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Published on Monday, April 2, 2018 by Chittorgarh.com Team | Modified on Monday, February 12, 2024
Options have emerged as a popular investment avenue. In the last few years, we have seen a growing participation from retail investors in the options market. Though options trading is an old phenomenon in the world markets, options trading in India started with the launch of index options on June 4th, 2001. On July 2nd, 2001, stock options were launched. And from there, index and stock options have risen to over Rs 4,45,561 crores in value in 2017-18.
| Year | Index Options | Stock Options | ||
|---|---|---|---|---|
| No. of contracts | Premium Turnover (Rs cr.) | No. of contracts | Premium Turnover (Rs cr.) | |
| 2017-18 | 115,94,95,408 | 3,27,703.55 | 10,02,31,648 | 1,17,858.86 |
| 2016-17 | 106,72,44,916 | 3,50,021.53 | 9,21,06,012 | 95,570.09 |
| 2015-16 | 162,35,28,486 | 3,51,221.01 | 10,02,99,174 | 61,118.39 |
| 2014-15 | 137,86,42,863 | 2,65,315.63 | 9,14,79,209 | 61,732.59 |
| 2013-14 | 92,85,65,175 | 2,44,090.71 | 8,01,74,431 | 46,428.41 |
Source: NSE
Options are a form of 'derivative'. Derivatives are financial instruments that derive their value from an 'underlying asset", e.g. shares in a company, a currency, gold, etc.
Curd is a derivative of milk, i.e. derived from milk. Similarly, options are derived from an underlying financial instrument, e.g. a share of a company, a currency, or gold.
As we all know, the price of curd moves up and down according to the rise and fall of the price of milk. Similarly, the price of options moves up and down with the price of the underlying asset.
An option is a derivative, a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date (expiration date) at a certain price (strike price).
Options trading involves the purchase or sale of options contracts. These contracts are agreements that allow the holder to buy or sell several underlying assets at a fixed price up to a certain date. Investors do not necessarily have to own the underlying asset to buy or sell an option.
In the normal stock market, investors buy and sell shares. The prices of shares often move up or down on the market. If you think a particular share will go up in the next few days/weeks/months, you buy a certain number of shares by paying the market value at that time. The transaction value (share price + brokerage fee) is deducted from your trading account and the shares are delivered to your account within a few days.
If the share price reaches your expectation, you sell the share and make a profit. However, if the share price falls below your purchase price, you make a loss on the sale. In both cases, the shares are deducted from your trading account and the transaction value is credited to your account.
Options trading differs slightly from share trading. In options trading, you do not buy shares and have them delivered to your account, but you buy the opportunity to perform an action at a predetermined price and within a predetermined time. The action is to buy/sell or get out. The second difference is that there is no delivery with options. All transactions are settled in cash.
An option contract gives you the opportunity or choice to enter into a transaction to buy a fixed number of shares at today's price at a future date. To purchase this option, you must pay an amount (which is significantly less than the value of the underlying shares). The amount you pay is called the premium. If the transaction does not seem advantageous to you at that time, you have the option to get out of the transaction. In this case, you lose the premium you paid when you bought the option.
Every option contract mentions its strike price, premium, lot size and expiry date.
Options trading example
Suppose there is an option available on Infosys for August at a strike price of Rs 2000 and a premium of Rs 200 for a lot size of 100 Infosys shares. This option gives you the right to buy 100 shares of Infosys at Rs 2000 anytime from now till the end of August. To buy this right, you pay a premium of Rs 200 x 100 shares = Rs 20000. Now, if the market price of Infosys is above Rs 2200 at any time in August, you can exercise the right and make profits. However, if you find that the price is below Rs 2200 and exercising the right would lead to losses, you can choose to exit. You will then lose the premium paid when you buy the option. So with an option, you can buy shares if it is profitable for you and exit the trade if you see that it is a losing trade for you.
So an option allows you to buy shares when it is profitable to you and opt out of the deal when you see there's a loss for you.
Options are of two types - Calls and Puts
Calls give you the right, but not the obligation, to buy a certain amount of the underlying asset at a certain price on or before a predetermined date.
Puts give you the right, but not the obligation, to sell a specified amount of the underlying asset at a specified price on or before a predetermined date in the future.
Depending on how they are exercised, options can be classified as European or American options.
American options are contracts that can be exercised at any time up to the option's expiration date. In India, American options can be exercised on individual securities such as Reliance, SBI, etc.
European options can be exercised only on the expiry date. Options on indices like Nifty 50, Nifty Bank, etc. are European options.
In India, all exchange-traded options are European options, regardless of whether they are index options or equity options. 1. Call contracts are represented as CE, i.e. Call European 2. Put contracts are represented as PE, i.e. Put European
There are 4 types of orders for options:
An option name is made up of these components:
For example Bank Nifty is trading at Rs. 43700 and a trader wants to buy a call option with a strike price of Rs. 43600. Since the index options have both weekly and monthly expiry, it looks like this:
A weekly contract: BankNifty 6thDEC 43600 CE
Here,
A monthly contract looks like this: BankNifty DEC 43600 CE
Here,
A put option looks like this:
You buy a call option on SBI for August at a strike price of Rs 1000 and a premium of Rs 100 for a lot size of 100 shares. This gives you the right to buy 100 shares of SBI at Rs 1000 anytime from now till the end of August. To acquire this right, you pay a premium of Rs 100 x 100 shares = Rs 10000. Now, if the market price of SBI is above Rs 1100 at any time in August, you can exercise the right and earn profits. Suppose the option price at expiry is Rs 1150. Since all financial derivatives are cash-settled and there is no delivery of the underlying, the contract is settled by paying an amount of Rs 150 (strike price - market price) x 100 shares Rs 15000.
Your profit is Rs 15000 - Rs 10000 = Rs 5000.
Now if the share price falls below Rs 1000 on the expiry date, you have the right not to exercise this option. You would only lose the premium amount of Rs 10,000 that you paid at the time of cancelling the option.
You buy a put option on SBI at a strike price of Rs 1200 with a premium of Rs 50 for a lot size of 100 shares. You pay a premium of Rs 50 x 100 = Rs 5000 while buying the option. If the share price of SBI is below Rs 1250 on the expiry date, you make a profit by exercising your right to sell the option. However, if the share price has risen above Rs 1250, you cannot exercise the option and lose the premium.
Some options jargon you need to know:
The price of an option is made up of two different parts: the intrinsic value and the time value. The intrinsic value is a measure of the profitability of an option based on the strike price compared to the share price of the share. The time value is based on the expected volatility of the underlying and the time until the option expires.
Factors that drive the price of an option are:
Read more on options pricing here.
The option expiration date is the specific date and time at which the option contract becomes invalid. In the case of American options, the buyer can exercise the option at any time up to and including the expiry date. In the case of European options, the holder can only exercise the option on the expiry date itself.
Options that are well before the expiry date are more expensive than options that are closer to the expiry date. This is because they lose value due to time decay. Options have different expiration dates: daily, weekly, monthly as well as 1 year or longer than 1 year, which is called LEAPS (Long-Term Equity Anticipation Securities).
Index options with a monthly expiration date expire on the last Thursday of each month.
When trading options, you can increase your buying power by using leverage. This means you can buy more with less capital.
This is the great advantage that options offer over other financial instruments, which is why they're often used by investors who don't have large amounts of capital.
Investors trading shares, for example, must have enough money in their accounts to cover the total cost of buying shares before they can take a position. With options, on the other hand, you can pay a relatively small amount for an option contract.
Leverage effects also harbor downside risks. If the price of the underlying asset moves in an unfavorable direction, the leverage effect can increase the percentage loss of the investment. Options offer their holders a predetermined level of risk. However, if the holder's options expire worthless, this loss can equal the entire amount of the premium paid for the option.
Margin is the amount required to execute a transaction. The margin required for intraday trading is much lower than that required for delivery trading. For example, if ABS is traded at a price of Rs. 2000 and you buy 10 shares for delivery, the margin required for this trade is Rs. 20,000 i.e. a full margin. However, for intraday trading, the margin required may be less than this amount.
Pre-market session: The 15-minute pre-market session for stock options begins at 9:00 am. During this period, investors can place orders, modify existing orders, or withdraw orders for the following trading session.
Regular session: It starts at 9:15 a.m. and ends at 3:30 p.m.
Here are the various charges associated with options trading:
An option chain is a list of all option contracts. The option chain has two sections: call and put. The list contains information about premium, volume, open interest, etc. for different strike prices.
Components of an option chain
Underlying assets are the real financial assets on which the price of a derivative is based. The price of the derivative is therefore dependent on the price of the underlying asset. Any change in the price of the underlying is reflected in the price of the corresponding derivative.
The price of an underlying is often referred to as the current market price or CMP. Market participants also refer to the CMP as the spot price. Both terms essentially mean the same thing.
The underlying price or current market price or spot price is a fundamental component for calculating the price of a derivative. The strike price or CMP is the last traded price of the underlying and often reflects the true value or market price of the underlying.
There are different types or classes of underlying assets which have unique characteristics, which in turn affect the nature and structure of the derivatives associated with each type of underlying asset. All the underlying assets are subject to market risk, balance sheet risk, and general economic risk factors, as their price depends on both fundamentals and market forces of supply and demand.
Buying options offer upside potential, with losses limited only to the option premium. However, this can also be a disadvantage as the options expire worthless if the stock does not move enough to be in the money.
If you declare your option loss on your income tax return, you can benefit from several advantages, such as the Tax deduction: One of the main advantages of the loss is that you can offset it against other income you have earned. A loss from an F&O trade can be offset against all income except your salary.
Although options trading is generally not considered gambling per se, options trading, just like gambling, involves some risks.
Options trading has several benefits over stock trading:
Options trading can be risky and difficult for new traders, so do not enter this field without proper research and knowledge.
Beginners can start with some basic strategies such as buying calls, buying puts, selling covered calls, buying protected puts, etc.
Options traders can profit as option buyers or option writers. Options offer profit opportunities in both volatile phases, regardless of the direction in which the market moves. This is possible because options can be traded in anticipation of a market rise or fall.
Buying options is usually a Level I trade because it doesn't require margin, but selling naked puts may require a Level II trade and a margin account. Level III and IV accounts often have lower margin requirements.
Options can have a leverage effect. This means that an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can make large percentage gains from comparatively small, favorable percentage movements in the underlying product.
People trade options for three reasons:
1. Hedging: options can serve as a "hedge" or a form of insurance to minimize the risk of sudden market changes.
2. Speculation: Similar to stocks, options can also be used for speculative purposes. You can make a bet on how a stock will perform over time and then buy an options contract that reflects that assessment.
3. Profit: Some traders also use options for general profit-making. That is, options can play a role in their larger investment strategies. Sellers can make a profit on the premiums they charge buyers.
Options trading is a great investment opportunity. A trader may choose to trade options if they are confident in the performance of a particular asset but find it too expensive. An options contract can be much cheaper than the original asset. A trader may also choose to trade options if they are long on an underlying asset but are concerned that the price may move in a different direction and want to hedge against a potential loss.
A trader can do options trading in the following steps:
Learn more on how to do options trading for beginners here.
Most online brokers today offer options trading. As a rule, you must submit an application and be approved for options trading. You also need a margin account. Once you are approved, you can place orders to trade options, similar to stock trading, using an options chain to determine the underlying asset, expiration date, strike price and whether it is a call or put option. You can then place limit or market orders for that option.
In the Indian market, various types of underlying assets can be traded as derivatives. These include stocks, bonds, commodities, interest rates, market indexes, and currencies.
Underlying is an investment term that refers to the real financial asset or security on which a financial derivative is based. Underlying assets include shares, bonds, commodities, interest rates, market indexes, and currencies. An underlying asset of the derivative contract is that which is to be bought or sold at a future date.
The expiration of an option is the specific date and time at which the option contract becomes invalid and ceases to exist.
On the expiration date of the options, no more options contracts can be traded and all remaining positions become worthless - they simply disappear from your account.
All monthly options expire on the last Thursday of each month, except for FinNifty contracts, which expire on Tuesday of each month. Weekly contracts, on the other hand, expire every Thursday. On expiry days, options contracts expire at the end of trading hours.
Checking the expiry date of options contracts is simple. A trader must remember that all monthly options contracts expire on the last Thursday of the month after the market closes. Weekly options expire every Thursday. However, derivatives on the Fin Nifty index expire on Tuesdays.
Due to the T+1 settlement cycle for F&O contracts, options expire on Thursdays. On the last Thursday of the month, all index and stock contracts are closed and cash settlement takes place on Friday evening (deposit and withdrawal of funds), unless Friday is a trading holiday.
In India, stock options expire on the last Thursday of every month. On the other hand, index options with weekly expiry expire every Thursday for Nifty and Bank Nifty contracts, and FINNIFTY weekly contracts expire every Tuesday. The index options with monthly expiry expire on the last Thursday of every month.
If the options are not exercised at the end of the term, the system will automatically square off the position, unless you have opted for physical settlement. Physical settlement is only possible for stock options.
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