Basics of Options Trading

Simply put, as the name suggest, Options give you options!

While we all now know that a Futures Contract moves in line with the underlying asset, it leaves you obligated to fulfil the terms of the Contract on the date of expiry. But what if, in the interim, the situation had changed drastically and you wish to have a more flexible alternative that can be traded on the Exchange and also provide similar benefits?

That is what an Options Contract provides you with an alternative. When you enter into an Options Contract, you are simply buying a choice of possible future action. This choice allows you to lock in a fixed price while maintaining the ability to forego the Option in order to take advantage of favourable price movements, should they occur.

Thus, an Options Contract gives you the right but not the obligation to buy or sell the concerned asset at a predetermined price within or at end of a specified period. Should you wish to buy the asset at the end of the specified time period, the Buyer or Holder of the Option, would then have to purchase the right from the Seller or Writer for a consideration known as a premium. The Seller is then obligated to settle the Option as per the terms of the Contract or when the Buyer exercises his right to buy.

There are different kinds of Options Contracts that an investor can enter into. A Call Option is a Contract gives you the right but not the obligation to buy the Contract while a Put Option is a Contract gives you the right but not the obligation to sell the Contract at a fixed price (Strike Price) at any time on or before a given date. A Call Option is akin to taking a long position on a stock while a Put Option is similar to going short on your market position. 

An Options Market has its own unique set of players- Buyers and Sellers of Calls and Buyers and Sellers of Puts respectively. Buyers are also known as Holders while Sellers are considered to be Writers. Buyers are not obligated to buy or sell, they can choose not to while Sellers have to make good on their promise to buy or sell at the end of the Contract period.

Each Option is purchased at a Premium which needs to be paid irrespective of whether the Contract is exercised on or not. You can consider the Premium to be a price that you pay to exercise Options in the Derivatives Market. The Premium Payable would differ depending upon several factors including price of stock, time left for Contract expiry and current volatility prevalent in the markets.

As in the case of Futures Contracts, Option Contracts can be also be settled by delivery of the underlying asset or cash. However, unlike Futures, cash settlement in the Options Contract includes the difference between the Strike Price and the price of the underlying asset either at the time of Contract expiry or at the time of exercising the Option. The Strike Price here is defined as the fixed minimum price at which you can purchase or sell the asset in question in an Options contract.

The Strike Price is also known as the Exercise Price and is considered a key variable in an Options Contract between two parties. As and when the underlying asset is delivered, the trade takes place at the Strike Price, regardless of the Spot or Market Price of the underlying instrument at that time.

One term that you will hear in an Options market is “Moneyness”. Moneyness describes the relationship between the Strike Price of an Option and the current trading price of its underlying security. When the settlement of the contract is vide cash, the difference between the Strike Price and the Spot Price determines the "Moneyness" of the Contract. The Moneyness of the Contract is described as follows-

• A Call Option is in-the-money if its Strike Price is below the Market Price of the asset it represents while a Put Option is in-the-money if the Strike Price is above the                 stock’s Market Price 

• A Call or Put Option is at-the-money if the price of the stock and the Exercise Price are the same 

• A Call Option is out-of-the-money if the Strike Price is above Market Price while a Put Option is out-of-the-money if the Strike Price is below Market Price of the                      underlying stock

Options offer flexibility as they allow you to adjust your market positions according to any situation that does or is expected to arise. Thus, Options let you be as speculative or as conservative as you choose allowing you to both protect your investment in the market and also play the markets by anticipating future market movements.