What are Options?

Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details

Options are a type of contract between buyer and seller to buy or sell certain number of stocks at an agreed price.

Lets assume if you hold 1000 quantity of Infosys shares and they are trading at Rs 1000 and I agree with you to buy them at Rs 1000 after a month. With this agreement, you are guaranteed a return of at least Rs 1000 on your holdings, if the price fall below Rs 1000, you can ask me to buy those shares at Rs 1000, which would be “exercising the option”, however if price go above Rs 1000, you may not exercise the option.

So with the agreement, you have a guaranteed return, but what do I get for this agreement, so for this agreement, I would charge a premium to you, so that if you do not execute the option, I would keep the premium. This is called the option premium, which is usually the price which you see for any option.

Types of Options

There are two types of options contract, one which allows buyer to sell his/her holdings to the seller of the contract at the determined price, this is called PUT option usually denoted by PE, in this case you are putting your holding for sale at expiration.

The other type of option contract allows buyer to buy sellers holding at a determined price, this is called CALL option usually denoted by CE, in this case you are calling on someone to buy his stocks.

Option Buyers perspective

The buyer of the option is hedging his/her returns by buying an insurance, so if the prices fall they are guaranteed a minimum return for their investment.

Option Sellers perspective

The seller of the option is counting on the possibility that the situation of execution of option is less likely, hence if at the end of expiry, he/she gets to keep the premium amount as profit.

Conclusion

Options were designed to provide hedging opportunity to the big investors, however due to its highly leveraged property it can generate high amount of profit as well as high amount of losses. There are way too many people who look at options trading as “get rich quick” scheme and end up loosing their capital.