Options trading is a trading strategy used by investors and traders. Simply put, an option is a contract between the seller and buyer that gives the buyer the right but not the obligation to buy or sell a particular asset at a specific price in the future.
For call options, the buyer has the right to buy the particular asset, and for put options, the buyer has the right to sell the particular asset. Since the seller gives this option, a payment or premium is collected from the buyer.
Are you considering trading in options? Intrigued to know more about the types of options trading? Read ahead for more information.
Investors can choose from different options trading strategies, mentioned below are two basic types of options trading.
Call options: A contract in which the buyer can buy an asset at a specific price
Put options: A contract in which the buyer can sell the asset at a specific price
Also read: Types of options
A call option is an option contract that gives the buyer the right, but not the obligation, to buy a certain asset at a predetermined price within a specified time period. The asset can be a bond, stock, or commodity.
Here's an example
Rahul believes Tata Motors' stock will rise from the current price of ₹400. He buys a call option from Amit:
Strike Price: ₹420
Premium: ₹20
Expiration: 3 months
If Tata Motors' price rises to ₹480, Rahul can buy at ₹420, as agreed on the contract, making a net profit of ₹40 per share (₹60 profit minus ₹20 premium). If the price stays below ₹420, Rahul won't exercise the option and loses only the ₹20 premium.
Also read: What are call options
A put option is a trading strategy that gives the buyer the right to sell a security at a specific price within a particular date. The specific price is known as the strike price because the buyer is expected to exercise the option and strike as soon as the price of the asset drops to that level or lower.
If the price of the asset falls, the put option becomes more valuable, and if the underlying asset increases in price, the value of the put option falls. This is why put options are often used as a hedging tool.
Rahul believes Tata Motors' stock will fall from its current price of ₹400. He buys a put option from Amit:
Strike Price: ₹380
Premium: ₹15
Expiration: 3 months
If Tata Motors' price falls to ₹340, Rahul can sell at ₹380, making a net profit of ₹25 per share (₹40 profit minus ₹15 premium). If the price stays above ₹380, Rahul won't exercise the option and loses only the ₹15 premium.
Also read: What is put option in share market
European Style Options Trading Strategies:
A European-style option is an option contract that can only be executed on the expiration date. If the value of the underlying asset moves in price before the expiration date, the investor is unable to exercise the option early and either buy or sell the stock. The call option or put option will only take place on the date of the options contract's maturity.
American Style Options Trading Strategies:
The American style of options trading is different, as the option can be exercised at any time before and on the expiration date. If the price of the asset changes before the expiration of the contract, the buyer can execute the contract before expiry.
There are two main indexes in India: Nifty 50 and Sensex. Index option trading is a strategy that allows investors to buy and sell options on these indexes rather than individual stocks.
The value of these options contracts will depend on the movement of the entire index. This trading strategy is very good for hedging, speculation, portfolio diversification, and income generation.
Did you know, the concept of options trading has its roots in ancient Greece? It’s believed that Thales of Miletus, a mathematician and philosopher used the concept of options. How? He observed that the olive harvest was expected to be particularly good for a specific year, and assumed that this would increase the demand for olive presses. Instead of investing money to buy many olive presses, he entered into a contract with the olive press owners. This contract gave him the right to rent the olive press in the future, after the harvest was ready. When the demand for the olive presses surged, Thales rented out these presses to olive farmers at a higher rate than he paid the owners. By securing the rights of the olive presses, in advance of the harvest season, Thales was able to mitigate and speculate the price of the olives in the future. This shows that the concept of speculation via options has been around for thousands of years, and have evolved into the complex financial instruments of trading, today.
Options trading is a good way to earn profits without investing much capital. Options contracts are easy to understand once you have grasped the basic and simple fundamental concepts. You will then be able to buy or sell an asset at a specific price within the specified timeframe by paying a small premium to the seller.
To learn more about options trading strategies, visit the Sharekhan Knowledge Centre. You have a wealth of knowledge and information at your fingertips to help you understand options trading and achieve financial success.
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