Understanding Options Trading in the Indian Stock Markets
Options trading is the most traded segment in the Indian stock markets. Close to 72 out of 100 trades executed in Indian markets are in OptionsSponsored Product. However, many retail traders take trade in the Options segment without fully understanding how it works and what drives the prices up and down.
In this article, we will provide a detailed introduction to OptionsSponsored Product and explore how retail traders can learn to trade in Options like a professional.
Introduction to Options
Let’s start by understanding what the term “Options” means.
What is an Option?
Options in stock markets provide users with a choice whether to exercise their rights or leave them unused. To understand this concept, consider the example of going to a movie. When you buy a movie ticket, you can go to the movie or decide not to go. The ticket price is Rs 500. If you go to the movie, you are using the ticket and putting your Rs 500 to the right use. On the other hand, if you decide not to go to the movie, you lose your Rs 500, as there is no refund from the theatre.
To protect yourself against this loss of Rs 500, you can book tickets online from an app which offers a feature to pay an extra Rs 30 for a refund in case you decide to cancel your plans. In this case, you pay Rs 500 + Rs 30 (fee) = Rs 530 and give yourself a choice or the “Option” of whether to go to the movie or cancel it. In both cases, your loss is limited to just Rs 30.
By paying extra, you got an Option and the Rs 30 paid is called the Premium. In other words, the Rs 30 premium was the insurance against your movie ticket of INR 500.
Similarly, in stock markets, you can pay a small premium and protect yourself from losses in your portfolio. Hence, Options are also called the insurance of stocks. Since the stock market moves both up and down, we need to have insurance for both the Bulls and the Bears. Therefore, we have two types of Options:
- Call option, denoted by CE (stands for Call European)
- Put option, denoted by PE (stands for Put European)
Since the value of the premium depends on the underlying value, the Call and Put option values also depend on the underlying stock price. As the stock price goes up and down, the values of Call and Put also go up and down. Therefore, they are also called Derivatives, instruments whose value is derived from underlying value. If the stock price goes up, the Call price will go up, and the Put price will go down. If the stock price goes down, the Call price will go down and the Put price will go up. Clearly, Call and Put always go opposite to each other.
As a bullish trader, to protect your underlying stocks, you can buy a Put option if the stock will go down. The Put will go up, and losses faced in stock will be compensated by profits in the Put option. Similarly, as a bearish trader, to protect your underlying short trades, you can buy a Call option if the stock goes up against your bearish view. The Call option will give you profits to compensate for the losses.
There are two types of Options – Call and Put, and both are used as insurance to protect your underlying trades. In the next lesson, we will dive deep into these OptionsSponsored Product and learn how to take trades in them.
(The author is the Co-founder of Algofox).
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. They do not represent the views of the Economic Times).