Call and Put Options-A Beginner’s Guide to Options Trading-chapter 1

1.1. What Are Options? Call vs Put Explained

Definition of Options

An option is a financial derivative that grants the holder the right, but not the obligation, to buy or sell an underlying asset like stocks, commodities, or currencies at a predetermined price also known as Strike Price before or on a specific expiration date.

What are Call Options: Features, Use Cases, Examples

What are Call Options:

A call option is a financial contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a specified price  before or on the contract’s expiration date.

Key Features:

1. Premium: The buyer pays a fee (premium) to the seller for this contract.
2. Profit Scenario: A call option is valuable when the price of the underlying asset rises above the strike price. For example:

If you own a call option with a strike price of ₹100, and the market price rises to ₹120, you can buy the asset at ₹100 and potentially sell it at ₹120 for a profit.

3. Risk: The buyer’s maximum loss is limited to the premium paid, whereas the seller (writer) faces potentially unlimited losses if the asset price skyrockets.

Use Cases:

• Speculation: Predicting a rise in asset prices to generate profit.
• Hedging: Investors use call options to protect against missing out on potential gains if the asset price rises.

What are Put Options: Features, Use Cases, Examples

What are Put Options

A put option is a financial contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price (the strike price) before or on the contract’s expiration date.

Key Features:

1. Premium: Like a call option, the buyer pays a fee (premium) to the seller.
2. Profit Scenario: A put option is valuable when the price of the underlying asset falls below the strike price. For example:

If you own a put option with a strike price of ₹100, and the market price drops to ₹80, you can sell the asset for ₹100 instead of ₹80, potentially profiting from the price difference.

1. Risk: The buyer’s maximum loss is the premium paid, while the seller faces significant risks if the asset price plummets.

Use Cases:

• Speculation: Anticipating a decline in asset prices to profit.
• Hedging: Protecting against losses by locking in a sell price if the asset’s value drops.

Call Option vs Put Option: Key Differences for Traders

Options provide flexibility for investors but also come with risks. It’s vital to understand the market and have a clear strategy when trading.

1.2 A Brief History of Options Trading

Ancient Roots

The concept of options dates back thousands of years, even before the advent of formal financial markets. One notable example is the philosopher Thales of Miletus in ancient Greece. Around 350 BCE, Thales predicted a bumper olive harvest and used his knowledge to secure rights to rent olive presses at a fixed price. When the harvest proved to be abundant, demand for olive presses skyrocketed, allowing Thales to profit by renting out the presses he had secured earlier. This early example of an options contract demonstrated the use of forecasting and risk management.

17th Century Developments

Dojima Rice Exchange (Japan):

1. During the late 1600s, Japan established one of the world’s first organized commodity exchanges, the Dojima Rice Exchange in Osaka. At the time, rice was not just a commodity but also a currency and store of wealth. Samurai, who were often paid in rice, started trading futures and options to secure profits despite fluctuations in rice prices.
2. These contracts were essential in reducing financial uncertainty for sellers and buyers.

Tulip Mania (Netherlands):

In the Netherlands during the 1630s, options-like agreements played a key role in the infamous Tulip Mania, where tulip bulbs became speculative assets. Traders made deals allowing them the right to buy or sell tulip bulbs at set prices in the future, fueling a bubble that eventually collapsed. This highlighted both the power and risks associated with speculative trading.

Early Modern Era

The foundation for contemporary options trading was laid in the late 19th and early 20th centuries:

• Unregulated Markets: By the late 1800s in the United States, stock options were traded, but there were no standardized contracts or regulatory oversight. This often led to uncertainty and disputes among traders.
• Informal Agreements:Options during this time were more akin to private contracts between parties rather than the standardized financial instruments we know today.

The Creation of the Modern Options Market

1. Chicago Board Options Exchange (CBOE):
   1. The establishment of the CBOE in 1973 marked a pivotal moment in options trading. This was the first exchange to introduce standardized options contracts. Standardization made trading easier and reduced risks associated with discrepancies between contracts.
   2. Contracts became accessible to retail investors, paving the way for the modern derivatives market.

2. The Black-Scholes Model:

Around the same time, economists Fischer Black, Myron Scholes, and Robert Merton introduced a groundbreaking mathematical formula for pricing options. Known as the Black-Scholes model, this formula provided traders with a scientific approach to determining the value of options, revolutionizing the industry.

Key Milestones in Options History

The evolution of options trading reflects the growing sophistication and inclusivity of financial markets. From ancient olive presses to mobile apps, the principles of forecasting and risk management remain at the heart of options trading.

1.3. Options Trading in India – How It Evolved

Options trading in India has an interesting history. It began in the 1970s with the introduction of index options on the Bombay Stock Exchange (BSE). However, during those early years, the market for options was relatively limited due to factors like lack of awareness, regulatory constraints, and technological limitations.

A significant milestone came in 2001 when the National Stock Exchange (NSE) introduced index options based on the Nifty index. This was followed by the introduction of stock options in 2002, which allowed trading on individual stocks. These developments expanded the scope of options trading and made it more accessible to a broader range of investors.

Over the years, options trading in India has grown rapidly, with innovations like weekly options contracts and the introduction of options on commodities. Regulatory bodies like SEBI have played a crucial role in ensuring transparency and investor protection

1.4 Understanding Call Options: Meaning, Examples, Strategies

A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset (like a stock, bond, or commodity) at a specified price, known as the strike price, within a predetermined time frame. The buyer pays a fee, called the premium, for this right.

If the price of the underlying asset rises above the strike price before the option expires, the buyer can exercise the option to buy the asset at the lower strike price, potentially making a profit. On the other hand, if the price doesn’t rise above the strike price, the buyer may choose not to exercise the option, and their loss is limited to the premium paid.

Call options are often used for speculation, income generation, or hedging against potential price increases. They can also be combined with other financial instruments to create more complex investment strategies.

How to profit from buying call options?

Buying call options can be profitable when the price of the underlying asset rises above the strike price before expiration. The key to success is:

• Choosing the right strike price: Opt for a strike price that balances affordability and profitability.
• Timing the market: Enter when the asset is expected to rise.
• Managing risk: Use stop-loss strategies and avoid over-leveraging.

Reliance Call Option Example: NSE Stock Option Explained

Example: Call Option – Reliance Industries

Let’s say it’s 1st June, and Reliance Industries’ stock (RELIANCE) is trading at ₹2,500 per share.

You believe the price will rise in the next month, so you buy a Call Option.

 Trade Details:

• Stock:Reliance Industries (RELIANCE)
• Strike Price:₹2,600
• Premium Paid: ₹30 per share
• Lot Size: 250 shares (standard NSE lot for Reliance)
• Option Type: Call Option
• Expiry: End of June

 Scenario 1: Price goes up to ₹2,700

At expiry, the stock is ₹2,700. You exercise your option:

• Intrinsic Value:₹2,700 – ₹2,600 = ₹100
• Profit per share:₹100 – ₹30 = ₹70
• Total Profit:₹70 × 250 = ₹17,500

 You made a profit!

Scenario 2: Price remains below ₹2,600

At expiry, Reliance is at ₹2,550. Your option expires worthless:

• Loss:₹30 × 250 = ₹7,500 (the premium paid)

You lose the premium, but not more than that.

Here’s the payoff chart for the Reliance call option:

• The break-even pointis ₹2,630 (Strike ₹2,600 + Premium ₹30).
• You start making a profit only above ₹2,630.
• Your maximum lossis limited to ₹7,500 (i.e., ₹30 × 250 shares), which occurs when the stock remains below the strike price.

1.5 Understanding Put Options: Definition, Use Cases, Profit Scenarios

Is put option buying profitable?

Put option buying can be profitable when the price of the underlying asset declines before the option expires. Here’s how it works:

1. Understanding Put Options

A put option gives the buyer the right (but not the obligation) to sell an asset at a predetermined price (strike price) before expiration. If the asset’s price falls below the strike price, the buyer can sell at the higher strike price and profit from the difference.

2. Profitability Factors

• Market Direction: Put options are profitable in bearish markets where asset prices decline.
• Strike Price Selection: Choosing the right strike price is crucial—ITM (in-the-money) puts have higher premiums but greater chances of profitability.
• Time Decay: As expiration nears, the value of the option decreases, so timing is key.
• Volatility: Higher volatility increases the value of put options, making them more profitable.

3. Example of Put Option Profitability

Suppose Reliance Industries is trading at ₹850, and you buy a put option with a strike price of ₹900 at a premium of ₹20 per share. If the stock price drops to ₹800, you can sell at ₹900, making a net profit of ₹80 per share (₹900 – ₹800 – ₹20 premium).

4. Risks of Put Option Buying

• Limited Timeframe: If the stock price doesn’t drop before expiration, the option expires worthless.
• Premium Cost: The buyer pays a premium upfront, which is lost if the option isn’t exercised.
• Market Reversal: If the market unexpectedly turns bullish, put options lose value.

1.6 Best Bullish Option Strategies – From Spreads to Synthetic Calls

In a bullish market, traders aim to profit from rising asset prices using various options strategies. Here are some of the most effective ones:

1. Bull Call Spread

        This strategy involves:

• Buying a call option at a lower strike price.
• Selling a call optionat a higher strike price.
• It reduces the cost of buying calls while limiting potential profits.

2. Bull Put Spread

• Selling a put optionat a higher strike price.
• Buying a put optionat a lower strike price.
• This strategy generates income while limiting downside risk.

3. Call Ratio Back Spread

• Buying multiple call optionsat a lower strike price.
• Selling fewer call options at a higher strike price.
• Profits increase significantly if the stock price rises sharply.

4. Synthetic Call

• Buying the stock and purchasing a put option.
• This strategy mimics a long call position while providing downside protection.

5. Bull Butterfly Spread

• Combining multiple call optionsat different strike prices.
• Profits are maximized if the stock price reaches a specific target.

6. Bull Condor Spread

• Similar to the butterfly spread but with wider strike price gaps.
• Provides a balanced risk-reward ratio.

7. Bull Call Ladder Spread

• Buying two call options at different strike prices.
• Selling one call option at a higher strike price.
• Profits increase with a strong bullish move.

“What should I do when the market is bullish but volatile?” “Is it worth buying options on expiry day?”

When the market is bullish but volatile, it’s essential to balance optimism with caution. Here are some strategies to consider:

• Review Your Risk Tolerance: Ensure you’re comfortable with potential price swings and adjust your portfolio accordingly.
• Diversify Your Investments: A well-diversified portfolio can help mitigate risks associated with volatility.
• Consider Defensive Assets: Adding stable investments can provide a cushion against market fluctuations.
• Adapt Your Trading Strategy: Fast-moving markets require agility—consider adjusting your approach to capitalize on opportunities.

As for buying options on expiry day, it can be highly risky but potentially rewarding. Some traders use strategies like buying at-the-money (ATM) call and put options just before expiry to take advantage of sharp market movements. However, options that expire out-of-the-money (OTM) or at-the-money (ATM) become worthless, meaning you could lose your entire premium. It’s crucial to manage risk carefully and understand the implications before making a move.

1.7 Case Study – Hedging Electricity Prices in the Power Sector

Here’s a hypothetical yet realistic example set in the Indian power sector to show how call options could work.

1. XYZ Power Distribution Company: A company that purchases electricity from power-generating stations and sells it to consumers.
2. Electricity Producers: Power plants that generate and supply electricity.
3. Market Platform: An electricity futures trading exchange where participants buy and sell electricity contracts.

Initial Situation

• In India, electricity prices are highly volatile due to variations in demand, government regulations, and input costs like coal and natural gas. XYZ Power anticipates a sharp increase in electricity prices during the summer due to high demand for air conditioning.
• To hedge against this risk, the company decides to purchase a call option on electricity futures.

Call Option Purchase Details

• Strike Price (Pre-agreed price):₹5 per kilowatt-hour (kWh).
• Premium Paid:₹0.50 per kWh (this is the cost of acquiring the call option).
• Contract Size:1 million kWh (this means the option is for purchasing 1 million units of electricity).
• Expiration Date:End of the summer (e.g., August 31).

Two Possible Scenarios

1. Scenario 1: Electricity Prices Increase

Market Price in Summer: ₹6 per kWh.

• XYZ Power exercises its call option and buys electricity at the strike price of ₹5/kWh instead of ₹6/kWh. This results in savings:
• Savings per kWh = ₹6 (market price) – ₹5 (strike price) = ₹1 per kWh.
• Total Savings = ₹1 × 1,000,000 units = ₹1,000,000.
• Net Profit = Savings – Premium Paid = ₹1,000,000 – (₹0.50 × 1,000,000) = ₹500,000.

• This graph illustrates the net payoffwhen the market price is ₹6/kWh:
• The orange dashed lineshows the market price at ₹6.
• The red dotrepresents the net profit of ₹0.5 million (₹500,000) after exercising the call option.
• The payoff line clearly demonstrates profit beyond the breakeven point (₹5.5)and a maximum loss (₹0.5 million) when the market price is at or below the strike price (₹5).

1. Scenario 2: Electricity Prices Decrease

Market Price in Summer: ₹4 per kWh.

XYZ Power lets the call option expire, as it is cheaper to buy electricity at the market price of ₹4/kWh. The loss incurred is limited to the premium paid:

Loss = ₹0.50 × 1,000,000 units = ₹500,000.

XYZ Power avoids additional costs by not exercising the option.

This graph shows the payoff outcome when the market price is ₹4/kWh:

• The orange dashed line marks the market price at ₹4.
• The red dot represents a net loss of ₹0.5 million (₹500,000), equal to the premium paid.
• Since the market price is below the strike price (₹5), XYZ Power does not exercise the call option.
• This scenario confirms that the maximum loss is capped at the premium.

Benefits for XYZ Power

• Risk Mitigation:The call option serves as insurance against price spikes, ensuring the company doesn’t have to buy electricity at unreasonably high rates.
• Budget Predictability:By capping potential costs, XYZ Power can prepare more accurate budgets for the summer.
• Flexibility:If prices fall, the company can let the option expire, benefiting from lower market price

Key Takeaway

1. Cost of the Option:The premium represents the cost of securing price protection. It’s an upfront cost that must be accounted for.
2. Risk-Reward Tradeoff:While the premium cost is a potential loss if the option is not exercised, it safeguards against far greater losses in a volatile market.
3. Wider Application:Call options are not limited to electricity; similar strategies are employed in natural gas, crude oil, and renewable energy markets.

India’s Electricity Derivatives Market is still evolving, but the concept of energy hedging is gaining popularity. In more mature markets like the U.S. or Europe, power companies frequently use call options to lock in favorable rates for future energy procurement.

In India, with the growth of renewable energy, fluctuations in solar and wind power generation are also influencing electricity prices. Using call options allows companies to better manage these uncertainties.

1.8 Call Buyer vs Seller – Risk Graphs Explained

1. Buyer’s Profit/Loss Graph (Call Option)

• The buyer (XYZ Power) pays a premium of ₹0.50 per unit.
• If the market price is above the strike price (₹5/kWh), the buyer exercises the option and gains.
• If the market price is below ₹5/kWh, the option expires worthless, and the loss is limited to the premium paid.

Formula:

• Profit = Max(0, Market Price – Strike Price) × Quantity – Premium Paid
• Loss = Premium Paid, if the option is not exercised.

Buyer’s Risk Graph:

• Breakeven Point: ₹5 (strike) + ₹0.50 (premium) = ₹5.50/kWh.
• Profit Zone: When price > ₹5.50.
• Max Loss: ₹500,000 (premium paid) when price ≤ ₹5.

Seller’s Profit/Loss Graph (Call Option)

• The seller (option writer) collects a premium of ₹0.50 per unit.
• If the market price stays at or below the strike price, the seller keeps the premium as profit.
• If the market price rises above ₹5/kWh, the seller suffers losses as they must sell electricity at ₹5 when it is worth more.

Formula:

• Profit = Premium Received, if the option expires worthless.
• Loss = (Strike Price – Market Price) × Quantity – Premium Received, if exercised.

Seller’s Risk Graph:

• Breakeven Point: ₹5.50/kWh.
• Profit Zone: When price ≤ ₹5 (keeps premium).
• Max Loss: Unlimited if prices rise significantly. (Higher the price, bigger the loss.)

1.9 Tools for Smart Trading – FnO 360 by 5paisa

FnO 360 is a specialized trading platform designed for derivatives traders, particularly those dealing with Futures and Options (F&O). It offers a range of tools and features to simplify and enhance the trading experience. Here’s a detailed breakdown:

Key Features of FnO 360:

1. Open Interest (OI) Analysis:It Provides real-time tracking of open interest with graphical insights. It also Helps traders gauge market sentiment and predict price movements.
2. Advanced Option Chain:This section Offers in-depth data on contracts, including Straddle and Greeks. It Enables traders to analyze strike prices, implied volatility, and execute trades efficiently.
3. Predefined Strategies:Predefined strategies include Includes ready-to-use strategies like Straddle and Strangle. It Simplifies complex calculations, making it beginner-friendly.
4. Basket Orders:It Allows placing multiple orders simultaneously for efficient execution. Also it is Ideal for multi-leg options strategies.
5. Real-Time News Integration:Real Time news Intergration section Provides updates on market and corporate announcements. It Helps traders react quickly to market-moving news.
6. Lightweight Charts:It Displays current market trends visually, offering an at-a-glance view of market direction.
7. Powerful Screeners:It Enables real-time market scanning across derivative contracts. It Helps identify trading opportunities swiftly.
8. Elegant Orderbook and Positionbook:It Offers lightning-fast order and trade confirmations. This also Ensures traders can manage their positions confidently.
9. Strategy Charts:This section Provides strategy-level price charts for better understanding and positioning of trades.
10. Rollover and Quick Reverse:It Facilitates hassle-free rollover of futures positions to the next expiry. It Allows quick conversion of short positions to long positions and vice versa.

Benefits of Using FnO 360:

• User-Friendly Interface: Simplifies the complex world of derivatives trading.
• Comprehensive Tools: Offers a wide range of features to cater to both beginners and experienced traders.
• Efficiency: Enhances trading speed and accuracy with advanced functionalities.

FnO 360 is available as a desktop platform and mobile app, ensuring flexibility for traders. You can explore more about it here or here.

“Try FnO360 by 5paisa – India’s leading options trading toolkit.”

Link –  https://fno.5paisa.com/

1.10 Key Takeaways

Final Thoughts – Using Options for Profit and Protection

• Options Trading Basics– Call options give the right to buy, while put options give the right to sell an asset at a set price before expiration.
• Risk and Profit Potential– Buyers have limited risk (premium paid), while sellers face potentially unlimited losses.
• Historical Evolution– From ancient Greece to modern exchanges, options trading has developed over centuries, with innovations like the Black-Scholes model and standardized contracts.
• Growth in India– Options trading gained traction in India after the early 2000s, with NSE introducing index and stock options, making them accessible to retail traders.
• Strategies for Success– Various bullish and bearish strategies, including spreads and hedging techniques, help traders maximize profits while managing risks.
• Real-World Application– Companies, like those in the power sector, use options to hedge against price fluctuations, ensuring cost stability.
• Smart Trading Tools– Platforms like FnO 360 by 5paisa provide analytics and predefined strategies to enhance decision-making in the options market.
• Final Advice– Understanding options, managing risks, and leveraging market insights are crucial for profitable trading.