How to trade in options

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. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. In the case of stock trading the underlying asset are the shares of a company or the indexes.

First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. This is called as the premium paid for buying the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our case, the shares of a company or index are the underlying assets.

Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market. There are four types of participants in options markets depending on the position they take:

1. Buyers of calls 2. Sellers of calls 3. Buyers of puts 4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers: -Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. -Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. We will look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

The Lingo

To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in the money if the share price is above the strike price. A put option is in the money when the share price is below the strike price. The amount by which an option is in the money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this article.

To better understand the terms an example is given below:

Let us take the shares of ONGC. An option contract will be as follows

The Strike Price Rs.1400
Trading lot 225 shares
Expiration Date 27/Aug/2009 (last Thursday of the month)
Premium Rs.50 per shares
Current Price Rs.1300

The current market price is Rs.1300/- you expect the price to still further. So you buy a call option for 225 shares at a strike price of Rs.1400/- expiring on 27/Aug/2009. The price you will pay for this is the premium for 225 shares. That is 225 x 50 = Rs.11250/-

If the prices go up the premium also will go up. If the prices go down the premium will also go down.

You can hold on till the expiry date or sell it of before that.

After you bought the call options market can move in two directions. The price of ONGC shares can go up or come done.

If the price of ONGC goes up as expected by you to Rs.1500, then in option terminology it is called as in the money. It is because the market price is above the strike price and you are holding a long position.

If the price of ONGC goes down to 1200 then you are out of money. The market price is below the strike price and you are holding a long position.

If you are in the money and you expect the price to still go further then you can wait till the expiry date. On the expiry date if the price is Rs.1600 you will get a settlement amount of 200 x 225 = 45000. You will make a net profit of 45000 – 11250 = 33750 (11250 is the premium that you have already paid).

If you are in the money and you expect the price to not rise further and remain around 1500. You can sell the call option at the prevailing premium. Say if the market price is around 1500 and the premium is 150 per share, you will get an amount of 33750 – 11250 = 22500.

If the prices falls and you allow the contract to expire you loss will be the premium that you have paid.

The important feature of options is the extent of loss is limited to the premium that you pay and the opportunity to make a profit is unlimited.