OPTION TRADING (EQUITY)

THEME 1 UNDERSTANDING THE BASIC

Options are considered to be the riskiest assets of the world. It is a apart of the derivative segment
which also includes futures market also. Options were designed basically to hedge positions in futures
and the spot market. Hedging is minimizing the risk potential, let us say u feel that prices of sugar will
move up in the next month, now you enter into a contract with your retailer stating no matter what the
price in the next month take current market price and provide me sugar the next month regardless of
price. Here the cost of hedging will be the interest price foregone on payments done to the retailer.
There are various hedging strategies in options and it does not involve paying the current market price
but only a fraction of the spot price we'll study the various strategies in future themes.

KEY FEATURES:

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying
asset at a specific price on or before a certain date. Here the underlying is the
stock/commodity/currency. a lot of people get confused with the term the right but not the obligation
we will look at it with a practical example(assume 10%margin on spot price).let us say you want to buy
1kg of apple at the end of the month assuming today is 1st of the month .today the price is 90Rs a kg
and u feel the price will touch 100 by month end now you buy a strike of a call90 now since the current
price is90 the intrinsic value of the strike price will be zero but since there are 30days to go you need to
pay premium which is also called as insurance value along with this interest rate prevailing in the
economy the insurance factor is also added to the cost. Let us say the insurance premium is 1.1Rs and
interest rate is 10%p.a then we've a total premium of Rs2(1.1+90*10/100*1/12).we'll study in detail
option pricing in the next theme.

Now we've arrived at a price of the 90call i.e.Rs.2.now as predicted at the end of the month the price
reaches Rs.100 then the price of our strike will be Rs.10 (price at the end of the month -strike price)(100-
90=10).now let us say the price comes down to 80 it doesn’t mean that the price of the option will move
into negative all we lose is only the 2Rs premium.

Short selling: let us say we have got someone who says please find me a house for 10lakhs in a specific
locality so what we do is take cash and start searching for a flat in that locality for below 10lakhs the
difference will be our profit. So here you have sold something which is not yours but you think of buying
it at a lower price.

Now you may ask if the loss is only the premium paid then why is it that people get stuck in the option
market and lose money in huge quantities. There are many reasons and some of the important one’s are
listed below.

 The lot size multiplies your losses: Let us say you have one lot of the stock unitech whose lot size
is 4000units then a 1Re fall in unitech will wipe out 4000Rs in your account.
  Short selling: The buyer looses only the premium paid but the seller looses due to increase in
price.In the example of apples the buyer gains 8Rs but the seller loses 8Rs.

 Time value: if the price of the apples remains at 90 at the end of the month the price of the
option will be zero inspite of no changes in the spot price.

Types:

CALL OPTION & PUT OPTION

Call option: when you think the value of the underlying will move up you buy a call option. Just like the
above case where we bought a 90call of the commodity apple.

Put option: If you feel the price of the underlying will come down you buy a put option.

Even the strike price of 90put will be calculated in the same way although the movement will be the
other way around i.e. price comes down to 80 the price of the option strike will be 10Rs and above 90
the price at the end of the month will be zero .In India all futures and options contract expire on the last
Thursday of the month (stock market)

AMERICAN OPTION & EUROPEAN OPTION

In finance, the style or family of an option is a general term denoting the class into which the option
falls, usually defined by the dates on which the option may be exercised. The vast majority of options
are either European or American (style) options. These options - as well as others where the value is
calculated similarly - are referred to as "vanilla options". Options where the payoff is calculated
differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation
and hedging.

A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined
point in time. An American option on the other hand may be exercised at any time before the expiry
date.

EXERCISING AN OPTION:

In Options Trading, exercising an option means to enforce your rights to buy the underlying stock if
you are holding call options or to sell the underlying stock if you are holding put options. When you
exercise a call option, you will buy the underlying stock at the strike price of the call option. For
instance, if you exercise 1 contract of a 90strike price call option, you would buy 4000 shares of the
underlying stock at 90no matter what price it is at the time of exercise. This price is known as the
"Exercise Price". When you exercise a put option, you will sell your shares at the strike price of the put
options. For instance, if you exercise 1 contract of 90 strike price put option, you would be selling
4000 shares of the underlying stock at 90 no matter what price it is at the time of exercise. If you do
not have the underlying stock, you will end up with a short stock position. That's right; you cannot
exercise an option unless you are the holder of a long position. If you are short an options contract,
you cannot exercise the option.
The above concepts are the basic concepts and are the foundation for a individual who intends to
understand and trade in options.

Gambling:

It’s a basic argument which I’ve been hearing that trading in stock market is like gambling. I’ve seen
people hesitating to enter stock markets for this very belief but is option trading a gambling? no not at
all, if someone’s answer is yes then he should consider even the normal buying and selling also as a
gamble because the same good is sold at different price to different people which means the seller is
taking a chance or assuming that every other customer will buy this product at so and so price. When
the very notion of trade stands on the base of gambling why hesitate trading in options? Expecting your
feedback on sushilkumar811@gmail.com. Technically yours Sushil Kumar.