Suppose a share is available at 100 bucks and one bets one's money on the cost of the share going up. In such a scenario he buys, say 100 shares for which he has to invest 10,000 bucks. Now suppose the stock gained by 25% and the owner sold it at 125 bucks he would have made a cool profit of 2,500 bucks. But if instead of buying and selling the shares, if one were to trade an option, the profit derived out of putting the same amount of money on exiting the trade at 125 bucks on the hundred buck stock will yield a manifold profit. Here is how it works. But first one ought to understand what exactly an option is.
An option is a contract by which the buyer of the contract (i.e option) has the right to buy or sell a specified number of shares at a specified price on a particular date. But he is under no obligation to buy or sell. In other words he is under no compulsion to buy or sell.
There are two types of options available in the stock market. Call option and Put option.
Let us explain a bit more. It is important to get the concept.
Let us explain a bit more. It is important to get the concept.
A Call option of a share is a contract, the buyer of which has the right to buy specified quantity of the share at a specific price. But he has the choice to not to buy the shares if he does not want to buy.
Every month there is a settlement date which happens to be on the last Thursday of every month in India. On the last Thursday of a month the options of that month expire. It is on this day that the buyer of an Option my choose to buy (or not to buy) the underlying share of the contract.
Let us assume that there is a company GAMBIT-GAMEIT listed in the stock exchange and that its Options too are available in the exchange.
Suppose you think that the cost of the share is likely to go up to 125 bucks till the settlement date. So if today you enter into a contract wherein you agree to buy say 100 shares of GAMBIT-GAMEIT at 100 bucks on the settlement date, i.e. on the date on which the contract expires, then you can buy 100 shares at 100 bucks on the date of expiry and sell them at 125 bucks the same day collecting a cool 2,500 bucks per option.
But herein lies the catch. The contract or option is between two people. The seller of the contract, called Option writer, sells the contract at a price called 'ask price'.
The price at which the contract got bought in the exchange goes to the Option writer.
The price at which the contract got bought in the exchange goes to the Option writer.
Every share's options have a specified strike price. The strike price of the option in our example is 100. The strike price of a call option is the specified price at which the buyer of the contract has the right to buy the underlying share.
The option is traded in the stock markets just like the shares with ask and bid prices. Bid price is the price that the prospective buyer of the option is willing to pay to the seller for the option.
Now let's say the Call option of our underlying scrip GAMBIT-GAMEIT of strike price 100 bucks is available at a price of 2 bucks. Lets assume that one lot of Call option of the scrip consists of 100 shares then the buyer of the GAMBIT-GAMEIT Call 100 will pay 200 bucks to the seller. Now if the share price goes up to 125 bucks then you will have received 2,500 bucks by exercising the option and buying at 100 while selling at 125 on the same day i.e. the settlement date. But as you had put in only 200 bucks while buying the contract you gain 2300 bucks (2500-200) which in percentage terms is many fold. If you had bought the stock for 10000 bucks you could have bought only 100 stocks whereas if you had bought Call options for 10000 bucks you would have bought 50 contracts for the same amount. That is the power of options.
Now suppose the stock did not trade above your strike price and in fact slipped down to 90 bucks then the maximum amount you loose per contract is 200 bucks.
Thus your profits can be unlimited while loss is limited.
However, it is only in theory that the owner of stock call option buys at strike price and sells at actual price. In practice one buys and sells Options just like shares. If the price of a share increases, the the price of the Call Option too increases and one sells the option he had bought earlier and makes handsome profits. On the other hand the loss is limited to the cost of the option which is very small in comparison to the cost of the underlying share. Options are also available for index. One may click on the following link to see the bid and ask price of Call and Put Options of the index 'Nifty' of expiry date 26/12/2013 as on 13/12/2013.
Option Chain of Nifty
We will explain Put Options in a subsequent article. (Click here for part II - Put Option)
If the followers of this blog have not traded options, they are advised not to trade in options till they become well versed. We will be publishing more of such tutorial posts and will advice the followers to start trading only after we have finished this series.
However, it is only in theory that the owner of stock call option buys at strike price and sells at actual price. In practice one buys and sells Options just like shares. If the price of a share increases, the the price of the Call Option too increases and one sells the option he had bought earlier and makes handsome profits. On the other hand the loss is limited to the cost of the option which is very small in comparison to the cost of the underlying share. Options are also available for index. One may click on the following link to see the bid and ask price of Call and Put Options of the index 'Nifty' of expiry date 26/12/2013 as on 13/12/2013.
Option Chain of Nifty
We will explain Put Options in a subsequent article. (Click here for part II - Put Option)
If the followers of this blog have not traded options, they are advised not to trade in options till they become well versed. We will be publishing more of such tutorial posts and will advice the followers to start trading only after we have finished this series.
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