Updated: Apr 8, 2021
Welcome to yet another existing chapter in the series of Futures and Options. In this chapter, we will learn about the basics of options trading and its strategies. This is our third chapter in the series. I hope you might be enjoying it and learning something new. What else you want to know about options and options strategies and if anything else you want to improve in the options trading, stick with us. So without wasting any time, let's go to the chapter.
This is my master class series on options strategies and we are at a basic level so we are discussing the basic information and the basic knowledge about the options and how to deploy the option strategies.
The point that will be covered in this topic is what are options? Why are they required in the first place? Who are buyers and sellers? What are the different kinds of options on different underlying assets?
So what are the options? In simple terms, if I say the options are insurance policies for businesses. If you have insurance policies, it will be very easy to understand options. If you know how the insurance work, in similar way options, also work. The only difference in the insurance business is that there are insurance companies who write or who issue insurance policies and generally those individuals buy the insurance but in options trading, every investor or every seller can write one insurance policy.
So before we understand what is my insurance policy? How it is similar to an insurance policy?
The first thing I want to tell you why this insurance is required? Now, once you understand all businesses work in a certain business environment but the world itself is uncertain. For example, suppose you are doing some business like a jeweler. So, what is the most important input for you? The most important input for you is your gold.
So, suppose one client came to you and he got some baggage in his family and he wants you to make some jewelry for him and the jewelry should be delivered after one month or one month from today's date. He gives you some advanced say Rs. 50,000 rupees and in saying the balance what he will give you once the jewelry is ready. Now you understand that you got this order but you are going to execute this order after one month or at the end of one month.
So you understand that you have done some calculation and put that calculation on gold prices of today's rate. But when you will execute the work after one month, what if the gold price jumps up to 20 to 30%. Don't you think you will not be able to do the work because you might have done the calculation on today's rate?
Suppose today's rate of gold is Rs. 10,000 per 10 grams. Maybe after one month or before you start buying for that order; the prices go to Rs. 15,000. Then, you will make losses because you have agreed on Rs. 10,000 per 10 grams but now the price is at Rs. 15,000 per 10 grams.
So in that scenario, definitely you cannot work and if such a situation exists all the time, the business of the jeweler will become a loss-making business instead of a profitable business. If the price goes to Rs. 9000, then you will make profits because you have agreed on Rs. 10,000 per 10 grams but now, the price is at Rs. 9000 per 10 grams.
One of the most important options is hedging. Hedging rules are to protect capital from losses. Suppose one farmer whose crop is to be harvested in say one month. Now, he's worried that what will be the price he will get after one month? Maybe, the prices can crash at that time and he will not get that much money. So what can he do?
He can simply go to the market and he can buy one you can say put. What is put? Don't worry about it. We will discuss this in detail in the later article. In this way, his capital will be hedged or protected. So let me clear it. For the time being you understand buying call or put or by selling call or put, you can manage your positions.
Alternatives are a sort of derivatives, and subsequently, their price relies upon the estimation of an underlying asset. The underlying asset can be a stock, yet it can likewise be a list, cash, a commodity, or some other security.
Since we have perceived what options are, we will take a look at what an options contract is? An option agreement is a monetary agreement that gives a financial investor an option to either purchase, sells a resource at a pre-decided cost by a particular date. In any case, it likewise involves an option to buy, however not a commitment.
When understanding option agreement/contract meaning, one necessity to comprehend that there are two gatherings included, a buyer (additionally called the holder), and a seller who is alluded to as the option writer.
At the point when the Chicago Board Options Exchange was set up in 1973, present-day options appeared. In India, the National Stock Exchange (NSE) presented a trading list in option on June 4, 2001.
Hedging tools are like insurance policies so somebody who does not want uncertainty in their business, buy that insurance. It is the biggest myth in the market that if you are ultra-rich then only you can write options.
See, if you got two lakh rupees in your account, you know a home you can write one lot of options. So all the people who can take a little bit of risk can be option writers and can make sure shot profits. So, financial institutions banks that have big rich people can write the options up to 20 lots or 50 lots. So people like you and me will write only one lot.
I am taking this analogy so that you can understand it very well. It should not become more complex because most of you might be understanding about health insurance and life insurance and how health insurance and life insurance evoke. So, similar option writing and options also work.
The seller of an option contract is known as the 'Options writer'. Not at all like the purchaser in an option contract, the merchant/seller has no rights and should sell the resources at the agreed cost if the purchaser decides to execute the options contract before the agreed date, in return for an upfront installment from the buyer.