Options are financial instruments that give investors flexibility, protection, and profit opportunities in the stock market. While often considered complex or risky, options can actually be very effective tools for managing risk and taking advantage of market movements—if used with the right knowledge and discipline.
What Are 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. Since this is a right without an obligation, the buyer pays a premium to the seller.
There are two basic types of options:
- Call Option – The right to buy the asset.
- Put Option – The right to sell the asset.
The value of an option is primarily determined by the price movement of the underlying asset and the time remaining until the option expires.
Understanding Call and Put Options
A call option allows the buyer to purchase a stock at a fixed price (called the strike price) within a specified time. A put option allows the buyer to sell a stock at the strike price within a specific period.
Example:
- If Reliance Industries is trading at ₹960 and you expect it to rise to ₹1000, you can buy a ₹980 call option for ₹4.
- If the stock reaches ₹1000, the value of that option may increase to ₹20 or more.
- You can then sell the option and book a profit.
Similarly, if you expect the price of a stock to fall, buying a put option lets you profit from the price drop. In both cases, your maximum loss is limited to the premium paid, while potential gains can be much higher.
In-the-Money (ITM) vs Out-of-the-Money (OTM) Options
Understanding ITM and OTM is crucial in options trading:
- Call Options:
- ITM – Strike price is below the current market price.
- OTM – Strike price is above the current market price.
- Put Options:
- ITM – Strike price is above the current market price.
- OTM – Strike price is below the current market price.
Example:
If SBI is trading at ₹260:
- ₹250 call is ITM.
- ₹270 call is OTM.
- ₹270 put is ITM.
- ₹250 put is OTM.
Intrinsic Value and Time Value of Options
An option’s price is made up of two parts:
- Intrinsic Value – The real, in-the-money value of the option.
- Time Value – The additional value based on time left until expiry.
Example:
If SBI is at ₹260 and a ₹250 call is trading at ₹14:
- Intrinsic Value = ₹10 (260 – 250)
- Time Value = ₹4
OTM options have only time value. As the expiry date approaches, time value reduces and can even drop to zero.
When to Buy Call or Put Options
- Buy Call Options when expecting the stock price to rise.
- Buy Put Options when expecting the stock price to fall.
While OTM options are cheaper, they consist entirely of time value, which declines as expiry approaches. This means timing is very important when selecting which option to buy.
Understanding Option Expiry
In India, stock and index options expire on the last Thursday of every month. Contracts are available for:
- 1-month
- 2-month
- 3-month durations
Bank Nifty and a few other indices also offer weekly options.
When to Sell Call and Put Options
Option selling involves collecting premium by taking a contrarian view to the buyer:
- Call sellers expect the stock to stay below a certain level.
- Put sellers expect the stock to stay above a certain level.
Option sellers have limited potential profit (the premium received) but unlimited potential loss if the market moves against their position. Hence, stop-losses are critical for option sellers.
Using Options for Trading
In India, options are typically cash-settled on expiry day. However, most traders square off (reverse) their positions before expiry to book profit or reduce loss.
Options are liquid in popular stocks and indices, making them easy to enter and exit.
Using Options to Hedge a Portfolio
Options are excellent tools for risk protection. Suppose you hold Tata Motors shares at ₹345:
- You can buy a ₹340 put option at ₹3.
- Your effective cost is ₹348.
- Even if the stock falls to ₹250, the maximum loss is only ₹8.
This strategy is called a protective put, and it acts like insurance for your holdings.
Using Options to Reduce Cost of Holding
If you’re holding a stock for the long term, you can sell higher strike price OTM call options every month. This strategy, known as covered call writing, helps you earn additional income and reduce the cost of owning the stock.
While it limits upside beyond the strike price, the downside risk remains unless separately hedged.
Do Option Buyers Make Money
Globally, it is estimated that around 80% of option buyers do not make consistent profits. This is mainly because many options are bought for hedging, not for trading. Also, most successful trades come from experienced sellers who understand pricing, volatility, and time decay.
Still, options can be profitable when used wisely for both trading and hedging.
Final Thoughts
Options are powerful financial instruments. When used correctly, they help in risk management, profit generation, and portfolio protection. However, they require a solid understanding of how they work, especially regarding time decay, strike selection, and market outlook.
Investors should start with basic strategies and gradually progress as their confidence and knowledge grow.
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