A beginner on a journey towards expertise!
Options are one of the types of Stock derivatives (derivatives derive their value from the underlying asset) which are traded freely in the Stock Market. If you are already confused that’s because most definitions for Stock Options are extremely convoluted with difficult and technical words. But in this post, I will try to explain it in a very simple manner.
Let’s suppose your friend has an old car which he wants to sell. He thinks that the value of the car is around Rs. 2 Lakhs (200,000). But you have an expertise in cars and think that he is wrong. According to you the real value of the car is much higher than what your friend thinks. So you and your friend agree on a bet. There are three rules which you and your friend decide –
- You pay Rs. 20,000 to your friend upfront.
- You can purchase the car from your friend at anytime for his quoted price of Rs. 2 Lakhs (200,000). However, you have an ‘option‘ to not buy his car at all.
- You friend cannot wait for too long. So, he decides that the bet will ‘expire’ after 2 months.
This right here is a CALL option which you have just agreed on with your friend.
So what do you do now? For the next 2 months before the bet expires, you try to sell your friend’s car to potential buyers. It can only end up in one of these two possible ways –
- You cannot find a buyer willing to pay more than Rs. 2 Lakhs
It turns out that you were wrong in evaluating the car and there is nobody willing to buy it for more than Rs. 2 Lakhs. You forfeit the bet and tell your friend that you will not buy his car from him and will let the bet ‘expire’.
- You find a buyer willing to pay Rs. 3 Lakhs
It turns out that you were right. There is one buyer willing to purchase the car for Rs. 3 Lakhs and you are able to find the buyer before the bet ‘expiry’ date of 2 months. You buy the car from your friend at Rs. 2 Lakh as promised and sell it to the buyer for Rs. 3 Lakh thereby making a profit of Rs. 1 Lakh.
Your friend was able to sell his car for Rs. 2 Lakhs and received an additional Rs. 20,000 (which you paid upfront) and you were able to make a sweet profit of Rs. 80,000 (Rs. 1,00,000 – Rs. 20,000).
You were the real winner in this bet turning your Rs. 20,000 investment (paid upfront to your friend) into a four fold profit of Rs. 80,000.
This is exactly how CALL Options work which get traded every single day in the Stock Market. Just like the bet which you had with your friend, an Option has three components –
- Price to buy the Option which is paid upfront – called Option premium
- Price at which you have an option to purchase the stock (or index) from the seller – called Strike Price
- Time after which the Option expires – called expiry day
An example of a CALL option is a NIFTY option which is illustrated below –
CALL option contains all the information of the bet which you need to trade that option. It contains a Strike Price (18000), a premium (196.8) to be paid upfront and a month of expiry (November). If you were to buy this call, you will have an option to buy NIFTY at 18000 at any point of time before expiry regardless of what is the current price of the index. CALL options are profitable for call buyers if the stock (or index) is bullish and it’s price increases in value. The opposite is true for CALL sellers who will lose money if the stock (or index) price increases in value.
An example of a PUT option is a NIFTY option which is illustrated below –
PUT option also contains all the information of the bet which you need to trade that option. It contains the Strike Price (17000), a premium (29.25) to be paid upfront and a month of expiry (November). PUT works in exactly the opposite fashion as a CALL option. If you were to buy this put, you are betting that the stock (or index) will fall. The more index fall below the Strike Price, the more profit you will make. The opposite is true for PUT sellers who will lose money if the stock (or index) price decreases in value.
Now that we know about Stock Options the main question remains – Should you trade in Stock Options?
The answer for most retail investors and newcomers is a resounding no!
Stock options are extremely volatile, require very active participation during the trading day and high understanding of the nitty gritty of the stock market. I can say with very high confidence that most newbies who get attracted towards Options in hopes of becoming rich quickly end up lost most of their capital.
But there are a few experienced traders who are consistently able to make profits through Options trading. So, it is up to the reader to take part in Option trading as per their own risk appetite and level of expertise.
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