However, some participants in the market seek to capitalize on potential gains while safeguarding against losses. This has given rise to the use of options as a financial instrument. Options offer the opportunity for unlimited profits when buying or selling underlying assets while providing a mechanism to limit potential losses.
An option represents a contractual agreement granting the holder the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price on or before a specified date. This entitlement is acquired through the payment of a premium, which is the price of the option. The individual assuming a long position by buying the option is referred to as the buyer or holder, while the party taking the short position by selling the option is known as the seller or writer. The option’s premium is settled upfront, at the time of purchase.
Importantly, the option holder possesses the right to execute the option but is not obliged to do so. This decision typically hinges on whether the market conditions are favorable for the holder. In contrast, the option writer is bound by a legal obligation to fulfill the terms of the contract whenever the option holder chooses to exercise their right.
Options can be categorized into two primary types:
Call Options: These provide the holder with the right to buy the underlying asset.
Put Options: These provide the holder with the privilege to dispose of the underlying asset.
Below are some of the important option terminologies that one must know before trading in option:
Instrument Type: This indicates whether it’s a call option or a put option. A call option provides the holder with the ability to purchase, whereas a put option grants the holder the capability to sell.
Underlying Asset: The asset on which the option is based, such as stocks, indices, or commodities.
Expiry Date: The date of the option contract’s expiration. Beyond this date, the option loses its validity.
Option Type: Specifies whether it’s a call or put option.
Strike Price: The pre-determined price at which the underlying asset can be bought (for a call option) or sold (for a put option).
Open Price: The price at which the first trade of the option occurred on a given trading day.
High Price: The highest price at which the option traded during the trading day.
Low Price: The lowest price at which the option traded during the trading day.
Close Price: The final price at which the option traded at the end of the trading day.
Traded Volume: The total number of option contracts that were traded during the trading day.
Open Interest: The total number of outstanding option contracts for a particular strike price and expiry date.
Underlying Value: The current market price of the underlying asset, which influences the option’s price.
Example: Let’s say you are interested in a call option for ABC Ltd. (the underlying asset) with a strike price of Rs. 1500. The option’s expiry date is one month from now. The open price today was Rs. 50, and it reached a high of Rs. 70 and a low of Rs. 40 during the trading day. At the end of the day, the option closed at Rs. 60. The total traded volume was 500 contracts, and the open interest for this option stands at 1,000 contracts. The underlying value of ABC Ltd. is currently Rs. 1,600.
Lot size or Contract size: Contract size, also known as lot size, refers to the quantity of the underlying asset specified in a single contract. The contract size varies depending on the stock or index underlying the option contract. For instance, Nifty option contracts have a fixed contract size of 50 units. To illustrate, in the scenarios mentioned earlier, the total premium for a call option contract would be Rs 124.50 multiplied by 50, equating to Rs 6225. Similarly, for a put option contract, it would be Rs 177.60 multiplied by 50, totaling Rs 8880.
Tick size: Tick size pertains to the smallest permissible price change in quotations. In the context of index and stock option contracts, similar to stock and index futures contracts, the tick size is set at 5 paisa.