What are Options?

In this post I would like to explain the basics of Options, the post is intended for the complete beginner. I will try my level best at explaining about Options Trading with respect to Indian Markets. I will try to explain it using Questions and Answers as I feel its the best way to explain things, also if you have any other questions you are welcome to comment down below.

What is an Option?

Options is a type of derivative instrument, it is called derivative as they derive their value from other securities. Confusing at first but if we consider Nifty as the base security, there are Options of Nifty whose prices are derived based on the value of the underlying i.e Nifty. Like Nifty being the base instrument there are options for different stocks present in the F&O list.

Before explaining the different types of options I would like you to know some basics of the option contract

  1. They have an expiry date like the futures (last Thursday of each month) and there are up to 3 month contract available to trade with the maximum volumes in the current month.
  2. There are something called Strike Prices for Options more on this later.

There are two types of Options which everyone trades

  1. Call Option
  2. Put Option

Call Option – It gives the buyer of the option a right but not the obligation to purchase (in case of Nifty Call Option) Nifty or other securities at a determined price.

Now how does this help the Buyer of a Call Option?

As I told before, there are something called Strike Prices for Options. In case of Nifty, As the current closing price of Nifty is near 9304. If you were to believe Nifty could touch 9500 in the coming month what could you do?

  1. You could have a long position in a Futures Contract.
  2. You could possibly buy individual stocks based on your view.
  3. OR You could buy a Call Option

Now we are back to Strike Prices. There are different strike prices for each security and I could buy a Nifty Option of Strike Price 9500 for the coming month for which I would have to pay a price equal to premium for the right and could profit say once Nifty reaches near that levels.

Benefit of Options and why you would consider over other methods of trading

To buy an option the margin required would be limited to the option premium and the lot size.

For Nifty, the margin required for 1 lot of Nifty would be near 10% of Current Market Price * Lot Size (50k for current context)

while for Nifty 9500 the premium price is 27.50 so total margin required is 27.5*lotsize (75) = 2062.5

So for only 2k you can keep a position.

With this I would like to end the post, a continued post while be posted later explaining the Put Option and some basic Option Greeks.