Did you know out of the 100 trades executed in Indian markets, close to 72 are in Options, but many retail traders take trade in the options segment without having complete knowledge of how exactly they work, and what drives the prices up/down.
In this series, we will learn in detail about options and also explore how retail traders can learn to trade in options like a professional.
Introduction to Options:
Let’s start by understanding word “OPTIONS”
What is an Option?
In a layman’s language, it can be called as a choice, on whether to do something or not.I have an option, whether to go to a movie or not. Similarly, Options in Stock Markets also provide users with a choice whether to exercise the rights or leave it unused.
Let’s understand it in more detail with our example of going to a movie.
When I buy a movie ticket, I can go to a movie or decide not to go. The ticket price is Rs 500. If I go to a movie, I am using the ticket and putting my Rs 500 to the right use, but If I cancel going to the movie, I lose my Rs 500, as there is no refund from the theatre.
Now, to protect myself against this loss of Rs 500, let’s say I book tickets online from any app, which has a feature to pay extra Rs 30 and it will refund our money in case I decide to cancel my plans.
In this case, we pay Rs 500 + Rs 30 (Fee) = Rs 530 and give ourselves a choice or the ‘Option’ whether to go to the movie or cancel it. In both the cases our loss is limited to just Rs 30.
By paying extra we got an option and this Rs 30 paid is called the Premium. In other words, the Rs 30 premium was the insurance against my movie ticket of INR 500.
Similarly in stock markets, we can pay a small premium and protect ourselves from losses in our portfolio, and hence options are also called as insurance of stocks.
Since market moves both up and down, we need to have insurance for both Bulls and Bears and hence we have 2 types of Options (Insurance)
Call option denoted by CE (stands for Call European)
Put option denoted by PE (stands for Put European)
Since the value of the premium depends on the underlying value, similarly, Call option and Put option values will also depend on the underlying stock price.
As the stock price goes up and down, the values of Call and Put also go up and down and hence they are also called as Derivatives i.e instruments whose value is derived from underlying value.
If the stock price goes up, the call price will go up and the put price will go down.
If the stock price goes down, the call price will go down and the put price will go up.
Clearly call and put always go opposite to each other.
The relation chart looks like this:
As a Bullish trader, to protect my underlying stocks, I can buy Put option, if a stock will go down. Put will go up and losses faced in stock will be compensated by profits in the put option.
Similarly, as a bearish trader, to protect my underlying short trades, I can buy a call option, if the stock goes up against my bearish view. Call option will give me profits to compensate for the losses.
There are two types of Options Call and Put, and both are used as insurance to protect our underlying trades. In the next lesson we will dive deep into these options and learn how to take trades in them.
(The author is Co-founder Algofox)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)