An option is a right without an obligation. It can be a right to buy (call option) or a right to sell (put option). Options are traded in the stock market like shares and futures. The only difference is that when you trade in options, you don’t trade the stock; rather you trade the right (without an obligation) to buy or sell the stock at a particular price.
Broadly, there are two types of options viz. index options and stock options. Stock options, as the name suggests, are the options on a particular stock. Here, you can have the right to buy a stock (call option) or the right to sell a stock (put option).
Understanding a call option: How you can make money off of it
Let us look at the case of the Tata Motors call option with a strike price of Rs200 when the market price is Rs190 in the example below.
The table represents the price of a call option of Rs200 strike when the spot price of Tata Motors is Rs190. This is the right to buy Tata Motors at Rs200 without the obligation to buy. For the right, you have to pay this price of Rs4.90. You may wonder as to why someone is buying a right to buy Tata Motors at Rs200 when the stock is available at Rs190. The reason is that the trader may be looking to play on the volatility.
The price of the option is determined by factors like the stock price, strike price, time till expiry, volatility, and interest rates as captured in the Black & Scholes Model. We shall not go into the nuances of the Black & Scholes model but it suffices to say that volatility is the key factor determining the price of the option.
If the price of Tata Motors goes to Rs210, then the option value could go up to, say, Rs15. Then you can book a profit of Rs10.10 (Rs15 minus
Rs4.90) and take it home. Since futures & options have to be traded in lots (lot size of Tata Motors is 1,500 shares), your total cost to buy one lot of 200 call options of Tata Motors would be Rs7,350 (Rs1,500*Rs4.90). When you sell the option at Rs15 you realize Rs22,500 (Rs1,500*Rs15). Effectively, you have made a profit of Rs15,150 on an investment of Rs7,350, which is an unbelievable ROI of 206%.
The counter-argument could be; what if the stock price of Tata Motors had gone down to Rs160. In that case, your option becomes worthless and all you lose is Rs7,350 on one lot of Tata Motors call option. Had you bought the same Tata Motors in the cash market, your investment would have been Rs2,85,000 (Rs1,500*Rs190). However, not only would your ROI be much lower, even your downside risk would be huge if the stock fell to Rs160. Call options give you the ability to participate in the upside movement in a stock by taking a limited risk on the downside. Your investment is also small, so capital is freed up for other trades.
Understanding a put option: How you can make money off of it
Let us look at Tata Motors put option with a strike price of Rs180 when the market price is Rs190 in the example below.
Put option is a right to sell; hence, you will buy a put option when you expect the stock price to go down. It is a good way to play on the negative news on a stock. The same Tata Motors has a Rs180 strike put option that is available at Rs5.10. This is a right to sell, so the put option becomes more valuable when the market is bearish and less valuable when the market is bullish. Clearly, the market is bullish on Tata Motors which explains why the call option is up by 78% in a single day while the put option is down by (-45%) in the same timeframe. The problem comes if you are bearish on the stock.
If you have the stock, you can sell, but that will have tax implications on capital gains. You cannot short stocks you don’t own beyond a day. One of the best ways to play a stock on the downside is by purchasing a put option. In the above case, if the price of Tata Motors goes down to Rs160, then the Rs5 put option goes above Rs30 and you end up with a fancy profit. Else, Rs5.10 is all that you lose. Buying put options is not only less risky but it can also improve your ROI due to the small investment that options entail.
Buying and selling rights to buy and sell
This may sound complicated, but it is not. Let us put this idea in a chart form.
You can make your choice based on which grid you want be in and your expectations. Your choice can then be framed accordingly.