Options, as the name of the instrument suggests, provide you an "option" of either buying or selling some underlying assets or securities on a future date. Options are actually a part of a larger circle of instruments called derivatives, which is again comprehensible from its name as the intruments which "derive" their value from a group of underlying assets. Options impart rights to an investor without obligations, and hence in order to embrace the untamed volatility of the current market, options have become an important instrument at the present stage. India currently boasts the world's largest derivatives market with 6 billion contracts in 2019.
As mentioned, options provide you the right to choose to either or buy or sell an underlying group of assets on a future date, the details of which are outlined in the options contract. Let's traverse through some basic terms so as to be adept in reading the options contract. In case you desire for the right to buy a stock (or a portfolio of stocks/assets) in your purview in the future, you need to "buy" a call option, and if you are willing to have a choice to sell a stock (or a portfolio of stocks/assets), you need to "purchase" a put option. The strike price (mentioned in the contract) is the price to be paid for the asset which has been agreed upon by both the parties involved in the contract. Also, while trading in the open market, you will come across Bid Price : The highest price a buyer is willing to pay and Ask Price : The lowest price at which a seller is willing to sell. The liquidity (ease of trading) of the option (or of any asset) is determined by the bid-ask spread, i.e. the Ask Price - Bid Price. Logically, lower will be the spread, the easier it is to trade the options, and thus higher is its liquidity.
Well, feeling ill at ease after going through a plethora of terms? We are now in a position to elucidate everything from here on the basis of some illustrations. Consider a fine day when you were aimlessly scrolling through your phone, and come across a tweet which is of the opinion that the stock of Black Key Limited is going to witness some tremendous gains in the near future. You have some money to spare from your stash, but you decide not to buy the stock outright, since an inherent fear of incurring a heavy loss disturbs you (the firm was really volatile in the past). You are an avid reader of IIT Tech Ambit, and thus you are aware of the usage of options as a financial instrument. You check the current stock price of Black Key Limited, and it's 415 INR. You purchase a call option with a strike price of 410 INR, and the option is worth 50 INR. The expiry date of the option is after a month. A month passes. The price of Black Key Limited has gone up to 550 INR, but since you already have a call option at your perusal, you have the choice of exercising the option and procuring the stock at the price of 410 INR, mentioned in the strike price column of your option contract. You immediately sell the stock on market and Voila! You have earned a profit of 550-410-50 = 90 INR. Now, you may argue that your pal, who had the guts to endure the risk, bought the stock a month back itself and made a profit of 550-415 = 135 INR, a lot more than you did. Well, you are certainly right. But, for once, just think about what would have happened if the tweet you read a month back would have been deemed null and void, and the stocks of Black Key Limited plunged to 280 INR in a single month, due to the production of substandard products in the wake of the COVID-19 crisis. I guess by now, you have already done the math, your pal has incurred a loss of 135 INR, while you on the other hand only lost 50 INR. There you go, you now have the first reason as to why options are preferred in the times of recession : because they act as a protective hedge against a detrimental movement in asset prices.
Alright, let's take up another illustration. Consider that you buy the stock of Black Key Limited, worth 415 INR at present. Now, you, through some astute analysis ( or again, let's assume you witnessed a tweet), came to know that the stock price of Black Key Limited is going to plummet in the coming month. You thus secure yourself by buying a put option worth 15 INR with a strike price of 440 INR. After a month, your prediction turns out to be correct, and indeed, the price of Black Key Limited has plunged down to 340 INR. But, you have already gained the right to exercise your put option and thus you are able to sell the stock at 440 INR and earning a meagre profit of 10 INR, when your adventurous friend (who had bought the stock with you, but hadn't subscribed to an option) has incurred a loss of 75 INR. Now comes the second reason to learn the preference of options over stocks : because they act as a leverage for expected price movements.
Phew! That was quite a lot to go through, wasn't it? By this stage of the article, some of you mathematics enthusiasts have already started thinking about options and the profits to be earned in a graphical manner, so let's delve into it right away. You may come across the term Payoff across many news articles about options, which is nothing but the amount an investor receives at the expiration of the strategy. Thus, the minimum payoff from any investment is zero. Profit is then defined as Payoff minus the cost of setting up the strategy (in this case, the price you pay for buying an option). Let's create a graph from the aforementioned illustrations itself.
Well, you have already grasped the basics of options trading by now. That's what it takes, some basic mathematics and logic. But wait, don't just start trading on the basis of this article, there is a lot more going on in the market, which will be included in the next installment.
Till then, Au Revoir!