Options trading in India has seen a huge jump in last couple of years and more retail traders are attracted towards this instrument now a days. This market has a large reward potential on low capital but at the same time it has a high risk too. Before investing and trading real capital in this instrument , its very important to understand them fully to take calculated risks. Options offers opportunity to get the benefit from all kind of market sentiment whether it’s Bullish, Bearish or Range bound.
Options are a type of “derivative”, and hence their value is derived (That’s why they are called derivatives). Now the question is from where options value is derived? Options value is derived from the value of an underlying instrument which can be a stock (Like Reliance, TCS etc.), or it can also be an index also (Like Nifty , Bank Nifty and Finnifty)
Let’s understand what are Options ?
The concept of options remains the same whether you are doing options trading in India or when it is done outside Indian markets. In this article we will understand it on the basis of Indian markets.
Definition:
An option contract is a financial contract between buyer and seller for a specified date in future, at a price agreed today. However, it also entails a right to buy, but not an obligation for buyer of the contract.
If you are a beginner and reading Options for the first time, then this definition seems confusing. So, let’s understand this now for complete clarity on options.
There are 3 things mentioned in the above definition which are important:
Right and no obligation: This means buyer have the right to exercise the contract but there is no obligation (You as a buyer is not forced to exercise the right)
Agreed price today: There is a price already set
Specified date in future: There is also a date which is predetermined.
Example ( Real Estate Trader) :
Suppose you are a Real Estate trader (You buy and sell houses in a short period of time). You really liked one of the houses and the current price is 1 Cr. You do not have 1 Cr now and hence you gave 1 lakh to the owner as a token money with two conditions.
1st condition: You will buy the house within 3 months otherwise the seller can sell it to anyone. 1 lakh rupee is also nonrefundable after 3 months if the buyer doesn’t buy the house.
2nd condition: Even if the price of a house goes above 1cr within these 3 months, you will get it for 1 Cr only (Because you are paying the token money now when the price is 1 Cr. It is like paying the premium of 1 lac for locking the price of house for 3 months)
In this example also there are 3 things (If you relate it with the definition of Options Contract)
1.Buyer have the right but no obligation:
If the price of the house increases to 1.2 Cr in 1.5 months, then you can exercise your right to buy the house at 1 Cr only. As prices are now 1.2 Cr, you are already in a profit of 20 lacs. (Remember that seller of the house must sell you the house in this case and he cannot refuse it. So, if buyer want to exercise the right, seller is obligated)
Suppose if the price decreases to 0.8 Cr (80 lacs) , then buyer have the choice of not exercising the right to buy (No one will force the buyer to buy) . In this case your 1 lac will be taken by the seller
2.There is a predetermined price
You have paid a predetermined price of 1 lacs rupees to lock the prices for 3 months
3.There is a predetermined period of 3 months
This contract is valid for 3 months only . After 3 months , 1 lac will be taken by the seller
I hope the example is clear now along with 3 points mentioned. You can go through it again for more clarity because now we will understand the same from the stock market perspective.
Example ( Indian Stock Market ) :
Suppose HDFC BANK is currently at 100 Rs. You expect prices of HDFC BANK to go up to 150 Rs in next 1 week . The price of option is 2 Rs which has a validity of 7 days. If the price of share rises to 150 Rs within 7 days , then you will exercise the contract and in this case your profit will be 150-100-2 = 48 Rs .
In this case Rs 2 is deducted because you have already paid this to seller to lock prices of HDFC at 100 Rs. This is the option premium.
But if the price of HDFC falls to 75 Rs , then you are not obligated to buy and in this case you have to let go of the premium paid to the seller. Here seller will earn 2 Rs.
Few points that you should consider in above example
- 2 Rs is the option price which is like the token money paid to lock the buying price of security ( In this case HDFC BANK) for next 7 days
- If you are buying an option and price of the security increases then you can exercise the right to buy the security. In this case you will be in profit.
Nomenclature of Options : How you will see options on trading platform and what it means
If you check any trading platform , options will come like this: ( Lets say you are interested in HDFCBANK )
“HDFCBANK NOV 1330 CE”. At 1330 lets say option price is 10 Rs. What does this mean?
HDFCBANK = This is the underlying instrument from where options will derive value.
NOV = This is the expiry date ( This is the “predetermined period” which we discussed in our examples )
1330 = This is “predetermined price” where you can buy option for Rs 10 Rs( 10 Rs is the option premium). Now if prices of HDFC BANK go up to Rs 1400 and you want to exercise the right , then seller has to sell you at 1330 Rs because you have paid 10 Rs to lock the prices . So your profit will be 1400-1330-10 = 60 Rs.
CE is call option which we will discuss in next article .
We will see another example of Index ( BANK NIFTY / NIFTY / FINNIFTY etc.) because of two reasons :
- Lot of retail traders do options trading in Indexes.
- There is no price of index ( Like HDFC BANK share has a price ). So lets see
“BANKNIFTY 01st Nov 42700 PE” . At 42700 lets say option price is 200 Rs. What does this mean?
Bank Nifty = This is the underlying instrument from where options will derive value
01st Nov = This is the expiry date ( This is the predetermined period as per our example )
42700 = This is the BANK NIFTY level where option price is 200 Rs.
In the case of Index options trading ( Unlike HDFC BANK where you can exercise the right and take HDFC BANK shares from seller ) , there is no delivery of BANK NIFTY ( This means you can not ask for Bank Nifty shares which can be put in your portfolio ). Buying and Selling of options slightly works differently in case of index options trading in India which will be the topic of our next article .
The objective of this article is to help you understand the basics of options trading in India and what is options . I hope it is clear to you now and don’t forget to read the next article where we will discuss call and put option , strike price etc. and get into more details.