An option is a contract that is written by a seller that conveys to the buyer the right — but not an obligation to buy (for a call option) or to sell (for a put option) a particular asset, at a specific price (strike price/exercise price) in future.

In return of granting the option, the seller collects a payment (known as a premium) from the buyer.

Utility of the Exchange-Traded Options

Exchange traded options constitute an important class of options that have standardized contract features and trade on public exchanges, facilitating the investors.

These instruments provide settlement guaranteed by the clearing corporation, thereby reducing counterparty risk.

Options can be used to hedge, take a view on the future direction of the market, for arbitrage, or for implementing strategies that could help in generating income for traders.

What Are Index Options

These are the options that have an index as the underlying. In India, the regulators authorized the European style of settlement. Example of such options include Nifty options, Bank Nifty options, etc.

What Are Stock Options

These are options on the individual stocks (with stock as the underlying). The contract gives the holder the right to buy or sell the underlying shares at the specified price.

The regulator has also authorized American style of settlement for such options.

Participants in Options

1.Buyer of an Option – The one who by paying the premium, buys the right to exercise his option on the seller/writer.

2. Writer/seller of an Option – The one who receives the premium of the option and thus is obliged to sell/buy the asset if the buyer of the option exercises it.

3.Call Option – An option that provides the holder the right but not the obligation to buy an asset at a set price before a certain date.

4. Put Option – An option that offers the holder, the right but not the obligation, to sell an asset at a set price before a certain date.

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Types in Options Trading

1.Premium -The price that the option buyer pays to the option seller is referred to as the option premium.

2.Expiry date – The date specified in an option contract is known as expiry date or the exercise date.

3.Strike price – The price at which the contract is entered is the strike price or the exercise price.

4.American option – The option that can be exercised at any date until the expiry date.

5.European option – The option that can be exercised only on the expiry date.

Profitability Scenario in Options

1. In-the-Money Option

In-the-money (ITM) option is the one that leads to positive cash flow to the holder if it was exercised immediately.

For example, in a call option on the index, if the current index value is higher than the strike price (spot price > strike price), the option is said to be in-the-money.

2. At-the-Money Option

At-the-money (ATM) option is an option that leads to zero cash flow ( a situation of no profit/no loss) if it were exercised immediately.

For example, in the previous case, if the current index value is equal to strike price (spot price = strike price), the option is ATM.

3. Out-of-the-Money Option

Out-of-the-money (OTM) option is an option that would lead to negative cash flow if it were exercised immediately.

For example, in the previous case, if the index value is lower than the strike price (spot price < strike price), the option is said to be OTM.

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Strategies in Option Trading

  • Long call options trading strategy
  • Short call options trading strategy
  • Long put options trading strategy
  • Short put options trading strategy
  • Long straddle options trading strategy
  • Short straddle options trading strategy

Disclaimer: The views expressed in this post are that of the author and not those of Groww