What is options trading?

Options are contracts that grant the holder the option, but not the obligation, to purchase or sell a certain quantity of an underlying asset at a predetermined price at or before the contract’s expiration. Options trading can help you make significantly higher profits if the price of the security increases, despite being a little more complicated than stock trading. This is so that you can buy a security in an options contract without having to pay the whole amount. Hedging is the process of using options trading to limit losses in the event that the price of the security declines.

Decoding Options in Simplest Terms

There are two different kinds of options: call and put. You have the option of buying or selling these choices. Your actions affect how the P&L profile looks. Of course, we’ll talk about the P&L profile much later. Let’s first define what “The Call Option” means.

Think about this scenario:

Avinash and Karan are two close buddies. Avinash is actively weighing the possibility of purchasing an acre of land from Karan. The worth of the land is Rs. 800,000. Avinash has been advised that a new roadway project is most likely to be approved next to the property owned by Karan within the next six months.

Avinash would profit from the investment he would make today if the motorway is built since it is likely to improve the value of the property. Avinash would be stuck with a useless plot of property if the “highway news” turns out to be untrue, meaning he would purchase the land from Karan today and there would be no roadway tomorrow. So what is Avinash supposed to do? Avinash wants to be cautious, so he ultimately suggests to Karan a unique, organised arrangement that he believes would benefit both of them. The specifics of the agreement are as follows:

1. Avinash makes a one-time payment of Rs. 50,000 today. Consider this to be Avinash’s
non-refundable agreement fee.

2. In exchange for such fees, Karan consents to sell the land to Avinash after six months.

3. The selling price, which is anticipated to take place in six months, has been set at Rs.
800,000.

4. Only Avinash may cancel the agreement after six months since he paid an advance fee;
Karan is unable to do so.

5. If Avinash cancels the agreement after six months, Karan keeps the initial costs.

After starting this deal, Avinash and Karan must now wait the next six months to find out what will truly occur. It is obvious that the cost of the land will change depending on how the “highway project” turns out. However, there are only two scenarios that might occur regardless of what happens to the highway:

● The cost of the land would increase once the highway building was underway, maybe
soaring to Rs. 10,00,000.

● People are dissatisfied when the highway project is abandoned and the price of land
drops to, say, Rs. 500,000.

Let’s see what happens in each scenariosScenario 1: The price increases to Rs.10,00,000.

The price of land has increased since the highway project happened as Avinash had anticipated. Keep in mind that, according to the contract, Avinash has the right to terminate the relationship after six months. It is obvious that Avinash will benefit from the sales dynamics.

The land is now being sold for Rs.10,00,000.

Value of the Sale Agreement: Rs. 800,000

As a result, Avinash now has the option to purchase a plot of land for Rs. 500,000 even though it would normally sell for Rs. 10,000 on the free market. Avinash is definitely getting a great deal here. He would thus demand that Karan sell the land to him. Karan has a duty to sell. How much money does Avinash now make? Here is the math, though:

Purchase Price: Rs. 8,00,000

Agreement Fees = Rs. 50,000 (remember this is a non refundable amount)

Total Cost = (8,00,000 + 50,000)/-

The land’s current market value is Rs. 10,00,000.

His profit is thus Rs. 10,00, 000 – Rs. 8,50, 000, or Rs. 1,50,000.

Avinash is currently earning 3 times as much for Rs. 50,000 initial cash commitment!

Scenario 2: Price drops to Rs. 500,000

It turns out that the highway project was really a rumour, and nothing significant is truly anticipated to come of it. The cost of the land is reduced to Rs. 500,000 as a consequence. He would back out of the contract since it is obvious that buying the land is not a good idea.

Keep in mind that the sale price was set at Rs. 800,000/- six months ago. Therefore, if Avinash needs to purchase the land, he will need to pay Rs. 800,000 in addition to the Rs. 50,000 he already paid for the agreement costs. This implies that he is effectively spending Rs. 8,50,000 to purchase a plot of property that is only worth Rs. 500,000. Avinash would obviously not understand this as he has the right to cancel the contract and would just refuse to purchase the land. But take note: Per the deal, Avinash must lose Rs. 50,000, which Karan keeps.

Options Related Terms

Now, let’s relate the aforementioned scenarios with stock market terminologies-

The payment made by Avinash to Karan assures that Avinash has a right (keep in mind that only he has the authority to cancel the agreement) and Karan has a duty (if the circumstances call for it, he must uphold Avinash’s claim). This initial payment is known as Premium. The ‘premium’ is a fixed sum that the contract’s owner must pay in order to have the right to exercise an options trade

The land is referred to as an Underlying Asset. The cost of the land will decide how the agreement turns out when it expires (at the end of six months). Without the land, the contract is worthless. Thus, the arrangement is referred to as a derivative and such a contract is known as an Options Agreement. As a general rule, the buyer always has a right and the seller always has a responsibility under an options agreement.

Karan is referred to as the “agreement seller or Writer” and Avinash is referred to as the agreement buyer” because Karan got the advance from Avinash. Each and every variable in the agreement, including the price and the sale date, is fixed.

Advantages of Options

Now that we are aware of what options are, let’s examine some of their benefits.

Risk hedging:

Options are a great tool to safeguard your stock holdings. Purchasing options really reduces your exposure to risk by purchasing like insurance for your stock portfolio. When a call option expires, it is worthless and you lose all of the money you paid up front if the price of the underlying securities has not increased over the strike price.

The highest level of your risk, however, is determined by the premium you ultimately pay. See in the example, if the price of a security falls to Rs 80 from a strike price of Rs 100, you would have lost Rs 20 per share. With the alternative, you only lose the substantial premium sum.

Low Cost of Entry

Compared to stock transactions, the primary benefit of options is that it enables the investor or trader to take a position with a smaller sum of money. When purchasing actual stocks, you must fork over a large chunk of money, which is equal to the price of each stock multiplied by the quantity of stocks purchased.

The alternative is to purchase call options on the same stock, which will be considerably less expensive. However, you would profit in the same amount as if you had paid money to buy the actual stock if share prices rose in the manner you had forecast. You would have to spend less money in this situation.

Flexibility

The flexibility of trading options allows the investor to take advantage of any short term change in the underlying security. An investor can employ an options strategy as long as he has a prediction for how the price of a security will change in the near future. An investor can purchase a call option and set the price of the asset at a specific level if he believes that the price of the security is likely to increase. He can buy the securities at the strike price and then sell them at the market price to benefit if the price of the underlying security increases.

Disadvantages of Options

Complicated

Options are a difficult investment strategy for new investors. Even for experienced investors, buying options can be a difficult proposition. On the price movement of a specific asset and the time by which this price movement will occur, a decision must be made. It can be difficult to get both right.

High Risk

As we have shown, the risk associated with options is only the option premium. An investor, however, risks losing their whole option premium if the price movement of the investment is unfavourable. Options Trading has gained more and more popularity recently among ordinary investors. Investors should make sure they completely grasp the potential consequences before entering into any options positions due to their potential for disproportionate gains or losses. Devastating losses may result from failure to comply.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

Note – This channel is for educational and training purpose only & any stock mentioned here should not be taken as a tip/recommendation/advice

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