Sep-12-2024
Options are tradable contracts that investors use to speculate about whether an asset’s price will be higher or lower at a certain date in the future, without any requirement to actually buy the asset in question.
Nifty 50 options, for example, allow traders to speculate as to the future direction of this benchmark stock index, which is commonly understood as a stand-in for the entire Indian stock market.
At first glance, options seem a little counterintuitive, but they’re not as complicated as they appear. To understand options, you just need to know a few key terms:
Let’s make sense of all of this terminology with an example. Consider a stock that’s currently trading for INR 100 a share. Here’s how the premiums—or the prices—function for different options based on the strike price.
| Call Option Premium | Strike Price | Put Option Premium |
|---|---|---|
| Highest | INR 90 | Lowest |
| INR 95 | ||
| ↕ | INR 100 —Current Price | ↕ |
| INR 105 | ||
| Lowest | INR 110 | Highest |
When trading options, you pay a premium up front, which then gives you the option to buy this hypothetical stock—call options—or sell the stock—put options—at the designated strike price by the expiration date.
A lower strike price has more intrinsic value for call options since the options contract lets you buy the stock at a lower price than what it’s trading for right now. If the stock’s price remains INR 100, your call options are in-the-money, and you can buy the stock at a discount.
Conversely, a higher strike price has more intrinsic value for put options because the contract allows you to sell the stock at a higher price than where it’s trading currently. Your options are in-the-money if the stock stays at INR 100, but you have the right to sell it at a higher strike price, say INR 110.
You can deploy a range of options trading strategies, from a straightforward approach to intricate, complicated trades. But broadly speaking, trading call options is how you wager on rising prices while trading put options is a way to bet on falling prices.
Options contracts give investors the right to buy or sell a minimum of 100 shares of stock or other assets. However, there’s no obligation to exercise options in the event a trade isn’t profitable. Deciding not to exercise options means the only money an investor stands to lose is the premium paid for the contracts. As a result, options trading can be a relatively low-cost way to speculate on a whole range of asset classes.
Option trading allows you to speculate on:
With call and put options, you need the underlying asset’s price to rise or fall to break even, which is a rupee amount equal to the premium paid plus the strike price. Here’s how you earn a profit:
If the asset’s price moves in the opposite direction than desired for either a call or put option, you simply let the contract expire—and your losses are equal to the amount you paid for the option (e.g., the premium plus associated trading fees).
Options trading strategies can become very complicated when advanced traders pair two or more calls or puts with different strike prices or expiration dates.
Options trading combines specificity with flexibility. Traders need to choose a specific strike price and expiration date, which locks in the price they believe an asset is headed toward over a certain timeframe. However, they also have the flexibility to see how things work out during that time—and if they’re wrong, they’re not obligated to actually execute a trade.
Because options contracts have an expiration date, which can range from a few days to several months, options trading strategies appeal to traders who want to limit their exposure to a given asset for a shorter period of time. Options traders need to actively monitor the price of the underlying asset to determine if they’re in-the-money or want to exercise the option.
Options trading is also attractive as a hedging tool. For example, if you own shares of a company, you could buy put options to mitigate potential losses in the event the stock’s price goes down. This is one reason that options for broad market benchmarks, like the Nifty 50, are commonly used as a hedge for potential declines in the market in the short term.
As a result, options trading can be a cost-efficient way to make a speculative bet with less risk while offering the potential for high returns and a more strategic approach to investing.
Options trading doesn’t make sense for everyone—especially people who prefer a hands-off investing approach. There are essentially three decisions you must make with options trading (direction, price and time), which adds more complexity to the investing process than some people prefer.
Unlike trading stocks, there’s also an additional hurdle for options trading: The Securities and Exchange Board of India (SEBI) requires that brokers approve customer accounts for options trading only after you fill out an options trading agreement. This is used to assess your understanding of options trading and its associated risks.
To make money from options trading, you’ll need to set price alerts and keep a close eye on the market to see when your trade becomes profitable. And you’ll need to be mindful of the risks and trading fees that can add up with various options strategies. While many brokers have eliminated fees for trading stocks or exchange-traded funds (ETFs), these still exist for options.
Commissions may range from a flat rate to a per-contract fee based on the amount you trade—both when you buy or sell options. As a result, options traders must take into account these fees when considering the profitability of an options strategy.
Finally, because options trades are inherently shorter term in nature, you’re likely to trigger short-term capital gains. Any investment that you’ve held for less than a year is taxed in India as ordinary income (up to 15%, depending on your RBI income tax bracket) versus a lower, long-term capital gains rate for investments you’ve owned for more than a year.
