How to Understand Index Options Trading

Finance Minister Nirmala Sitharaman tabled the Union budget 2019 a few days back. For equity markets, it included a proposal to impose taxes on share buybacks. Along with this the news of lack of changes on long term capital gains tax on equity funds and the proposal to increase the minimum public shareholding from 25 to 35 per cent left stock market investors disappointed. In order to understand the impact of these proposed reforms on the stock market and the ordinary investor, let us look at the what is index trading and what are the index trading options in India.

What are indices?

In financial markets, an index is a measure or an indicator of change. Indices consist of a group of stocks that represent a particular market or a section of it. For example, Sensex is an index of 30 well-established and financially sound companies listed on the Bombay Stock Exchange.

Indices are calculated using the prices of selected stocks. Indices only denote the collective movements of a group of stocks. The relative change in an index is more important than the actual value representing the index. Indices movements are measured in points and not on currency and investors cannot trade in an index directly.

Also read: What are stock market indices?

What is index trading?

Index trading is a type of stock trading involving stocks which make up an index. By trading on indices, investors can analyse whether an index will rise or fall, without actually buying shares in the underlying assets (the stocks of 30 firms in the case of Sensex).

Trading an index is similar to trading a stock, currency or commodity.

As is the case with individual equities, a trader can ‘sell’ an index at a higher price than the price at which he/she bought the stock or ‘buy’ an index back at a lower price than the one he/she originally ‘sold’ it for.

The overall value in an index contributes towards its overall value, with a particular index’s rise or fall in value depending on the performance of its collective stocks. An investor can buy stocks that will rise and fall in accordance with the stock market as a whole or with a segment of the market.

Also read: How to open a trading account?

What are index options?

Let us first look at the meaning of options in the context of financial markets. An optional is a financial contract that derives its value from an underlying asset.

Index options are those whose underlying assets are stock indices. With index options, traders can speculate on trends of an entire equity market (or market segment) without having to trade options on individual securities.

Investors can buy or sell an underlying stock index for a defined time period using index options. Since index options are based on a large basket of stocks in the index, investors can easily diversify their portfolios by trading them.

Also read: What is options trading?

What are index options strategies?

Call option

These are agreements which grant the buyer the right, to buy a stock, bond, commodity at a specified price within a certain time period. The stock, bond, or commodity is referred to as the underlying asset. A call buyer makes a profit when the price of the underlying asset increases. This specific price is fixed and is called the strike price.

The buyer has to exercise his/her option before the expiration date following which the seller has no other choice than to sell the asset at the strike price.

If a trader buys an option at a stock price below the underlying stock value and then sells the stock, he/she would make a profit. For example, if someone buys a call option with a strike price of 10, that person can exercise his/her option to buy that stock at Rs 10 before the expiration date.

Also read: Understanding how call options work

Put Option

A put is an options contract that gives the buyer the right to sell the underlying asset at a specific price at any time up to the expiration date. It means, the trader has purchased the option to sell it. When the stock price is below the underlying stock value, and if a trader buys the option to sell and buys the stock also, then the trader will make a profit because the purchase price was lower than the sell price.

Put options can be termed as being in, at, or out of the money. In the money refers to the situation when the underlying stock price is below the put strike price. When the underlying price is above the strike price, it is called out of the money. When the underlying price and the strike price are equal it is called at the money.

Also read: Understanding how put options work

One related number : 21.44

On July 11, 2019, maximum put open interest was seen at 11,300 strike price. This consisted of 21.44 lakh contracts. This was followed by the 11,000 strike price, supported by 17.49 contracts; and 11,500 strike price which is supported by 17.11 lakh contracts. This shows that the markets are expected to be less volatile in the short run.

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