Options Trading Beginner Guide Characteristics:
Before the examples will make sense, we need to understand a few things.
The first characteristics of options trading are that all Options have an expiration date, which means they no longer exist or can be traded after they expire. That’s why when you are trading in options, you have to choose a time frame for your position Unlike options, shares of equity stocks have no expiration date and can be held forever.
Second, all options have what is called a “strike price”. The strike price is the price at which the option can be converted into shares of stock. E.g. if my call option has a strike price of 105 Rs, I can use the option to buy shares of stock at the strike price of 105Rs.
The third characteristics are the “option contract multiplier”. A share of stock with a price of 120Rs can be purchased with 120Rs. But if an option is 5Rs, we can’t buy it with 5 Rs.
We actually need 500 Rs. This is because options can be used to trade 100 shares of stock, we need to multiply the price of the option by 100 to get its actual value or “premium”.
Option price-5 Rs .
Option Premium-500Rs.
Therefore we need 500 Rs to buy an option with a price of 5 Rs.
Options Trading in Reality :
When Trading options, the goal is to profit from a price change in the option, not to exercise the option to buy/sell shares.
You don’t need to exercise the option to realize a profit, you can simply close the option position.
You don’t have to hold the options to expiration. They can be closed whenever you want before they expire.
Types Of Options:
Call Option-
At a very high-level call, the option price will increase as stock price increases and call option prices will decrease as the stock price decreases.
A call option can be used by the owner to buy 100 shares of stock at the call options strike price. As the stock price increases, this ability becomes extremely valuable.
Let’s explain the above concept with a very simple example. Imagine that there is a house and the current value of this house is 20 lakh rupees.
Now say we personally interested in buying this house, because we think that the house is going to appreciate significantly over the next two years.
But we don’t want to buy a house right this second. So We are going to buy an option that gives us the right to buy the house at a price of 20 lakh between now and two years from now, so we can call the strike price 20 lakh rs.
So here is the golden scenario that if that house price will get rise to 35 lakh from 20 lakh, we still have to pay 20 lakh to buy it after two years.
So our net profit will be 15 lakh. But if the price decreases from 20 lakh to 15 lakh after two years. Then you might have to face a loss of about 5 lakh.
We need to discuss something that’s extremely important and it’s a sticking point for options trading beginners. When you trade options, you will almost never exercise options.
You need to understand that an option’s value comes from its ability to trade shares of stock at the strike price as opposed to the current stock price.
Option Pricing Law:
An option’s price will always include the benefit/profit that it can provide the owner if they were to exercise the option.
Any Share’s call strike price: 800 Rs
Any Share’s stock price: 1000Rs
Then we can use the call option to make a 200Rs profit per share.
Because of this, the call option must be worth 200Rs or have a premium of 20000 Rs since it can give us a 200Rs profit per share on 100 shares.
This is exactly how the option traders make money. They think that something will happen with the stock price they put on their positions. Then if their position benefit by seeing an increase in its value and then they can go ahead and sell their position at the higher price and the profit is the difference between the two prices.
Put Option-
Now if you’ve understood how call options worked in the previous example, then we’ll look at put options in our options trading beginner guide. I hope you’ll easily understand put options too.
Put options prices increase as the stock price falls, and visa versa. The reason is that a put option gives the buyer the right to sell 100 shares of stock at the put options strike price between now and expiration.
A put option is similar to a call contract, except that the roles are reversed. With a put, it is the buyer of the put who has the option to sell, and the seller of the put who has the obligation to buy.
Let’s run through the example, this time with a put.
Stock trades at 100Rs
The Price of the Put option is 5Rs
The Strike Price is 100Rs
The expiration date is January 21, 2022.
The primary reason that someone may want to buy a put is to ensure his stock. If an investor owns the stock in question, he might be worried that the stock might drop sharply if the company reports a bad quarter.
So he might buy a put at a strike price of 100Rs, which would guarantee him the ability to sell his stock for $100 on January 21, 2022, even if it has dropped down to 50Rs.
If it closes above 100Rs, then again, the option expires as worthless and the put seller pockets the 5Rs. In this case, the put seller acts as the insurer of the stock, and the put buyer is buying insurance for his stock, just as someone might buy insurance on their home for a small fee.
Options are powerful and useful instruments that can be used for many different purposes based on your investment strategy. It is worth noting that approximately 80% of all options expire without ever reaching the strike price, which implies that being a seller of options is a much better strategy than being a buyer.