Trading is not investing. It is speculation and can be risky, especially when the speculator takes a leveraged position. Options are financial instruments used by stock traders to hedge their bets. In this new series, we will look at how you can use options to reduce the risk to your portfolio, while earning handsome returns.
What are options?
Options are derivative instruments, which means that their price is derived from the price of another underlying security. They give the buyer the right to buy or sell the underlying stock or index at a predetermined price within a specified time period. The buyer pays a premium to the seller to obtain this right. Here we look at the key terms related to option trading:
Calls And Puts: A Call option gives the buyer the right to buy an underlying asset. A Put option is the reverse. It gives the buyer the right to sell. A trader buys a Call if he expects the price of the asset to go up, and a Put option if he feels it will go down.
Underlying: The underlying assets can be stocks, indices, currencies and commodities. Options for 183 stocks and 8 indices are traded on the National Stock Exchange. The Bombay Stock Exchange also offers such trading.
Stock And Index Options: An option with an individual stock such as the Reliance Industries, Hindustan Unilever or Tata Steel as an underlying asset is a stock option. If the underlying is an index like the Nifty or Sensex, it is an index option.
Expiry Date: All options have an expiry date. The last Thursday of a month is the expiry date for the contract for that month.
Strike Price: This is the price at which the trader has agreed to buy or sell the underlying. If a trader exercises his option to buy or sell the underlying, he will get the difference between the strike price and the closing price of the security on that day.
American And European Options: There are two kinds of options. American options can be exercised any time up to the expiry date, while the European options can be exercised only on the day the contract expires. In India, index options are European, whereas stock options are the American ones.
Lot Size: Option contracts are sold in the same lot sizes as futures contracts. A trader has to buy the entire contract. The lot size varies for different stocks and indices. For example, the lot size of the Infosys contract is 150, while it is 7,500 for Hotel Leela Venture. Similarly, the Nifty contract size is 50, while for the Junior Nifty the size is 100.
How options can benefit buyers
Low-risk game: The premium paid by the buyer is the maximum loss that he can incur. If you buy an Infosys Call for Rs 10, you pay Rs 1,500. If Infosys dips, you lose only Rs 1,500.
High leverage at a low price: The low premium also means that a trader can take a leveraged position with a small outlay. If a Reliance Call is for Rs 20, you buy 150 shares for Rs 3,000.
Liquidity: Stock and index options can be traded on the NSE and BSE. One can buy Calls and Puts of 8 indices and 183 stocks on the NSE. However, options of many stocks are not traded actively because there are few sellers.
Pricing: The huge volume of buyers and sellers on the NSE and BSE ensures that the options being traded are fairly priced.
Assurance of safety: Trading in options is cleared through the stock exchanges, which ensures payment of dues.
