Our attempt is to provide you a basic understanding of what stock and index options are all about without confusing you with any unnecessary and avoidable details. Though there indeed are lots of online resources on options, hardly any of them deal with the typical Indian equity market scenario - we bring you one right here - perhaps the first Indian OPTIONS BLOG.
New to OPTIONS ? It is so very easy. Just follow these basics for a quick launch into the wonderful world of OPTIONS trading :The equity market permits you to either purchase/sell shares (called CASH segment), or trade in FUTURES and/or OPTIONS (called the DERIVATIVES segment). FUTURES and OPTIONS segment in popularly referred to as FnO. However, here we talk only about OPTIONS and not about FUTURES at all. Why ? Because in OPTIONS the possible extent of loss is very limited, whereas in FUTURES loss can be potentially unlimited !
Basic Call Options
Buying a call option gives you the right to purchase a given number of shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the last Thursday of a specific month (called the expiration date). You can just as easily sell (square off) your purchased Call options, without necessarily having to exercise them to procure a company’s shares prior to the stipulated expiry date. That is why it is usually said that buying a Call options gives you a right, though not necessarily an obligation.
People buy calls because they hope the stock will go up, and they will make a profit, either by selling the calls at a higher price, or by exercising their option (i.e., buy the shares at the strike price at a point when the market price is higher).
Basic Put Options
Buying a put option gives you the right (though not the obligation) to sell a specified number of shares of a company’s stock at a certain price (called the strike price) from the date of purchase until the last Thursday of a specific month (called the expiration date). You can just as easily sell (square off) your purchased Put options, without necessarily having to exercise them to sell a company’s shares prior to the stipulated expiry date. That is why it is usually said that buying Put options gives you a right, though not necessarily an obligation.
People buy puts, because they hope the stock will go down, and they will make a profit, either by selling the Puts at a higher price, or by exercising their option (i.e., forcing the seller of the Put to buy the stock at the strike price at a time when the market price is lower).
So, as we have explained above, OPTIONS trading has two basic transactional instruments, called Calls & Puts. You can buy and sell both or either. Calls increase in their value as the cash scrip goes up, Puts decrease at the same time. Conversely, as the cash scrip goes down Calls decrease in value and Puts gain at the same time.
For sake of convenience, let us take Reliance as an example. Suppose the cash share of this company is currently trading at 1700. If you wish to purchase Reliance Calls, your broker or your online trading agency will tell you that Reliance Calls are available at different levels. These levels can be below, at or above the currently trading price of Reliance share. For example, Reliance Calls for the month of July are available at 1440, 1470, 1500, 1530, 1560, 1590, 1620, 1650, 1680, 1710, 1740, 1770, 1800, 1830, 1860 levels. These levels are called as Strike levels, Strike price, or simply Strikes for Reliance Calls available in the market. I have shown 1710 in bold as it is closest to the current market price (CMP) of a Reliance share. Such a level would be called as ‘At Money’ or ‘At the Money Level’. All levels below the CMP will be termed as ‘In Money’ or ‘In the Money’ levels (here 1440 till 1680), and, of course, all levels above the CMP will be termed as ‘Out of Money” levels (here 1740 till 1860).
Don’t attempt starting trading right-away. OPTIONS are time-sensitive, scheduled financial contracts. Learn the basic OPTIONS terminology and their basic calendar prior to beginning your first trade.
1. Don’t start trading in options until you are absolutely sure of the terms - ‘Buying a put’ or ‘buying a call’ and ’selling a put’ or ’selling a call’ (Look up in Terminology category). The IMPLICATIONS are different and so are your LIABILITIES .
2. Don’t start trading in options until you are reasonably well versed with short-term movements of the market as a whole (NIFTY, SENSEX), as well as in the stock you select.
3. Don’t become an initial SELLER of options - that is, selling options without having bought them first. This makes you an OPTION WRITER, and you have to pay heavy margins to the stock exchanges. Your losses can be unlimited as well.
4. Don’t select a trend less stock with narrow price movements. You will neither gain on the calls nor the puts and you will lose due to the inevitable time decay.
5. Don’t buy a put option on rising stocks.
6. Don’t buy a call option on declining stocks.
7. Don’t buy a stock where trading volumes are obviously very low.
8. Don’t get into several stock options at the same time. You may find it difficult to follow-up. Limit to two, or at most three.
9. Don’t get into buying an option until you have calculated the actual outflow per option. It may be low for Nifty (lot size merely 50) but extremely high for stocks like GMRINFRA (lot size 1000).
10. Don’t go for extreme ‘out of the money’ or extreme ‘in the money’ options. For call options, ‘in the money’ would mean strike lower than Current Market Price ( CMP ), and for put options, ‘in the money’ would imply a strike higher than CMP (and vice-versa).
11. Don’t place ‘market orders’ for any option. You may end up paying absurdly high rates placed by sellers. These becomes astronomically high when you consider stocks where the number of units per option is large like 7875 per option for IFCI.
12. Don’t buy an option closer than 7 to 10 days prior to expiry date - unless you’re trading intraday where you would be squaring up the same day, or at the most during the next 1 or 2 days.
13. Don’t hold all the options for maximum gains. Start selling a percentage of them at each significant rise. Hold, say 20% towards expiry if you expect further rise in the cash market price. Make sure that the cash market price is already well above your strike plus premium in call options that you are holding to expiry. Reverse for puts of course
14. Don’t shift to higher options in equal numbers as the scrip is rising. Speaking of call options, if you wish to shift, remove part of profits and take lesser number of options at higher strikes and lower premium. Do the reverse for put options.
15. Don’t keep a stop loss in options on the trading screen. It can easily get triggered and then reverse, since options are volatile. Keep a mental stop loss if necessary and exercise the stop loss at will.
16. Don’t utilize 100% of your capital in options. The very advantage of options is lost. If you have Rs 5 lakhs as capital, you can take exposure to the same number of shares with Rs 50000/- worth options. Limit yourself to this 10% percentage of the available capital. As you earn profits with options, you can keep back your entire capital of Rs 5 lakhs, or keep it invested in a stable blue-chip cash scrip like L&T or Reliance and continue playing in options with the profits alone.
17. Don’t play on borrowed money. Once you gain experience, you may get margin funding on your cash shares from your brokerage. Take care not to over leverage. It is quite easy to fall prey to greed in the market, more so with options since investment required is substantially less.
18. Don’t average options during a fall as in long term investment for cash market shares. You may lose big time.
19. Don’t panic seeing intra day volatility in options. It is a natural phenomenon with options.
20. Don’t buy at the opening price since the demands from sellers are often absurdly high on opening. Watch the trend before taking a position.
21. Don’t hesitate to get advice from someone you trust in case of doubt.