘Shorting a call option’ or ‘Short Call’
7.P&L = Premium – Max [0, (Spot Price – Strike Price)]
8.Breakdown point = Strike Price + Premium Received
9.Selling (writing) a call option requires you to deposit a margin.
Example Of Option Selling (Writing):
The case remains the same, ICICI bank however this time instead of going up is going down or may go down in upcoming session. So, instead of buying the call option you decide to short the call option. Basically when you are bullish about something you buy a call and when you are bearish you opt for sell.
Let’s do some math and find out the profit and loss:
Note – the positive sign before the premium received represents a cash in flow to your trading account.
|Serial No.||Possible values of spot||Premium Received||Intrinsic Value (IV)||P&L P&L (Premium – IV)|
|01||360||+7.20||360 – 370 = 0||= 7.20 – 0 = 7.20|
|02||365||+7.20||365 – 370 = 0||= 7.20 – 0 = 7.20|
|03||370||+7.20||370 – 370 = 0||= 7.20 – 0 = 7.20|
|04||375||+7.20||375 – 370 = 5||= 7.20 – 5 = 2.20|
|05||380||+7.20||380 – 370 = 10||= 7.20 – 10 = -2.80|
So, as you have read the major point above for option selling, in above table you can see when the strike price is moved below 370 or is at 370, the option sellers makes money to the extent of the premium he has received from the options buyer.
Moreover, the breakeven point is till the option seller entire premium of 7.20 is not covered. But when the spot price moves above the range of the premium and goes high the seller start making the losses and it can go as much the spot moves above and beyond your strike price at which you have made the selling or writing.
What Is The risk Involves for a writer (seller) in Option Trading?
You might be thinking if seller have so much risk involved, than why would one sell at all. Comparatively to buyer it does not have that muck risk, let us check how :
- Suppose the price of the stock move up (Good for option buyer).
- In case if price stays flat (good for option seller) as the buyer will only make money once recovered the premium paid.
- However If price moves lower (good for option seller) as we short when you believe that upon expiry, the underlying asset will not increase beyond the strike price.
So out of three possibilities 2 are with seller. Yes he has unlimited risk potential but the probability for a situation favors him. Stock exchange manages the risk for a seller, the risk exposure of an option seller may be unlimited. What if the loss becomes so high that the option seller decides to default?
To avoid this situation to happen the stock exchange made mandatory for the option seller to have some money as margins.
The margins charged for an option seller is similar to the margin requirement for a futures contract. You can check the margin requirement for a seller on your broker website .
I hope the option buying and selling both concepts are better clearer to you now.
What Is Put Option Buying and Selling?
Just opposite to call option buying and selling, option trading also involves put option buying & selling. Put Option referred as (P.E). As an call option buyer you want the stock or index to go up whereas a put option buyer thinks the securities will fall and he buy put option to benefit from fall.
So, instead of selling a call option which requires more margin and the losses are unlimited, a put option buyer with less margin and limited loss can take a position. In other words the buyer of the put option is bearish about the underlying asset(stock or index).
Every Other thing remains same except the intrinsic value IV formula. Let me remind you first the IV for a call option;
Intrinsic Value of a Call option = Spot Price – Strike Price
Intrinsic Value of a Put option = Strike Price – Spot Price
So, the calculation remains same the only thing is you want the stock to go down in case of put option buying.
Important Points to remember for a put option Buyer:
- You buy a Put Option when you are bearish about the prospects of the underlying. In simple words a Put option buyer is profitable only when the underlying(stock, index etc) declines in value.
- The intrinsic value calculation of a Put option is little different when compared to the intrinsic value calculation of a call option.
- IV (Put Option) = Strike Price – Spot Price
- The P&L of a Put Option buyer can be calculated as P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid
- The breakeven point for the put option buyer is calculated as Strike – Premium Paid
A put option seller do writing to benefit from rise in securities. In layman terms a put option seller wants the stocks or index to go up. Everything remains same as of call option seller except that a call option sellers wants the underlying asset(stock, index) to go down, whereas a put option seller wants it go up.
This means the put option seller have a bullish view on the markets. He/she keeps the premiums paid by the put option buyers and his loss is unlimited but the profit is limited to the extent of the premium he received.
You might be thinking why one sell a put option if the view on the stock or index is bullish, he can simply buy a call option instead. Yes he can, but this depends upon the premiums, if the premiums are low going for a call option makes sense whereas if the put option premiums are higher than selling the put option and receiving the premium can be much better. Which is also known as option pricing.
The calculation of the intrinsic value of the option remains the same for both writing a put option as well as buying a put option. The only thing changes in the PL is the premium receivables at different spot prices.
Important Points to remember for a Put Option Seller:
- You sell a Put option when you are bullish on a stock or when you believe the stock price will no longer go down
- When you are bullish on the underlying you can either buy the call option or sell a put option. The decision depends on how attractive the premium is
- The put option buyer and the seller have opposite P&L behavior
- When you sell a put option you receive premium
- Selling a put option requires you to deposit margin
- When you sell a put option your profit is limited to the extent of the premium you receive and your loss can potentially be unlimited
- P&L = Premium received – Max [0, (Strike Price – Spot Price)]
- Breakdown point = Strike Price – Premium received
I hope the concept of put option buying and selling is understood to you now. let us move to another import aspect of option trading.
How Premiums Works In Option Trading?
Premium is the most important factor in option trading, this is what a call or put option buyer pays to get the contract with a call or put option seller who receives this premiums to be obliged to the contract.
Let us take an intraday option trading example and understand how one earns money in option trading on day trade. Checkout the rectangle box marked in red below:
The stock name is NTPC, if you see the premium value which is Rs.2.40, at the end of the trading day, also see the previous closing its about Rs0.95. This reflects the premium got increased about Rs.1.45 next trading day, now let us do some math and now exactly how much money you can make.
If you have bought, let say 1 lot which is 5700 at premium value of Rs.1 than the total amount required to buy the call option contract would have been Rs.1*5700= Rs.5700, the very next day the premium value for NTPC made a high of Rs3.75.
Even if you have sold the contract at Rs.2 than it was an easy Rs.5700 profit excluding brokerages and taxes. Which is in my opinion more than 5 days salary of an average job going individual in India.
Now let us take another example as an seller. Check out the image below:
The stock name is ZEEL(Zee Entertainment) the stock made a high previous day of Rs.17, as an option trader, one could have sold the call option and enjoyed the premium which is by the way 3000*17= Rs.51000.
Can you imagine within a day a earning of Rs.51000, that is why option trading is very popular among the traders in stock market.
Having said that one has to do a well research before making any trade and always use stop-loss while trading.
What Is Option Chain?
I won’t be explaining the option chain in detail as it itself is a very vast topic which i would make another blog to make you understand more, however you should be aware to know different strike prices and its premium values to decide which is better to trade. Option chain gives you all the specific data you need related to the underlying asset.
You can view this by going to NSE website .Select stock or index you want to look. To begin with in red (Strike Price) been specified. On left you can see the calls and the LTP (last traded price) of the premiums, on left you can see the value of all puts.
There are more detail mentioned in option chain like open interest, IV which also helps in choosing the correct call option trade. You can read in detail about How to read option chain table? and use in trading Nifty, Bank Nifty, Stocks in derivative segment.
Which Option Trading Platform Is Best?
I would suggest you to have your option trades to be with best broker in India. Below is the list of brokers who have best trading platform for any segments in markets such as equities, Futures and options, commodities, currencies and even mutual funds.
As a beginner in option trading and stock market below table will be very useful to know the type of trade to take according to the market direction.
|Market View||Option Type||Position also known||Other Substitutes||Premium|
|Bullish||Call Option (Buy)||Long Call||Buy Futures or Buy Spot||Pay|
|Flat or Bullish||Put Option (Sell)||Short Put||Buy Futures or Buy Spot||Receive|
|Flat or Bearish||Call Option (Sell)||Short Call||Sell Futures||Receive|
|Bearish||Put Option (Buy)||Long Put||Sell Futures||Pay|
I hope by now you have enough understanding of how Option Trading Works In India? Keep in mind options are tricky so this is not the only thing you have to read there are lot of strategies you can make when trading options.
Trading in derivatives market such as futures and options can be a good source of income for a trader, besides this the margin required to take position are very low on intraday basis.
Having said that, one should always do proper research before taking any trades in FNO because of being highly leverage products the risk also increases.
Always go with more liquid contract in case of stocks options. The more liquid a stock is, chances of buying and selling the contracts instantly become high. Indexes are already very liquid by nature so you do not need to worry about that.
Please do not just speculate while trading in stock market in any segment, instead look for learning new strategies based on different technical tools and indicators.
I hope you have thoroughly understood What Is option Trading, the basics concepts related to derivatives market. The post might seem to you very long, but trust me i have tried my best to keep it short and crisp without excluding any major points.
If your looking to invest in mutual funds through SIP than you should checkout moneycontain Monthly SIP Calculator HERE.
If you are a beginner in trading and investing, please read this amazing guide on how stock market works in India?
Incase you are looking to make any Fixed deposit or Recurring deposit also known as FD and RD in any bank, than you must check moneycontain best RD FD Calculator here.
If, you have liked the content please do share it with your friends or on social media, as sharing do bring the good karma. If you have any questions or feedback you can leave them in comment box below.
Note: Please do your own research and make investment. Moneycontain will not be responsible for any of your losses at all. The point made is for educational purpose only and intended to give information. All investments are subject to risks, which should be considered prior to making any investments.
We are sorry that this post was not useful for you!
Let us improve this post!
Tell us how we can improve this post?