Introduction to Options - Part 1

Options are one of the most lucrative ways of making money in the markets. The flip side is that they can lead to huge losses if not dealt with correctly. Let us explore the world of options. To begin with there are 2 type of Options, Put option and a Call Option. Put Option gives the buyer to sell a stock or index at a particular strike. It gives the buyer the right to sell at a particular strike price but not the obligation to sell. It is similar to taking insurance on your house or car. Buying a call option gives the buyer the right to buy a stock or index at a particular price but not the obligation to buy the underlying. It is similar to giving a deposit amount to buy a house at a particular price.
Options are of 2 flavors. The American Options and the European options. The European Options can be exercised only on expiry day whereas the American options can be exercised on any day till expiry. In plain English, it means though you can buy sell these options every day as per market price of options, the actual difference between market price and strike price can be got only on expiry day for European Options and any day till expiry for American Options
Example:
1. Nifty 6000 CE Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry (Strike price 6000, Call Option, Flavor European)
What this means is I believe the Nifty will go much higher in the next 10 days and will expire say at 6200. On the day of expiry I will get 6200-6000 = 200 rupees. My net profit on the trade is 200-70 = 130 rupees. Now, let us assume the market falls to 5800 instead of going up. I will end up only losing the premium I paid.

2. Nifty 6000 PE Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
What this means is that I believe that Nifty will go down in the next 10 days and will expire say at 5800. On the day of expiry I will get 6000-5800 = 200 rupees if the Nifty expires at 5800. My profit is 200-70 = 130. Now, if against my expectations if the markets move up and expire above 6000, I end up losing only the premium paid.

Now, we have learnt what options are. There are 4 possible things one can do with Options.
1. Buy a Call Option
2. Sell a Call Option
3. Buy a Put Option
4. Sell a Put Option
What does all this mean? Buying a Call or Put Option means that we have the right to buy or sell an underlying stock or index at a particular strike price. The loss is limited to the amount of premium paid. Selling a put or call option means we are open to facing unlimited losses or profit if the market moves opposite to our direction.
1. Nifty 6000 CE Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry.
Now, I sell the 6000 CE option as I believe the markets will move down. So, if the expiry is below 6000, I pocket the entire 70 bucks premium. If my direction goes wrong and market moves to 6500, I have to pay 6500-6000 = 500 rupees to the option buyer. My net loss is 500-70 = 430 rupees

2. Nifty 6000 PE Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
I sell the Put Option because I believe the markets will go higher in the next 10 days. If they expire above 6000, I pocket the entire 70 rupees premium. If my direction goes wrong and market crash to 5500, I have to pay 6000-5500 = 500 rupees to the buyer. My net loss is 500- 70 = 430 rupees.

From the above examples, we can see buying options, the loss is limited and profit is unlimited. Selling options, profit is limited and the loss is unlimited. Yet, it is more lucrative to sell options rather than buy options. Why is this so? Let us look at this in my next post. I plan to write a series of posts every month which would take us from the basics of options trading to complex strategies.