Option Trading is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options help you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright. They can also be used to protect yourself from fluctuations in the price of a share and letting you buy or sell the shares at a pre-determined price for a specified period of time.
Terms of Option Trading
The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract.
Strike Price / Exercise Price:
The pre-decided price at which the asset can be bought or sold.
Strike Price Intervals:
These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded. There are at least 11 strike prices declared for every type of option in a given month – 5 prices above the spot price, 5 prices below the spot price and one price equivalent to the spot price.
A future date on or before which the options contract can be executed. Options contracts have three different duration you can pick from:
- Near month (1 month)
- Middle Month (2 months)
- Far Month (3 months)
*Note: Long terms options are available for Nifty index. Futures & Options contracts expire on the last Thursday of the respective months, after that they are considered void.
Lot size refers to a fixed number of units of the asset that form part of a single Future and Option (F&O) contract. Lot size are different for each stock and is decided by the exchange on which the stock is traded. E.g. F&O contract for Bank Nifty have a lot size of 40 shares per contract.
Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.
American and European Option:
The terms ‘American’ and ‘European’ refer to the type of asset in an options contract and when it can be executed.
American options are Options that can be executed at any time on or before their expiration date. European options are Options that can only be executed on the expiration date.
*Note: In Indian Market only European type of options are available for trading.
Types Of Option Trading
As described earlier, Options are of two types, the Call Option and the Put Option.
The Call Option gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. A call option buyer can also be an put option seller.
The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls. A put option seller can also be an call option buyer.