Updated: Apr 8, 2021
Welcome to another article on futures and options. In the previous article, we had discussed the various terms related the options trading. As with any of the previous articles, we will again make the same old belief that you are new to the futures and 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 by running through some basic background information.
In this article, we are going to learn about the Call and Put options strategies. It is one of the most important parts of options trading in the stock market. The whole options trading are depending only on these. So, without any delay, let’s jump into the article:
A call option is a derivative agreement between two parties. The buyer of the call option acquires a right (it's anything but a commitment) to practice his option to purchase a specific resource from the call option seller for a specified timeframe. Once the buyer sells his option (before the expiration date), the seller has no other option than to sell the asset at the strike price at which it was initially agreed. The buyer looks for the price to increase and thus earns capital profits.
Assume a stock is trading at Rs. 1600 today. You are given a right today to buy the same stock after one month, at say Rs. 2000, but only if the share price on that day is more than Rs. 2000, would you buy it?. You would buy it, as this means to say that after 1 month even if the share is trading at 2100, you can still get to buy it at Rs.2000. To get this option, you are needed to pay a small amount today, say Rs.5.0.
If the share price goes above Rs. 2000, you can exercise your right and buy the shares at Rs. 2000. If the share price sticks at or below Rs. 2000, you do not exercise your right and you do not require buying the shares. All you lose is Rs. 5 in this case. An order of this sort is called an Option contract, a Call Option.
The call option buyer has the right, but not the commitment to buy an agreed quantity of a specific commodity or financial instrument (the underlying asset) from the seller of the option at a definite time (the expiration date) for a certain price (the strike price). The option seller or writer is committed to selling the commodity or financial instrument should the buyer so decide. The buyer pays an option premium for this right.
I wish by now you are through with the feasibility of a Call option from both the buyer's and seller's point of view. If you are surely familiar with the call option then align yourself to understand ‘Put Options’ is very easy. The only change in a put option (from the buyer’s point of view) is the view on stock markets should be bearish as against the bullish view of a call option buyer.
Think about this situation, between the option buyer and the option seller. Suppose the share price of Reliance Industries at the current market is Rs. 1600. Option buyer buys the right to sell Reliance Industries shares to option buyer at Rs. 1600 upon the expiry date. To acquire this right, the option buyer has to pay a premium to the option seller.
Against the delivery of the premium, the option seller will agree to buy Reliance Industries shares at Rs. 1600 upon expiry day but only if the option buyer wants him to buy it from him. Let’s take an example, if upon expiry Reliance is at Rs. 1500, then option buyer can order contract seller to buy Reliance at Rs. 1600 from him.
This means the option buyer can enjoy the welfare of selling Reliance at Rs. 1600 when it is trading at a lower price in the open market which was Rs. 1500. If Reliance is trading at Rs. 1600 or higher upon expiry day (say Rs. 1700), it does not make sense for the option buyer to exercise his right and ask the option seller to buy the shares from him at Rs. 1600.
This is quite clear since he can sell it at a higher rate in the open market. An agreement of this kind where one gets the right to sell the underlying asset upon expiry day is called a Put option. Option seller will be requiring buying Reliance at Rs. 1600 from the option buyer because he has sold Reliance 1600 Put Option to the option buyer.
I wish the above discussion has given you the needed direction to the Put Options. If you are still chaotic, it is alright as I’m sure you will develop more precision as we proceed further. So, there are 3 key points you need to be wise of at this stage: –
The option buyer of the put option is bearish about the underlying asset, while the option seller of the put option is neutral or bullish on the same underlying asset.
The option buyer of the put option has the right to sell the underlying asset upon expiry day at the strike price.
The option seller of the put option is compelled (since he receives an upfront premium) to buy the underlying asset at the strike price from the put option buyer if the buyer intends to exercise his right.
So to conclude this article, I would like to highlight few terms regarding the Call and Put.
Buy a Put Option when you are bearish about the expectation of the underlying asset. In other words, a Put option buyer is profitable only when the underlying asset declines in stock value.
The intrinsic value calculation of a Put option is slightly different when contrast to the intrinsic value calculation of a call option.
If the Put option buyer is bearish about the market, then certainly the put option seller must have a bullish view on the stock market.