Do Not Call
A thorough explanation of option buying, its mechanics, potential advantages, and risks to help beginners grasp how market moves can impact profits through options.
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.
To start, it is important to define option buying and differentiate between the main types of options:
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 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.
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.
Understanding the mechanics behind option buying is crucial for evaluating potential opportunities:
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.
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: 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.
Several elements influence option premiums, including the underlying asset’s price, volatility, time to expiry, interest rates, and dividends.
Beginners can access various option types depending on the market and underlying asset:
Options on individual stocks, allowing investors to speculate or hedge positions in specific companies.
Options based on stock market indices, enabling trading on broader market trends.
Options on physical goods like gold, oil, and agricultural products, offering diversification.
Options based on foreign exchange rates, useful for hedging currency risk.
Option buying offers unique advantages over other investment methods:
The maximum loss for the buyer is limited to the premium paid, providing defined risk.
Options allow control of larger asset quantities with smaller capital outlay compared to buying shares outright.
Options can be used to profit from upward, downward, or sideways markets.
Investors can use options to protect existing positions against adverse price movements.
While offering benefits, option buying also carries specific risks:
If the option expires worthless, the entire premium is lost.
Options lose value as expiry nears, which can erode profits.
Changes in market volatility can affect option prices unpredictably.
Options require understanding of various factors, making them less suitable for uninformed investors.
For those new to options, a clear process is essential:
A demat account with a registered broker is necessary to trade options. Bajaj Markets offers a platform to open such accounts efficiently.
Choose the underlying asset, strike price, expiry date, and option type aligned with your market view.
Submit the order through your trading platform and pay the required premium.
Track option value and decide whether to exercise, sell, or let expire based on market movements.
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).
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).
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.
Adhering to regulations ensures a safer trading environment:
SEBI regulates derivatives trading, mandates disclosures, and sets margin requirements.
Brokers require margins for option trading to mitigate risk.
Investors must be informed about risks and costs involved.
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.
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.
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
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.
