A Quick Introduction to Options Trading

4 Apr 2022  Read 2115 Views

If you are an avid market watcher, like most of the people who visit this blog, you must have heard your friends talking about ‘Futures’ and ‘Options’ that give spectacular returns.

Well, a lot of what you heard is true. Futures and options belong to a class of financial instruments called derivatives. They come with the potential to offer much better returns as compared to equity trading. In equity markets, you make money only when the market goes up but in Options, you can make money even when the market is going down or sideways

Let’s first talk about what Futures contracts are. And then talk about Option contracts.

Understanding Futures contracts

Let’s start with an example:

  • Assume it’s 15-Jan-2021

  • You are a Jeweler and you’re making a deal with a gold importer.

  • The deal is this:

    • After three Months i.e. on 15-Apr-2021 you will buy 5 Kg of Gold from him. 

    • The price at which you’ll buy the gold will be the Current Market Price i.e. Rs. 5000/g (50L/kg). 

    • This makes the contract value 50L/kg * 5kg = 2.5CR

    • This is called a Futures Contract.

      • You are the buyer in this contract

      • The importer is the seller in this contract.

  • Here’s the mindset of buyer and seller

    • You, the buyer, think that the price of gold will increase in this 3-month duration of the contract.

    • The importer, i.e. the seller, is convinced that the price of gold is likely to go down. 

Now that a Futures contract has been made, there can be three possible scenarios:

To put it simply:

  • A futures contract is an agreement between two parties to exchange something, say a stock or a commodity, at a pre-agreed price, which is usually the current price.

  • The buyer in the contract is betting on the price of that asset/commodity going up

  • The seller in the contract is betting on the price of that asset/commodity going down

A key point to note is that this is a binding contract. Both parties are bound by law to honour the exchange agreement on the date of maturity of the contract. This date is known as the ‘expiry date’ of the contract.

While the example above dealt with Gold as a commodity, a futures contract can be created between two parties on pretty much anything. It could be stocks, or as is the most common trading contract, based on the value of a broad-based index like NIFTY. The price of the commodity, stock or index that the contract is based on is called the underlying of the Futures contract.

The National Stock Exchange (NSE) is the largest exchange in India where futures contracts are traded on a daily basis. Trading on NIFTY and BANKNIFTY indices make up the bulk of the futures market by volume.

Understanding Options contracts

In the last section, we explained how Futures work. 

Options were introduced as a “hedging” instrument. Think of “hedging” as insurance. 

When you buy a car, you are afraid of any damage that can happen to it and the cost involved in repairing it. So, what do you do? You buy car insurance, which will cover any damage that can happen to the car.

Similarly in Options, if you are afraid that the price of an underlying (i.e a commodity/stock/index) may fluctuate, you can buy one of two types of options: Call options or Put options to act as insurance for your position.

Before understanding these Options types let's revisit what futures are once more:

  • Let’s say that the State Bank of India (SBIN) stock is trading around Rs.500. You want to buy the stock next month at Rs.500 or lower. You are worried that the price will go up.

  • So, you come to me and say: “I’d like to buy SBI next month from you at Rs.500” 

  • And I say “Deal!”

  • Because you think the price will go up and I think the price will go down we strike this deal.

  • This is a Futures Contract.

  • Note that here, there’s no upfront payment that the two parties exchange.

If SBI goes up you’ll make a profit and if SBI goes down I’ll make a profit. Whatever the scenario, we both will honour the deal. Fairly simple.
After some time you came up with another offer. And said, “I want to buy SBI next month from you at Rs.500 only if I feel like doing it. I may or may not buy from you. But if I want to, you have to give me the stock at 500”.
Let’s see in which case you’ll buy the shares from me at 500 and in which case you will not.

See this table for detail:

SBI Price
in market

Price agreed

Will you Buy from me?

Your Profit

My Loss

480

500

No, as you can buy at a cheaper price from the market

0

0

490

500

0

0

499

500

0

0

500

500

Doesn't matter

0

0

501

500

Yes

1

-1

502

500

Yes

2

-2

510

500

Yes

10

-10

520

500

Yes

20

-20

530

500

Yes

30

-30

You’ll buy the shares from me at 500 only when the price is above 500 rs. 

In case the price is less than 500, why will you buy it from me at 500? You will buy it from someone else in the market at a lower price.

I don’t like the deal as you’ll buy it only when it suits you and you are making a profit. 

Basically loss mera profit aapka

I am about to refuse the deal. But then I gave it a second thought. 

I approach you again with a new perspective saying, 

  • Hey, I am protecting you from the risk and insuring you from losses. 

  • You are an Option Buyer, buying insurance. And I am an Option Seller, selling insurance.

  • As I am protecting you with insurance, I want some compensation. I’ll charge some “Premium”. 

  • Just like LIC, which takes a small premium to insure your life for a huge sum.

In this case, I propose charging you a small amount upfront, say Rs.20 per SBI stock.

You might be thinking why Rs.20? 

This is because I think the SBI will not go above 520 [500 (Price at you want to buy) + 20] till next month. 

  • If SBI is trading below 520 till next month I have no problem.

  • Whether you buy SBI from me or not - the premium is not refundable and that’ll be my earning.

Let’s look at three scenarios of P&L here:

SBI Price next month

Option Buyer's P&L

Option Seller's P&L

510

You’ll buy the stock at 500 from me which you can sell in the market for 510. You'll be making a profit here

 

510-500 = Rs.10 (Profit)

But you already paid a premium of Rs.20

So, 10 - 20 = -Rs.10 (Made Net Loss)

I have to sell the stock at 500 which is worth 510 in the market. I'll be making a loss here

 

500-510 = -Rs.10 (Loss)

But I have received a premium of Rs.20

So, -10 + 20 = Rs.10 (Made Net Profit)

520

You’ll buy the stock at 500 from me which you can sell in the market for 520. You'll be making a profit here

 

520-500 = Rs.20 (Profit)

But you already paid a premium of Rs.20

So, 20 - 20 = 0 (No profit; no loss)

I have to sell the stock at 500 which is worth 520 in the market. I'll be making a loss here

 

500-520 = -Rs.20 (Loss)

But I have received a premium of Rs.20

So, -20 + 20 = 0 (No profit; no loss)

530

You’ll buy the stock at 500 from me which you can sell in the market for 530. You'll be making a profit here

 

530-500 = Rs.30 (Profit)

But you already paid a premium of Rs.20

So, 30 - 20 = Rs.10 (Made Net Profit)

I have to sell a stock at 500 which is worth 530 in the market. I'll be making a loss here

 

500-530 = -Rs.30 (Loss)

But I have received a premium of Rs.20

So, -30 + 20 = -Rs.10 (Made Net Loss)

By the above example, you might have understood two things: 

  1. to make a Profit on the Expiry your stock needs to be below the strike by more than the premium you paid. Our agreed price was 500 and the premium was 20 so to make a profit on expiry SBI needs to go above 520.

  2. whatever is your profit, that’ll be my loss and vice versa.

What we described above was ‘Call options’  - which gives you, the buyer, the right but not obligation to buy from me.

As you can guess, Put options are just the opposite of this: it gives the option buyer the right to sell something at a pre-agreed price on a pre-agreed date. The option buyer is not compelled to sell though.

Options Trading Simplified

Are you feeling overwhelmed by all the information above? If so, we’re here to help.

Option Learning Video Series

If you are a beginner, looking to get a solid start in your options trading journey, head over to the link above. This is Sensibull’s complete free Options learning video course on Youtube. This is a series of videos giving a gentle introduction to the basics of Futures and Options trading that is ideal for beginners. In addition, they also put out daily market analysis videos that will help you understand markets as you start out on your trading journey.

Easy Options

For many people, Options trading is Buy Calls when they think the market can go up and Buy Puts when they think the market can go down. Which is a very bad way to trade Options. There are several other great strategies out there that can increase your profitability and ROI.

Sensibull comes in with a solution to this problem in the form of Easy Options (Our personal favourite). In this feature, a trader needs to only make a prediction regarding the price movement of a stock or an entire index and leave the rest to Sensibull as the platform suggests the best limited-loss strategies to choose based on the trader’s prediction.

Virtual Trading

While the Learn platform is a great start for one’s journey in options trading, theoretical knowledge will only get you so far. Sensibull provides newcomers with Virtual Trading. 

If you are new to the world of options trading and want to learn and practice how they work, Virtual trading by Sensibull is the best platform for you because there is zero risk involved

Virtual Trading allows traders to practise with a wider range of possibilities and is, in all honesty, a lot less tedious than scribbling away with a pen and some paper.

Expert Advice

If you just want to unlock the high returns that options trading offers without having to deal with all the complexities associated with it, Sensibull has great Expert Advisors waiting to help you with that. Click the link above to check them out.

The internet is filled with self-proclaimed experts who claim to make unbelievably large profits in the stock market. What they show you are excel sheets and screenshots of trading accounts that take under 3 minutes to fake. 

This is where Expert Advice on Sensibull is different. You can now follow India’s top-ranked SEBI registered advisors based on their transparent performance, audited and verified by Sensibull. Get live market trades delivered instantly to your mobile with real-time entry, target and stop-loss alerts.

 

About the Author: Deb P Samaddar | 248 Post(s)

Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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