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Understanding Option Buying: Beginner’s Guide to Profiting from Market Moves

A thorough explanation of option buying, its mechanics, potential advantages, and risks to help beginners grasp how market moves can impact profits through options.

Introduction

Option buying is a strategy that gives investors exposure to market movements with predefined potential loss, limited to the premium paid. Unlike buying shares directly, options provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time. This guide covers the fundamentals of option buying, explaining its mechanics, types, benefits, risks, and how beginners can participate in this segment of the market effectively. Understanding these key aspects can help demystify options and assist investors in making informed decisions aligned with their financial goals.

What is Option Buying

To start, it is important to define option buying and differentiate between the main types of options:

Definition of Options and Option Buying

Options are derivative contracts that grant the buyer the right to buy or sell an underlying asset at a specified price, known as the strike price, before or on a particular expiry date. Option buying involves purchasing these contracts, entitling the buyer to exercise the option if it is profitable or let it expire if it is not.

Call Options vs Put Options Explained

  • Call Option: Gives the buyer the right to purchase the underlying asset at the strike price. Buyers profit when the underlying asset’s price rises above the strike price plus the premium paid.

  • Put Option: Gives the buyer the right to sell the underlying asset at the strike price. Buyers profit when the underlying asset’s price falls below the strike price minus the premium paid.

Role of the Option Buyer and Seller

The buyer pays a premium for the option and holds the right to exercise it. The seller, or writer, receives the premium but assumes the obligation to fulfil the contract if the buyer exercises the option.

How Option Buying Works

Understanding the mechanics behind option buying is crucial for evaluating potential opportunities:

Option Premium and Strike Price

The premium is the price paid by the buyer to acquire the option. The strike price is the predetermined price at which the asset can be bought or sold. The relationship between the market price of the underlying and the strike price determines the option’s intrinsic value.

Expiry Date and Its Significance

Options have a finite life and expire on a specific date. The value of an option diminishes as expiry approaches, a concept known as time decay.

Intrinsic Value and Time Value of Options

  • Intrinsic Value: The actual value, if the option were exercised today, i.e., the difference between the market price and the strike price, when favourable.

  • Time Value: The additional value based on the remaining time until expiry and volatility expectations.

Factors Affecting Option Pricing

Several elements influence option premiums, including the underlying asset’s price, volatility, time to expiry, interest rates, and dividends.

4 Types of Options Available to Buyers

Beginners can access various option types depending on the market and underlying asset:

1.Equity Options

Options on individual stocks, allowing investors to speculate or hedge positions in specific companies.

2.Index Options

Options based on stock market indices, enabling trading on broader market trends.

3.Commodity Options

Options on physical goods like gold, oil, and agricultural products, offering diversification.

4.Currency Options

Options based on foreign exchange rates, useful for hedging currency risk.

Benefits of Option Buying

Option buying offers unique advantages over other investment methods:

Limited Risk Exposure

The maximum loss for the buyer is limited to the premium paid, providing defined risk.

Leverage

Options allow control of larger asset quantities with smaller capital outlay compared to buying shares outright.

Flexibility

Options can be used to profit from upward, downward, or sideways markets.

Hedging Opportunities

Investors can use options to protect existing positions against adverse price movements.

Risks Associated with Option Buying

While offering benefits, option buying also carries specific risks:

Total Loss of Premium Paid

If the option expires worthless, the entire premium is lost.

Time Decay Impact (Theta)

Options lose value as expiry nears, which can erode profits.

Volatility Risk

Changes in market volatility can affect option prices unpredictably.

Complexity

Options require understanding of various factors, making them less suitable for uninformed investors.

How to Buy Options: Step-by-Step Guide

For those new to options, a clear process is essential:

Opening a Trading and Demat Account

A demat account with a registered broker is necessary to trade options. Bajaj Markets offers a platform to open such accounts efficiently.

Selecting the Right Option Contract

Choose the underlying asset, strike price, expiry date, and option type aligned with your market view.

Placing an Order and Paying the Premium

Submit the order through your trading platform and pay the required premium.

Monitoring the Position and Exercising or Closing

Track option value and decide whether to exercise, sell, or let expire based on market movements.

Important Concepts and Terminology in Option Buying

Understanding key terms helps demystify options:

  • Strike Price: Price at which the option can be exercised.

  • Premium: Cost to buy the option.

  • Expiry Date: Last date the option can be exercised.

  • Intrinsic Value: Actual value if exercised immediately.

  • Extrinsic Value: Additional value based on time and volatility.

  • Moneyness: Classification of option value status (in-the-money, at-the-money, out-of-the-money).

Practical Examples of Option Buying

Example 1: Buying a Call Option

Suppose a stock is trading at ₹1,000, and you buy a call option with a strike price of ₹1,050, paying a premium of ₹20. If the stock rises to ₹1,100, the intrinsic value is ₹50 (₹1,100 - ₹1,050). The profit is ₹30 (₹50 intrinsic value - ₹20 premium).

Example 2: Buying a Put Option

If the same stock is trading at ₹1,000, and you buy a put option with a strike price of ₹950, paying a ₹15 premium, and the stock falls to ₹900, the intrinsic value is ₹50 (₹950 - ₹900). The profit is ₹35 (₹50 intrinsic value - ₹15 premium).

Please note: These are  simplified, hypothetical examples to explain the concept. Actual returns may vary and depend on multiple market factors.

Regulatory Guidelines and Market Practices

Adhering to regulations ensures a safer trading environment:

SEBI Guidelines on Options Trading

SEBI regulates derivatives trading, mandates disclosures, and sets margin requirements.

Margin Requirements and Position Limits

Brokers require margins for option trading to mitigate risk.

Disclosure Norms for Option Buyers

Investors must be informed about risks and costs involved.

Conclusion

Option buying presents a flexible investment method allowing participation in market movements with controlled risk. While it offers leverage and hedging capabilities, understanding the associated risks and mechanics is essential. Beginners should approach option buying with knowledge and caution to align with their financial objectives.

Disclaimer

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

Sources

  • Securities and Exchange Board of India (SEBI) — https://www.sebi.gov.in

  • National Stock Exchange of India (NSE) — https://www.nseindia.com

  • Investopedia: Options Trading Basics — https://www.investopedia.com

  • Zerodha Varsity: Options Trading — https://zerodha.com/varsity

  • Moneycontrol: Options Trading Guide — https://www.moneycontrol.com

Frequently Asked Questions (FAQs)

What is option buying in the stock market?

Option buying refers to purchasing contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain timeframe.

A call option gives the buyer the right to buy an asset at the strike price, while a put option gives the buyer the right to sell the asset at the strike price.

The maximum loss is limited to the premium paid to purchase the option contract.

If the option is not exercised before expiry and it is out-of-the-money, it expires worthless and the premium paid is lost.

Yes, option buying can be used to protect existing investments against adverse price movements in the market.

Yes, the Securities and Exchange Board of India (SEBI) regulates options trading and sets guidelines to protect investors.

You need to open a trading and demat account with a registered broker, select the option contract you want to buy, and place your order through the trading platform.

Option prices are influenced by the underlying asset’s price, volatility, time remaining until expiry, interest rates, and expected dividends.

Time decay refers to the reduction in an option’s value as it approaches its expiry date, affecting the premium the buyer can receive.

Option buying involves complexity and risks and is generally recommended for investors who understand the market and are comfortable with these risks.

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