Introduction to Options

This article gives an introduction to Options and serves as a beginners guide to those who want to explore them.

Just like Futures (which we covered in a previous post), options are derivatives that are traded on an underlying stock (in case of an NSE stock). A lot of beginners get attracted by the huge potential returns and jump into option trading with the ‘hope’ of getting rich quick! This article hopes to demystify options and ensure that you trade them properly.

An option can be of two types, American or European. Owners of American-style options may exercise at any time before the option expires, while owners of European-style options may exercise only at expiration. In India, the NSE stock options are American style and can be exercised and sold at any time before expiration, while all index options are European style and can be exercised only at expiration.

There are two types of options one need to understand: call and put. A call buyer is betting that the stock is going to go up in the future, and a put buyer is betting that the stock will go down in the future.

When you buy a call option, it gives you a right to buy a stock at a certain price (called the strike price) before a certain date (called an expiry date). The expiry date for all listed stock options in the India States is the last Thursday of the contract month, which is the month when the contract expires. However, when that Friday falls on a holiday, the expiry date is on the Wednesday immediately preceding the last Thursday.

In most cases though, buyers do not want to exercise the right to buy/sell the shares and end up selling/buying the option itself for a gain or loss. So, how does one make or lose money if INFY goes up or down. It is very simple actually.

Lets take a call option as an example. e.g., say you are bullish on Infosys (INFY) and think that it will go above 6400 by February end. You could buy one contract of INFY-FEB14-CALL-3800, which would basically give you the right to purchase one lot of INFY (i.e. 100 shares of INFY) at the strike price of Rs 3800 on the expiry date. Lets say the CALL buyer purchased the INFY-FEB14-CALL-3800 on 21st Jan 2014 at  the closing price of 71.

There are 3 scenarios we need to look at:

Scenario 1: On the expiry date, if INFY is trading at 3900, then the call would be worth Rs 100 (3900-3800) at expiry (because if you were to exercise your right to buy, you could buy INFY at 3800 and sell it in the open market at 3900 and make a Rs 100 gain). Hence the gain would be (100-71)/71 = 40.8%.

Scenario 2: But what if INFY failed to go above Rs 3800. Then the option would expire worthless, and you would lose all your money, i.e. your loss would be 100%.

Scenario 3: If INFY closes between 3800 to 3871 at expiry, the price of the CALL at expiry would be less than Rs 71 (3871-3800) and hence you would still be at a loss between 0 to 100%.

A put option works the exact opposite, where the option price goes up as the stock falls.

A CALL or PUT can be out-of-the-money, at-the-money, in-the-money or deep-in-the-money. The meaning of these terms is described in the following table.

If Call/Put is Call Put
Out of the Money Stock trading above the strike price Stock trading below the strike price
At the Money Stock trading at the strike price Stock trading at the strike price
In the Money Stock trading above the strike price Stock trading below the strike price
Deep In the Money Stock trading way above the strike price Stock trading way below the strike price
In Investar, it is easy to find out any option for any scrip that is either of the above. The figure below shows a screenshot of the F&O Lookup window that shows all NIFTY options that are out of the money.
Beginners usually get attracted by the high percentage gains provided by options and feel that they can get rich quickly by trading options. But, nothing can be farther from the truth! From the above example itself, it is clear that the risk in trading options is pretty high. As the INFY example above showed, when you buy a CALL or PUT option, you can lose all your money. This is important to keep in mind when you actually buy a CALL or PUT. In fact the majority of option buyers lose money because not only you have to get the timing right, but you are also betting on the stock to reach your target by a certain expiry date, which makes it all the more difficult.
Edited: To understand the mechanics of options pricing, let’s understand the components of an option price (also called option premium).
Option Premium = Intrinsic Value + Time Value
The “Intrinsic Value” is the difference between the underlying’s “Current Price” and the “Strike Price”. The “Time Value” is the cost the option buyer is willing to pay above its intrinsic value in the hope that it will move in the desired direction by the expiry date. It is this “Time Value” that decays as the option approaches expiry so that at the expiry date the option premium will consist entirely of the “Time Value”. This also means that while you don’t lose money while holding a stock that does not change, an option declines in value even if the underlying stock were to remain steady throughout. This “time decay” is why a lot of the option buyers lose money.
Indian stock market does not allow retail investors to short stocks and carry positions for delivery. This is another reason why options are popular because they allow you to be short on a stock (e.g., by buying a PUT option). If this is the strategy you want to use, you should use Deep-in-the-money PUT option as they are much more likely to move in tandem with the stock.
There are many factors to consider (like greeks and volatility) when trading options, but the important point to remember is that you cannot get option trading right unless you perfect the timing of your entries and exits. And that is why Technical Analysis is even more  important in option trading. Because if you get your timing wrong, then your capital will erode in no time!

But how does one use Technical Analysis (TA) to trade options? Should you really do TA on an option chart? You generally analyze the underlying stock technically and then make a decision to adopt a bullish option strategy if you are bullish (e.g. buying a CALL) and a bearish option strategy if you are bearish (e.g. buying a PUT).

Although the odds may be against option buyers, there are other less risky ways to trade options (e.g., option writing), that we’ll probably cover in a future article.
  1. Out of the Money – This means it is trading is below the strike price.