Options trading allows you to buy or sell stocks, ETFs, etc. at a specific price within a specific date. This type of trading also gives buyers the flexibility to not buy the security at the specified price or date.
While it is a little more complex than stock trading, options can help you make relatively larger profits if the price of the security goes up. That’s because you don’t have to pay the full price for the security in an options contract. In the same way, options trading can restrict your losses if the price of the security goes down, which is known as hedging.
Basics of options trading :
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset. The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Options emerged as a financial instrument, which restricted the losses with a provision of unlimited profits on the buy or sell of the underlying asset.
Options may be categorized into two main types:
- Call Options
- Put Options
Option, which gives the buyer a right to buy the underlying asset, is called the Call option and the option which gives the buyer a right to sell the underlying asset, is called the Put option.
Options trading terminology :
1.Premium -The price that the option buyer pays to the option seller is referred to as the option premium.
2.Expiry date – The date specified in an option contract is known as the expiry date or the exercise date.
3.Strike price – The price at which the contract is entered is the strike price or the exercise price.
4.American option – The option that can be exercised at any date until the expiry date.
5.European option – The option that can be exercised only on the expiry date.
An understanding call option trading with an example :
Rajesh purchases one lot of Infosys Technologies May 3000 Call and pays a premium of Rs250. At this time the share price was 290.
This means, under this contract, Rajesh has the right to buy one lot of 100 Infosys shares at Rs 3000 per share any time between now and the month of May. He paid a premium of Rs 250 per share. He thus pays a total amount of Rs 25,000 to enjoy this right to sell.
Now, suppose the share price of Infosys rises over Rs 3,000 to Rs 3200, Rajesh can consider exercising the option and buying at Rs 3,000 per share. He would be saving Rs 200 per share; this can be considered a tentative profit. However, he still makes a notional net loss of Rs 50 per share once you take the premium amount into consideration. For this reason, Rajesh may choose to actually exercise the option once the share price crosses Rs 3,250 levels. Otherwise, he can choose to let the option expire without being exercised.
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