Options: Calls and Puts

In our last blog, we discussed understanding future contracts, how future contracts work, and how they help traders fix up the prices of assets on some future date. And if you find this derivative instrument like futures exciting, another equally exciting option awaits you: options. This blog simplifies calls and puts and discusses their uses to the benefit of the trader.

What are Options?

At their core, options are financial contracts that give buyers the right but not the obligation to buy or sell an underlying asset at a predetermined price, known as the strike price, before a specific expiry date. Options are widely used in India's equity markets, commodities, and indices, offering flexibility and opportunities for hedging and speculation.

Unlike futures, which are binding agreements, options are much more flexible. The best analogy is to reserve a ticket for some event. You have the right to attend this event but can always skip it if you change your mind.

Calls and Puts: Options Building Blocks

There exist two major kinds of options: Calls and Puts.

1. Call Options: The Right to Buy

A call option grants the holder a right but not an obligation to buy the underlying asset at the strike price before the date of expiry.

• Why Buy a Call? If you expect the price of a stock or index to rise, buying a call is one good profitable strategy. Suppose you buy a call option in Reliance Industries at ₹ 2,500, and the stock shoots up to ₹ 2700 before expiry; you can exercise your option and pocket the difference - ₹ 200 per share minus the premium paid.
  
• Risk and Reward: The possible loss is only the premium paid, while the gain is theoretically infinite as long as the price keeps on rising to the sky.
  

2. Put Options: The Right to Sell

A put option is a financial contract between a buyer and seller where the holder has the right, but not the obligation, to sell an underlying asset at the strike price on or before the date of expiry.

• Why Buy a Put? If you anticipate that the price of the stock will fall, buying a put would safeguard your investment. Let's say you owned Infosys and felt its price could dip below ₹1,500. Well, with a buy option at ₹ 1,450, your stock will be covered against all losses in the price falling below ₹1,450.
  
• Risk/Reward: Like calls, the loss is limited to the premium paid. The reward can be hefty if the price falls dramatically.
  

Options in the Indian Stock Market

The popular options trading instruments in India include Nifty and Bank Nifty options, which are primarily traded on the exchange, especially through the NSE and BSE. Both retail and institutional investors use these to hedge their portfolios or speculate on the movement of the markets.

For instance, weekly and monthly expiry options on Nifty and Bank Nifty are the hot favorites of traders. This is because of the fact that they offer adequate liquidity to buy and sell. Besides, brokers in India have also nowadays started offering intuitive platforms that make options accessible even to novice investors.

Why Are Options Popular?

• Risk Management: Options are a hedge against adverse price movements.
  
• Leverage: The ability to control a much larger position with a limited amount of capital-the premium.
  
• Flexibility: Unlike futures, options are not an obligation but a choice whether to exercise them or not.
  

Conclusion

As we conclude this introductory blog on options, the true worth of these instruments comes out when one understands how they are priced. Terms such as intrinsic value, time value, and the so-called Black-Scholes Model determine the premium of options. Stay tuned to explore Pricing Derivatives in the next blog, where we will untangle these concepts in an easily understandable manner. Options trading in India is thus a journey of opportunity and learning. Be it hedging, speculation, or diversification, this understanding of calls and puts will be the first induction into the exciting world of derivatives. Let's keep learning, one step at a time!