Future and option trading basics
As with any of the previous modules in Varsity, we will again make the same old assumption that you are new to options and therefore know nothing about options. For this reason we will start from scratch and slowly ramp up as we proceed. Let us start with running through some basic background information.
The options market makes up for a significant part of the derivative market, particularly in India. Internationally, the option market has been around for a while now, here is a quick background on the same —. Clearly the international markets have evolved a great deal since future and option trading basics OTC days. However in India from the time of inception, the options market was facilitated by the exchanges. The badla system no longer exists, it has become obsolete.
Here is a quick recap of the history of the Indian derivative markets —. Though the options market has been around sincethe real liquidity in the Indian index options was seen only in !
I remember trading options around that time, the spreads were high and getting fills was a big deal. However inthe Ambani brothers formally split up and their respective companies were listed as separate entities, thereby unlocking the value to the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian markets, creating some serious liquidity.
However if you were to compare the liquidity in Indian stock options with the international markets, we still have a long way to catch up. There are two types of options — The Call option future and option trading basics the Put option. You future and option trading basics be a buyer or seller of these options. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets.
Consider this situation; future and option trading basics are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs. Ajay has future and option trading basics informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns.
If the highway indeed comes up, the valuation future and option trading basics the land is bound to increase and therefore Ajay would benefit from the investment he would make today. So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not.
While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy. Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as follows —. So what do you think about this special agreement? Who do you think is smarter here — Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement?
Well, the answer to these questions is not easy to answer, unless you analyze the details of the agreement thoroughly. I would suggest you read through the example carefully it also forms the basis to understand options — Ajay has plotted an extremely clever deal here!
In fact this future and option trading basics has many faces to it. Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen.
However irrespective of what happens to the highway, there are only three possible outcomes —. Remember as per the agreement, Ajay has the right to call future and option trading basics the deal at the end of 6 months.
Now, with the increase in the land price, do you think Ajay will call off the deal? This means Ajay now enjoys the right to buy a piece of land at Rs. Clearly Ajay is making a steal deal here. Venu is obligated to sell him the land at a lesser value, simply because he had accepted Rs.
Another way to look at this is — For an initial cash commitment of Rs. Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay. The profit that Ajay makes Rs. It turns out that the highway project was just a rumor, and nothing really is expected to come out of the whole thing. People are disappointed and hence there is a sudden rush to sell out the land.
As a result, the price of the land goes down to Rs. So what do you think Ajay will do now? Clearly it does not make sense to buy future and option trading basics land, hence he would walk away from the deal. Here is the math that explains why it does not make sense to buy the land —. Remember the sale price is fixed at Rs. Hence if Ajay has to buy the land he has to shell out Rs.
Which means he is in effect paying Rs. Clearly this would not make sense to Ajay, since he has the right to call of the deal, he would simply walk away from it and would not buy the land. However do note, as per the agreement Ajay has to let go of Rs. For whatever reasons after 6 months the price stays at Rs. What do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may ask, well here is the math —.
Clearly it does not make sense to buy a piece of land at Rs. Do note, since Ajay has already committed 1lk, he could still buy the land, but ends up paying Rs 1lk extra in this process.
For this reason Ajay will call off the deal and in the process let go of the agreement fee of Rs. I hope you have understood this transaction clearly, and if you have then it is good news as through the example you already know how the call options work!
But let us not hurry to extrapolate this to the stock markets; we will spend some more time with the Ajay-Venu transaction. I would suggest you be absolutely thorough with this example. If not, please go through it again to understand the dynamics involved. Also, please remember this example, as we will revisit the same on a few occasions in the subsequent chapters.
Do note, I will deliberately skip the nitty-gritty of future and option trading basics option trade at future and option trading basics stage. The idea is to understand the bare bone structure of the call option contract. Assume a stock is trading at Rs. You are given a right today to buy the same one month later, at say Rs. Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs.
In order to get this right you are required to pay a small amount today, say Rs. If the share price moves above Rs. If the share price stays at or below Rs. All you lose is Rs. After you get into this agreement, there are only three possibilities that can occur.
Case 1 — If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs. Case 2 — Future and option trading basics the stock price goes down to say Rs. Case 3 — Likewise if the stock stays flat at Rs. This is simple right? If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the future and option trading basics points, all of which we will learn soon. At future and option trading basics stage what you really need future and option trading basics understand is this — For reasons we have discussed so far whenever you expect the price of a stock or any asset for that matter to increase, it always makes sense to buy future and option trading basics call option!
Now that we are through with the various concepts, let us understand options and their associated terms. Hi Sir, Options is like greek and latin to me.
Thanks for the analogies. No, all derivative contracts are routed via the exchanges. You cannot enter into an OTC arrangement, even if you do, it would not be regulated hence quite dangerous. What benefit would Ajay get by calling off the deal before the expiry of 6 months? He will instead wait for the whole 6 months for any chance of the highway project. My first question Karthik is this: The dropdown value on the NSE website does not contain all months expiries — after 18th May we have 25th June followed by 24th Sept and then 31st Dec What happened to the other months?
For to only June and Dec contracts are available. What happened to the remaining? Saurabh, glad you noticed it! For all stocks options the expiry is very similar to futures. Hence we have current month, mid month, and far month contracts. However future and option trading basics Nifty there are several different expiry options. Leaps are good if you have a super long term view on markets. However the problem with leaps in India is that they are not liquid, there are hardly any trading activity here.
Here are a few things you absolutely need to understand before this Playbook will make as much sense to you as we hope it will. Some of you probably already know these terms and concepts, or at least think you do. But how will you really know you know them unless you read this section? Therein lies the paradox. So, What Exactly is an Option, Anyway? And for you rookies, well, read on. Actually, options can be traded on several kinds of underlying securities.
So feel free to substitute these terms to match your preferred style of trading. That period of time could be as short as a day or as long as a couple of years, depending on the option.
The seller of the option contract has the obligation to take future and option trading basics opposite side of the trade if and when the owner exercises the right to buy or sell the asset. When you buy a call, it gives you the right but not the obligation to buy a specific stock at a specific price per share within a specific time frame. A good way to remember this is: When you buy a put, it gives you future and option trading basics right but not the obligation to sell a specific stock at a specific price per share within a specific time frame.
Much of the time, individual calls and puts are not used as a standalone strategy. This term does not imply they are hard to understand. It just means these strategies are built from multiple options, and may at times also include a stock position. Options involve risk and are not future and option trading basics for all investors. For more information, please review the Characteristics and Risks of Future and option trading basics Options brochure before you begin trading options.
Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risksand may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.
There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or future and option trading basics to buy or sell a particular security or to engage in any particular investment strategy.
Future and option trading basics projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results.
All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, future and option trading basics financial product does not guarantee future results or returns. The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. Options Basics Here are a few things future and option trading basics absolutely need to understand before this Playbook will make as much sense to you as we hope it will.
Call Options When you buy a call, it gives you the right but not the obligation to buy a specific stock at a specific price per share within a specific time frame. Put Options When you buy a put, it gives you the right but not the obligation to sell a specific stock at a specific price per share within a specific time frame. Using Calls and Puts in More Complex Strategies Much of the time, individual calls and puts are not used as a standalone strategy.
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