Options trading in India is financial contracts struck on the trading floor of a stock exchange or by phone in which one party bets that a stock’s price will go up and another party bets it will go down. If you’re right, you win money from the other side. If you’re wrong, well, this is why they call them options, not guarantees.
The two parties in options trades
The two parties are a buyer and a seller. For example, suppose you think Apple stock is about to fall precipitously in value soon but still believes there’s sufficient upside potential. In that case, you could buy an out-of-the-money put from someone who feels the share price will rise when purchasing it at $500 when its current market price is $600. If shares become cheaper, you could exercise your option to sell them at $500. The other trader is on the hook to buy the stock from you, minus the difference between its current market price and that strike price which is their loss. Essentially this would limit your loss exposure while giving you some upside potential.
Options are everywhere
Not just in investing but also in our daily lives. For example, you have an option to watch TV or read a book when it’s your turn to do the dishes, pick up an apple or snickers bar for dessert after dinner tonight, or even walk out of a bad movie. You may perceive these decisions as trivial, but they’re examples of how options work in real life!
While there are many options, we can broadly categorise them into four main types. These are:
Call Option
This option allows you to buy an asset at a fixed price until the expiration date. It is out-of-the-money when the stock price is less than the strike price and considered in-the-money when it’s greater or equal to the strike price. A call option also includes another feature that allows you to extend its life if you want to by exercising it at any time before expiration, thus allowing more time for the underlying asset to move in favour of your bet.
Put Option
A put option gives you the right but not obligation to sell an asset at a fixed price up until the expiration date. It is out-of-the-money when the stock price is more than the strike price and considered in-the-money when it’s less or equal to the strike price. Like call options, put options also include an extendable life feature that lets you keep it alive for as long as you want to be provided you don’t sell it to someone else.
Futures
It is a legally binding agreement between two parties to buy or sell an asset at a fixed price on a specific date in the future. Futures contracts are often used by companies who need to purchase goods or raw materials in the future but want to lock in a reasonable price today. They can also be used by speculators who want to hedge against changes in the market price of an underlying asset.
Swaps
It is when two parties agree to exchange specific cash flows preceding the termination of the contract at a later date. These cash flows are usually periodic interest payments or receipts but can also be in terms of floating-rate costs that alternate every six months based on some predetermined schedule.
One party makes fixed-rate payments while the other makes floating-rate ones until they meet in the middle when one switches to paying off floating while receiving fixed, and vice versa. The most common example would be improving your variable mortgage rate for a period while having someone else pay you what your home’s current market value is every month.
In conclusion
If you’re a novice trader in India we strongly advise you to sign up for a demo trading account on a reputable brokerage platform first. It will allow you to test various trading strategies before investing real money.
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