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Basics of Option Trading

What is an Option in Trading?

  • An Option is a tool for protecting your position and reducing risk.
  • A buyer of the call option has the right and the seller should make delivery. 
  • To have that right buyer needs to pay some initial amount (Non-refundable).
  • The option is only given to one party in the transaction ( buyer of an option).
  • Options belong to the larger group of securities known as derivatives.
  • As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock.

What is an Option?

Understanding Option
A new development going up. You may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.
An Option is a tool for protecting your position and reducing risk.
You want to buy that home in the next three years at a price Rs. 40, 00, 000. Naturally, the developer wouldn’t grant such an option for free. You need to contribute a down-payment to lock-in that right.

Concerning an option, this cost is known as the premium. It is the price of the option contract.

In our home example, the deposit might be Rs. 8,00,000 that the buyer pays the developer.
Let’s say two years have passed, and now the developments are built and zoning has been approved. You exercises the option and buys the home for Rs. 40,00,000 because that is the contract purchased.

We will have three cases of completion.
In Time (Expected)
 The market value of that home may have doubled to Rs. 80,00,000.

 But because the down payment locked in a pre-determined price, the buyer pays Rs. 40,00,000.
A buyer of the call option has the right and the seller has an obligation to make delivery. 
Not in Expected Time
 The expected development does not come in the next three years. So the price of home become half i.e. Rs. 20,00,000.

 You still want to buy? No, You won't. In this case, the developer will keep your entire premium i.e. the initial amount you paid to lock up the deal.

After Time
 Now, in an alternate case, say the zoning approval comes after five years.
 This is two years past the expiration of this option. Now the home buyer must pay the market price because the contract has expired.
 In either case, the developer keeps the original Rs. 8,00,000 collected.

We will relate the example given above in upcoming posts. Before that, I would like to introduce the option contracts.

There are two types of option Contracts.
1. Call Option
2. Put Option

When you believe the stock will go up you buy Call Option and in case of put buy you believe is to crash the stock.

With this post, we are starting the journey of understanding Option Trading. I need your patience throughout the option journey. The endpoint of this journey will definitely make you a good option trader.
Happy Trading!
Basics of Option Trading Reviewed by Kumar Chandan on February 21, 2020 Rating: 5

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