How not to make Rs 38 lakh in options trading

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As with any of the previous modules in Varsity, we will again make the same old assumption that you are new to options and therefore know nothing about options. For this reason we will start from scratch and slowly ramp up as we proceed. Let us start with running through some basic background information. The options market makes up for a significant part of the derivative market, particularly in India. Internationally, the option market has been around for a while now, here is a quick background on the same —.

Clearly the international markets have evolved a great deal since the OTC days. However in India from the time of inception, the options market was facilitated by the exchanges. The badla system no longer exists, it has become obsolete. Here is a quick recap of the history of the Indian derivative markets —.

Though the options market has been around sincethe real liquidity in the Indian index options was seen only in ! I remember trading options around that time, the spreads were high and getting fills was a big deal.

However inthe Ambani brothers formally split up and their respective companies were listed as separate entities, thereby unlocking the value to the shareholders. In my opinion this particular corporate event triggered vibrancy in the Indian markets, creating some serious liquidity. However if you were to compare the liquidity in Indian stock options with the international markets, we still have a long way to catch up.

There are two types of options — The Call option and the Put option. You can be a buyer or seller of these options. In fact the best way to understand the call option is to first deal with a tangible real world example, options trading basics india we understand this example we will extrapolate the same to stock markets.

Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued options trading basics india Rs. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns.

If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would make today. So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy.

Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details options trading basics india the arrangement is as follows —. So what do you think about this special agreement? Who do you think is smarter here — Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement? Well, the answer to these questions is not easy to answer, unless you analyze the details of the agreement thoroughly.

I would suggest you read through the example carefully it also forms the basis to understand options options trading basics india Ajay has options trading basics india an extremely clever deal here! In fact this deal has many faces to options trading basics india. Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen. However irrespective of what happens to the highway, there are only three possible outcomes —.

Remember as per the agreement, Ajay has the right to call off the deal at the end of 6 months. Now, with the increase in the land price, do you think Ajay will call off the deal? This means Ajay now enjoys the right to buy a piece of land at Rs. Clearly Ajay is making a steal deal here. Venu is options trading basics india to sell him the land at a lesser value, simply because he had accepted Rs.

Another way to look at this is — For an initial cash commitment of Rs. Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay. The profit that Ajay makes Rs. It turns out that the highway project was just a rumor, and nothing really is expected to come out of the whole thing.

People are disappointed and hence there is a sudden rush to sell out the land. As a result, the options trading basics india of the land goes down to Rs.

So what do you think Ajay will do now? Clearly it does not options trading basics india sense to buy the land, hence he would walk away from the deal. Here is the math that explains why it does not make sense to buy the land —. Remember the sale price is fixed at Rs. Hence if Ajay has to buy the land he has to shell out Rs.

Which means he is in effect paying Rs. Clearly options trading basics india would not make sense to Ajay, since he has the right to call of the deal, he would simply walk away from it and would not buy the land. However do note, as per the agreement Ajay has to let go of Rs. For whatever reasons after 6 months the price stays at Rs. Options trading basics india do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the options trading basics india.

Why you may ask, well here is the math —. Clearly it does not make sense to buy a piece of land at Rs. Do note, since Ajay has already committed 1lk, he could still buy the land, but ends up paying Rs 1lk extra in this process. For this reason Ajay will call off the deal and in the process let go of the agreement fee of Rs. I hope you have understood this transaction clearly, and if you have then it is good news as through the options trading basics india you already know how the call options work!

But let us not hurry to options trading basics india this to the stock markets; we will spend some more time with the Ajay-Venu transaction. Options trading basics india would suggest you be absolutely thorough with this example.

If not, please go through it again to understand the dynamics involved. Also, please remember this example, as we will revisit the same on a few occasions in the subsequent chapters. Do note, I will deliberately skip the nitty-gritty of an options trading basics india trade at this stage.

The idea is to understand the bare bone structure of the options trading basics india option contract. Assume a stock is trading at Rs. You options trading basics india given a right today to buy the same one month later, at say Rs.

Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs. In order to get this right you are required to pay a small amount today, say Rs. If the share price moves above Rs. If the share price stays at or below Rs. All you lose is Rs. After you get into this agreement, there are only three possibilities that can occur. Case 1 — If the options trading basics india price goes up, then it would make sense in exercising your right and buy the stock at Rs.

Case 2 — If the stock price goes down to say Rs. Case 3 — Likewise if the stock stays flat at Rs. This is simple right?

If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the finer points, all of which we will learn options trading basics india.

At this stage what you options trading basics india need to understand is this — For reasons we have discussed so far whenever you expect the price of a stock or any asset for that matter to increase, it always makes sense to buy a call option!

Now that we are through with the various concepts, let us understand options and their associated terms. Hi Sir, Options is like greek and latin to me.

Thanks for the analogies. No, all derivative contracts are routed via the exchanges. You cannot enter into an OTC arrangement, even if you do, it would not be regulated hence quite dangerous. What benefit would Ajay get by calling off the deal before the expiry of 6 months?

He will instead wait for the whole 6 months for any options trading basics india of the highway project. My first question Karthik is this: The dropdown value on the NSE website does not contain all months expiries — after 18th May we have 25th June followed by 24th Sept and then 31st Dec What happened to the other months?

For to only June and Dec contracts are available. What happened to the remaining? Saurabh, glad you noticed it! For all stocks options trading basics india the expiry is very similar to futures. Hence we have current month, mid month, and far month contracts. However for Nifty there are several different expiry options. Leaps are good if you have a super long term view on markets. However the problem with leaps in India is that they are not liquid, there are hardly any trading activity here.

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Option is one of the two most widely traded derivative instruments in the stock market. The option contract is traded between a buyer and seller for the underlying asset that can be stocks, bonds, future contracts, index futures and so on. An option contract means that the buyer of the contract has the right but not the obligation to buy or sell a fixed number of underlying assets at a predefined price within a fixed date.

While trading in the option contract the buyer can exercise his buying or selling rights within the fixed date or he can let the contract expire worthless. But the seller of the option contract has the legal obligation to honor the trade when the buyer exercises the option contract within the fixed date.

In option trading the assets are traded in a lot instead of one unit. The price for which the option contract is signed is called the strike price and the date on which the option contract is scheduled to expire is called the expiration date or expiry.

Types of option trading - There are two types of option contract the call option and the put option. When you are buying the call option you are having the right to buy the underlying asset in the strike price of the contract within the expiry date.

When you are buying a put option you have the right to sell the underlying asset within the expiry date at the strike price. In a typical option trading there are two persons involved in the trading- the buyer of the call or put option and seller of call or put option. The person who created the option contract is called the writer of the option. In case of call option he has the legal obligation to sell the asset and in case of put option he has the obligation to buy the asset.

For buying the call option and the put option you need to pay the option writer the premium price of the contract. Specifications of an option contract — There are certain information that is specified in any option contract.

These are the specification or vital part of the contract on the basis of which the option is traded at the exchange between the two parties involved in the trading. The first thing that is mentioned in the contract is the type of the option contract. That means whether the buyer is having the buying right or selling right. On the basis of which it is determined whether it is the call option or put option.

The next specification of the option contract is about the underlying asset of the contract. The type of the asset and the number of the units in the lot are mentioned in the contract. Apart from these information the strike price in which the contract will be traded and the expiry date on which the contract will get expired are also mentioned in the contract. Types of options that are traded at the stock market — There are mainly two types of options and they are,.

Exchange traded option - The exchange traded options are derivative that is traded at the exchanges. These options have standard contract and the contract is settled between the two parties through a clearing house. As these option contracts are standardized there are accurate price models for these contracts. The exchange traded options are available for different underlying assets including stock, commodity, bond, stock market index, and futures contracts.

Over the counter options — These contracts are traded between the two parties without the intervention of the exchange and hence these trades are not listed at the exchanges. As these options are not restricted by the clearing authority the specification of these contracts are determined according to term and requirements of the businesses concerned in the trading. The common types of options that are traded in these types are the interest rate options, currency cross rate options, and options on swaps.

Benefits of option trading — Option trading lets you enjoy greater leverage. That means with significantly smaller deposit you invest in asset that is of much higher value. Secondly in option trading you have less risk involved as you can always let the contract expire without any action if your speculation go wrong.

Click here for Indian stock market tips. For more details click here. Types of options that are traded at the stock market — There are mainly two types of options and they are, Exchange traded option - The exchange traded options are derivative that is traded at the exchanges.