Basics of options trading curated from different sources
Option trading videos
The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. In options trading, the Strike Price for a Call Option indicates the price at which the Stock can be bought (on or before its expiration) and for Put Options trading it refers to the price at which the seller can exercise its right to sell the underlying stocks (on or before its expiration)
Since the Options themselves don’t have an underlying value, the Options premium is the price that you have to pay in order to purchase an Option. The premium is determined by multiple factors including the underlying stock price, volatility in the market and the days until the Option’s expiration. In options trading, choosing the premium is one of the most important components.
In options trading, the underlying asset can be stocks, futures, index, commodity or currency. The price of Options is derived from its underlying asset. For the purpose of this article, we will be considering the underlying asset as the stock. The Option of stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.
In options trading, all stock options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading, the expiration of Options can vary from weeks to months to years depending upon the market and the regulations.
There are two major types of Options that are practiced in most of the options trading markets.
- American Options which can be exercised anytime before its expiration date
- European Options which can only be exercised on the day of its expiration
It is very important to understand the Options Moneyness before you start trading in Stock Options. A lot of options trading strategies are played around the Moneyness of an Option. It basically defines the relationship between the strike price of an Option and the current price of the underlying Stocks. We will examine each term in detail below.
When is an Option in-the-money?
- Call Option - when the underlying stock price is higher than the strike price
- Put Option - when the underlying stock price is lower than the strike price
When is an Option out-of-the-money?
- Call Option - when the underlying stock price is lower than the strike price
- Put Option - when the underlying stock price is higher than the strike price
When is an Option at-the-money?
- When the underlying stock price is equal to the strike price.
Take a break here to ponder over the different terms as we will find it extremely useful later when we go through the types of options as well as a few options trading strategies.
In the true sense, there are only two types of Options i.e Call & Put Options. We will understand them in more detail.
A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of buying a Call Option, you pay a certain amount of premium to the seller which grants you the right (but not the obligation) to buy the underlying stock at a specified price (strike price). Purchasing a call option means that you are bullish about the market and hoping that the price of the underlying stock may go up. In order for you to make a profit, the price of the stock should go higher than the strike price plus the premium of the call option that you have purchased before or at the time of its expiration. In contrast, a Put Option is an option to sell an underlying Stock on or before its expiration date. Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down. In order for you to make a profit, the price of the stock should go down from the strike price plus the premium of the Put Option that you have purchased before or at the time of its expiration. In this manner, both Put and Call option buyer’s loss is limited to the premium paid but profit is unlimited. The above explanations were from the buyer's point of view. We will now understand the put-call options from the seller’s point of view, ie options writers. The Put option seller, in return for the premium charged, is obligated to buy the underlying asset at the strike price. Similarly, the Call option seller, in return for the premium charged, is obligated to sell the underlying asset at the strike price. Is there a way to visualise the potential profit/loss of an option buyer or seller? Actually, there is. An option payoff diagram is a graphical representation of the net Profit/Loss made by the option buyers and sellers. Before we go through the diagrams, let’s understand what the four terms mean. As we know that going short means selling and going long means buying the asset, the same principle applies to options. Keeping this in mind, we will go through the four terms.
- Short call - Here we are betting that the prices will fall and hence, a short call means you are selling calls.
- Short put - Here the short put means we are selling a put option
- Long call - it means that we are buying a call option since we are optimistic about the underlying asset’s share price
- Long put - Here we are buying a put option.
S = Underlying Price X = Strike Price
Break-even point is that point at which you make no profit or no loss.
The long call holder makes a profit equal to the stock price at expiration minus strike price minus premium if the option is in the money. Call option holder makes a loss equal to the amount of premium if the option expires out of money and the writer of the option makes a flat profit equal to the option premium. Similarly, for the put option buyer, profit is made when the option is in the money and is equal to the strike price minus the stock price at expiration minus premium. And, the put writer makes a profit equal to the premium for the option.