Introduction
Before we get into option trading strategies and all the technicals, let’s talk about the basic definition of options and why they even exist in the first place. So what are the Options?
What are the Options
Options contract that you can purchase gives you the right to buy or sell stock at an agreed price on or before a particular date.
You can also sell an option contract to sell this right to someone and collect a premium for it.
Okay, I’m sure that sounded confusing, especially if this is new to you but bear with me as we get through a few more definitions.
Once we get through these definitions, we’ll be able to show you some examples, and it will all start to make sense but go ahead and take notes and write down these definitions so you can refer back to them during the rest of this article you need to.
Different Type of Options
There are two types of Options:
- Calls
- Puts
A CALL option gives the option holder the right but not the obligation to buy shares of stock at an agreed-upon price on or before a particular date.
A PUT option is the same thing, except it gives the option holder the right to sell shares of stock at an agreed-upon price on or before a particular date.
And the agreed-upon price is what we refer to as the strike price, and the specific date is what we refer to as the options expiration date.
Now we got those out of the way, but in layman’s terms, let’s say you bought a call option, so you are the option holder, and the strike price of this call option is 120, and it expires in 30 days.
Owning this Call option will allow you to purchase the stock at 120 anytime during the next 30 days— no matter where the stock goes.
So if the stock goes up to 135 within the next 30 days, fortunately, you own a call option that allows you to buy the stock at 120, even though the stock is currently trading at 135.
Instead of a call, let’s say you purchased a put option with a strike price of 120 that expires in 30 days.
This will allow you to sell the stock at 120 anytime during the next 30 days, no matter where the stock goes.
This is cool because what if the stock tanks down to 100 per share.
Well, you own a put option that gives you the right to sell stock at 120. Even though the current market value is 100, you have a much better sale price than if you were to sell stock at the current market value.
Okay, simple enough, but why does someone want to purchase an option?
First, we will explain why you might want to buy a put option.
Which, if you remember, would give you the right to sell stock at a specific price on or before a particular date, and let’s put this in terms anyone can understand.
Let’s say you just bought your dream car, you just bought a new Ferrari, and to protect this Ferrari, you’re going to need insurance, so you go to the policy bazaar and purchase insurance.
Insurance financially protects your new Ferrari if you get into any problem such as accident, theft, etc., So this is somewhat similar to the concept of options.
Now instead of a car enthusiast, let’s say you were an investor and you just bought 100 shares of ABC stock at Rs 125 per share; the total cost of this investment is RS 12500.
We all know that stock prices fluctuate, and stocks can even go to zero if something catastrophic happens.
So your entire risk on this investment is technically Rs twelve thousand five hundred.
Like we purchased insurance on the Ferrari, we can also buy insurance on this investment.
We would do this by buying an option contract specifically; we would buy a Put Options in this example.
By definition, purchasing a put option gives us the right but not the obligation to sell stock at an agreed-upon price on or before a particular date.
Now, let’s recap your stock. You want to buy insurance on that stock investment, so you buy a put option simple enough right now.
If you purchased an option, someone had to have sold it to you, but the answer is any other trader willing to be paid to take on your risk, just like an insurance provider.
That’s the basic idea of options an investor has risk. Still, he’s ready to pay someone to take away his chance, and the person who gets paid now assumes that investor’s risk.
Now let’s look at a real example. You bought Rs twelve thousand five hundred worth of ABC stock, and you also purchased a put option as insurance.
Several factors will determine the price of this insurance, and you’re going to learn about these factors later in the article.
For now, let’s say you had to pay Rs five hundred for these PUT options, and this gives you full coverage insurance for the next 30 days.
Now let’s look at two different scenarios in the first scene; after you buy the stock and the PUT option, the stock price goes from Rs 125 per share up to Rs 132 per share, so you made Rs seven per share on 100 shares of stock.
That total to a profit of Rs seven-hundred on the stock you own but remember you also paid five hundred dollars for an option contract that now has no value to you, so your net profit is only two hundred dollars.
You’re probably saying what a rip-off, and the person who sold you the option is saying thanks for the easy money because they got to keep the 500 you paid them.
But let’s look at another scenario now; In this scenario, rather than the stock price going up, let’s say the stock price goes down to Rs 113 per share.
Hence, the stock’s share price is now Rs 12 lower than where you initially bought it, and since you own 100 shares, that means you’ve lost Rs twelve hundred.
Still, thankfully you bought a put option as insurance. Now you go to the person who sold you the option and said, hey, remember our contract.
Even though the stock is at 113, you can exercise your option to sell your shares at 125 per share, so you lost nothing on the stock.
Your only loss in this scenario is the 500 you paid for the put option, much better than the Rs twelve hundred that you would have lost if you did not purchase this option contract.
Now, remember the person who sold you the option agreed with you that they were obligated to purchase your shares from you at 125 dollars per share, so they got to keep the 500 you paid them for the put option.
So will; they are now sitting on a 1200 loss on their stock.
Now they can hold the stock and hope it goes back up, or they can sell it at the current market price of 113 for a total net loss of 700, so that’s all options are.
Guys, they are simply insurance for an investor.
That’s why they exist in the first place, so that a few thoughts may be running through your head at this point.
You might be saying, but I don’t want to buy insurance on my stock portfolio.
Maybe you don’t even own any stocks, and you’re hoping to learn options strategies that you can trade with very little capital without ever even touching the stock.
You can, and that’s the cool thing about options you don’t have to own stock to trade them;
You can trade the fluctuating option prices with your brokerage account like you can trade stock.
Still, we just had to lay the framework because understanding how options relate to insurance is crucial for knowing how options are priced, which we will cover in my upcoming article.
Okay, you get it by now buying a put option is like buying insurance on a stock investment, and selling a put option is like selling insurance on a stock investment.
But let’s look at another reason one might want to buy an option.
This time we’re going to explain to you why you might want to buy a call option this time; let’s say you don’t own any shares of stock yet, but you have your eye on a stock that you like;
There’s just one problem that stock is expensive, so if you were to buy shares, it would require a lot of capital.
What you could do instead is you could buy a call option.
This would allow you to pay a small premium for the right to purchase shares at a later date if perhaps you are correct about the stock.
The price goes higher, so let’s look at a real example stock XYZ is currently trading at Rs 125 per share.
To buy 100 shares of the stock would cost us Rs 12500, instead of putting up Rs twelve thousand five hundred to buy the stock.
Instead, let’s buy the 125 strike call option that has 30 days until it expires.
To give us the right to purchase 100 shares of stock at 125 per share anytime during the next 30 days.
The price we have to pay for this call option will be determined by several factors that you’re going to learn about soon but for now, let’s say we had to pay Rs hundred for this call option.
Let’s look at two scenarios.
In the first scene, after you buy the call option, the stock goes from 125 up to, let’s say, 137.
Now you own the 125 strike hall option; what you could do now at this point is exercise your call option.
Exercising your option means that you have decided to take advantage of your rights to buy the stock at a lower price.
So, in this case, you exercise your 125 strike call option; you now own 100 shares of stock at 125.
You are up 12 points on this stock.
Since you own 100 shares of stock, this means you’re up to Rs twelve hundred but remember you paid Rs five hundred for the call option, so your net profit is only Rs seven hundred.
Now you might be thinking, well, if I had just bought the stock, to begin with, I would have made more money.
Yes, this is true but let’s quickly look at one more scenario.
I like this scenario; the stock goes down.
I move down to, let’s say, 100 per share. Now, remember you own the 125 strike call an option that you bought for 500, and this call option gives you the right to buy the stock at 125 per share.
But why on earth would anyone want to purchase stock at 125 if the stock is currently at 100?
The answer is you wouldn’t, and thankfully you don’t have to.
Let’s think back to the definition of a call option; it gives you the right but not the obligation to buy stock, so owning this call option doesn’t require you to buy the stock if you don’t want to.
Of course, you aren’t going to exercise your right to buy the stock
at Rs 125 if the current market price is cheaper than that, so in this case, you lost the premium, you paid for the option, which was 500.
You had bought the stock at 125.
Instead, you would currently be down 2500, so that’s the benefit of buying an option.
Rather than just buying the stock, you can put up much less capital and therefore have much less risk, but you will have to pay a premium for it in exchange for that.
And by the way, you can trade put options in this way.
If you buy a put option without already owning shares of a stock, you are simply betting that the stock will go down because if you exercise your right to sell stock that you don’t own, you will end up with a short stock position.
So again, if you buy a call, you are betting that the stock will go up, and if you buy a put, you are betting that the stock will go down.
Now before you go out and start buying calls on every stock you think is going to go up and puts on every stock you think is going to go down, keep watching because there are big negatives to buying options like this, and of course, we are going to show you much better ways to trade options.
Conclusion:
One last note, before moving on, you don’t have to exercise your option contracts when you trade them.
As we showed you in the examples, you can buy an option and then sell it hopefully at a higher price than you bought it for.
We will cover that more in my next article, so alright, guys hope you enjoyed the articles and are staying safe out there.
You can go through my other article as well
Psychology Of Money | Morgan Housel | Book Summary – FINANCE-BHARAT (financebharat.in)
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