Basics of Option Trading

Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does. The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. An options contract does not carry the same obligation, which is precisely why it is called an “option.”

Let us start leaning in easy language.....

Option idea came from insurance, it work same like an insurance company risk. Meaning of option is it self insurance or used for hedging purpose.

Generally we buy insurance to secure our life or uncertainty, same lies with option it is used during uncertainty timing like election, flood, rain or war where one should enter in position.

Let us focus more on practical aspects.....

Option includes...
Call option
Put option

Once can short (sell) or long (buy) option as per situation,timing, news and risk appetite.

Call option : Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time.

Example: current price of reliance is 1300 rs lot size is 500 let take current premium of 1400 strike call is 20 rs. assume reliance stock on expiry April comes at 1500 rs.

Now relate with above theory .....
 

Option holder the right to purchase an underlying  asset,

How ?
Reliance Cmp is 1300 rs
Call option strike 1400 premium 20 rs
Lot size 500
Expiry rate of reliance 1500 rs

Now holder can exercise right if getting benefit .....
 

Here holder of call option paid net premium of 20*500 is equal to 10000 rs.
On expiry stock came to close at 1500 rs
 

Net pay off will be 1500-1400 (strike) = 100*500 (lot size) = 50000 rs

Investment of 10k excludes comes to 40000 net gain.

Now what learning we can get from above theory.....

Reliance strike call 1400 @ 20 rs.....

Premium  20 rs is like an insurance premium we pay for something

Premium is sum of intrinsic value plus time value.

Their are 3 kinds of options

At the money option (ATM)
In the money option (ITM)
Out of the money option (OTM)

Premium of option at ATM is more of time value
Premium of option at ITM is more of intrinsic value
Premium of option at OTM is more of time value only.

Call pay off comes.....

Current rate of underlying - strike price of call option.

Reliance example 1500-1400

Difference of 100 will be net payoff on expiry day but before expiry time value included in option pricing which depreciate day by day and at expiry only intrinsic value remain.

For call option of reliance Cmp 1300

ATM option will be 1300 strike
OTM option will be 1400 strike
ITM option will be 1200 strike

Let assume premium of 1400 call @ 20

Valuation of above option strike

ATM 1300 strike @ 40-50 rs
OTM 1400 strike @ 20 rs
ITM 1200 strike @ 110 rs

Let stock moved to 1350 rs

Tantitive rate will move like.....
ATM 1300 strike @ 75-80 rs
OTM 1400 strike @ 30-32 rs
ITM 1200 strike @ 152-155 rs

Premium learning when stock moved 50 rs what premium reflect at 1350rs,

# 1300 strike call option 75 rs includes 50+25 rs
 

Intrinsic value of 50 rs and time value of 25 rs
# 1400 srtike call option 30 rs increase by 50% all time value.
#1200 srtike call option 152 rs invludes 150 rs intrinsic value and 2 rs around time value.

So above concept prove that when stocks option become ITM option premium invludes maximum intrinsic  value and OTM option includes time value.

Will discuss more on this concept by taking real expiry and more notes on coming when.

Kindly prove your comment and quary for making live discussion.