Our last Blog was How to Buy Nifty Index, where we discussed Options as one of the way to trade Nifty. Not too many people are engaged in stock market directly, and a very few of them understand Options Trading. So here we are with Options trading guide from the Beginning.

Before going into today’s world of Option Trading, let me tell you how it started:

Options trading are operative in New York Stock Exchange (NYSE) since 1872-1874. But even before that, there was a Maths Teacher and Astronomer, who predicted huge crop production and price hike, much before harvesting.

So, he decided to buy major chunk of crops, but he has limited amount of funds. To get the maximum out of the amount of money he had, he paid only a token amount to the farmers and get commitment from the Farmers to sell all the crops they harvest at a certain price (which would obviously be lower than the price he predicted). Afterwards, when the price went up, he sold it to other buyers at a higher price and paid off the farmers.

Let’s understand this with figures:

Suppose, the Crops were trading at 1000 per quintal (100 KGs) and he predicted that it would reach to 1200. But he only had 10000 with him. With the amount he had, he could only buy 10 quintal. So he made an agreement with Farmers that he would pay farmers 50 as a token amount per quintal and told them, he would buy all the crops at 1050. If he fails to buy, the token amount remains with farmers and they can sell the crop somewhere else. By this way, he could buy 200 quintal of the crop.

Afterwards, the price went up, he sold the crops to other buyers at 1200 and paid another 1050 to farmers. Here his total cost is 1100 (1050+50). The difference of 100 (1200-1100) is his profit per quintal. Remember, he has bought 200 quintal with the leverage and his total profit is 20000 (200*100). That is 2x or 200% profit on the capital, while the price only went up 20%.

In modern day, this transaction is called ‘Call Option’. In this, there are various terminologies such as, Index Price (Current Price of the Crop), Option Premium, Strike Price, Break-Even, etc.

WHAT IS OPTION PREMIUM?

Option Premium, also called as Option Price, is the amount of money at which contract/ agreement is enter into. In our example above, the Option Premium is 50. It is determined by Market forces such as Volatility, Demand-Supply etc.

CALL & PUT OPTION:

Just as call option is used for Bullish view, Put Option is used for Bearish view. But there is a catch that when you sell option, it becomes vice-versa, so when you sell call options, it is actually bearish view and when you sell put options, it is a bullish view. Call Option is commonly called as CE and Put Option is commonly called as PE.

OPTION BUYING & SELLING:

Just as discussed, both Option types can be bought and sold. The buyer of any option has to pay premium to option seller. Option buying gives right to enter the contract or terminate the contract, however, option seller has to enter the contact, if buyer wants to. If the Buyer terminates the contract, the premium paid will NOT be refunded or given back to the buyer and will remain with the seller.

In our example, call option buyer paid call option premium to the seller at 50 per quintal. Therefore, option buyer will have a right to cancel the contact and in this case premium paid will not be given back.

OPTION CHAIN AND STRIKE PRICE:

Technically called as Options Matrix, it is a series of all the strike prices of a particular expiry, with their Open Interest, call and put premium prices, IV, Bid and Ask - Quantity and Price etc. The photo in cover of the article is Option Chain of 04-Feb-2021 Nifty. Nifty and Bank Nifty Options expire every week on Thursday, while the stock options expire on last Thursday of every Month. The gap between 2 strikes is 50 points in Nifty and 100 points in BankNifty. 

IN THE MONEY, AT THE MONEY AND OUT OF THE MONEY OPTIONS:

The strike price nearest to the last traded price is called At the Money (ATM). The last closing price of Nifty is around 13635.

For Call Options, Strike Prices showing above At the Money is called In the Money (ITM) as we are betting for an up-move. While the strike prices showing below the ATM is called out of the money (OTM).

For put Options, strike prices showing below At the Money is called In the Money as we are betting for a down move and strike prices above At the Money is called out of the money (OTM).

In simple words, If we buy At the Money options, the strike has to be become In the Money for us to become profitable or we buy out of the Money options, the strike has to be become In the Money or atleast At the Money for us to become profitable.

In our example of crops given above, last traded price was 1000 and the strike price was 1050, which is out of the money for the calls. Then the last traded price became 1200. So, the 1050 strike became In the Money.

In the cover photo shown, the white ones are out of money, 13650 strikes Call and Put are At the Money and the rest are In the Money.

HOW MUCH MARGIN IS REQUIRED FOR OPTION BUYING AND SELLING:

When you buy any option, call or put, you only need to pay the amount of (Option Premium*Lot size) of the contract. But when you sell any option, you need to pay the margin calculated on the basis of some percentage of total contact size, which is same as required in Option Selling.

Do we get leverage in Option Buying as we get in Intraday Stock Trading?
The straight answer is no. You can not have Additional Leverage in Intraday Option Buying. You will have to pay all margin as required to trade Intraday or Positional.

The benefit in Intraday Option Trading is that your position will be auto squared off if you forgot to do so.

WHAT ARE THE CHARGES IN OPTION TRADING?

The charges varies from broker to broker, but mostly it is Rupees 15-20 per trade. Some premium brokers charge Rupees 50-100 per trade. Some brokers just take heavy Annual Charges like Rupees 1000-1500 with free unlimited trades facility. Apart from that, there is GST, STT, SEBI Turnover charges and Taxes that is levied on combined turnover at the end of the day.

Personally, I use Zerodha, that charges Rupees 20 per trade, with all charges that would cost you Rupees 25. For buying and selling, you will be charges Rupees 50.

Annual Maintenance Charges is 300+GST, deducted quarterly. 

WHAT IS INTRINSIC VALUE AND TIME VALUE IN OPTION TRADING?

Any option premium consists of 2 values; Intrinsic Value and Time Value.

Intrinsic Value for call option = Last Traded Price – Strike Price.

Intrinsic Value for put option = Strike Price – Last Traded Price.

However, Intrinsic Value cannot be negative, so if we choose Out of the Money options, Intrinsic Value will always be zero. The difference between Total Option Premium and Intrinsic Value is Time Value of the Options.

In our Farmers example, it was Out of the Money call option, so the entire option premium is time value. Intrinsic Value has to rise before expiry of the contract as time value becomes zero at expiry.

If you notice, Time value around at the Money will always be highest, for call and put both. Nifty lot size is 75, so one need to pay total value * 75 to buy one contract. The Lot size for BankNifty is 25.

Time value example over various expiry - strike price 13600

WHAT IS BREAK-EVEN POINT IN OPTION TRADING?

Break-Even point is the point of no profit and no loss.

For Option Buyer, the total cost always increases upto the amount paid as option premium.

For instance, if someone buys, 13600 CE of current expiry at 263, nifty has to go up to 13600+263 for him to become profitable.

If nifty starts trading below or just at 13600 at the time of expiry, the option premium will start trading around 0, as the time value goes to 0 at the time of expiry and intrinsic value of Out of the Money contract is always 0.

If nifty starts trading around 13700 at the time of expiry, the option premium of 13600 CE would be around 100. Here the Nifty went up from Last Traded Price (13635) to 13700, his view stands correct, but he paid premium of 263. So the loss in the contract would be 163 points. Similarly if nifty starts trading around 13800, his loss would be 63 points.

At 13863, it will be a break-even point and at 13900, he will be in profit of only 37 points, while the nifty went up 265 points. (13900-13635).

Similarly, here is the pay-off chart for put option if we buy 13600 PE at 175 and LTP of index is 13635.

For option sellers, the pay-off chart is a little different as they receive the premium from the buyers. We will discuss that and other mid-advanced things in the other Blogs of the series. It is advised to see real-time data, how it changes when market open.