Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T15:21:13+05:30
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Introduction

Call and put options are a typical derivative or contract that provides rights to the buyer. However, there’s no obligation to purchase or sell the underlying asset within a specific date or at a specified price.

Options come in two classified distinctions - call option and put option. Nevertheless, the call-and-put options examples can be further categorized into American-style options and European-style options. While the prior can be exercised anytime prior to their expiration, the latter can be exercised only on the expiry date.

Today, this derivative guide will provide you with valuable insights into what are call and put options. Please stay tuned until the end to learn more about it.

Let’s dive in!
 

Call and Put Options for Beginners

Underlying Asset’s Price

What is to Be Done?

Probability of increasing

BUY call option or SELL put option

Probability of decreasing

BUY put option or SELL call option

 

Types of Option Contracts

When it comes to Option contracts can be broadly classified into two major distinctions, namely:

●    US Option Contracts

The US options can be exercised anytime prior to the expiration date.

●    European Option Contracts

The European options can be exercised only on the expiration date.

Please note that the traded call and put options examples belong to the US option contracts. And these can be seamlessly squared off anytime before the expiration date.
 

What Is a Call Option?

A call option is a typical contract that provides purchasing rights to a buyer. Thus, buyers have the privilege to purchase a particular security, like a stock, at a certain price. Most importantly, call options to come with expiry dates.
It is true that plenty of institutions deal with unusual and complex options on various types of financial securities. However, the call options can be bought and sold on numerous securities like currencies, swaps, ETFs, etc. In fact, the investors who purchase a call option aren't obligated to purchase and exercise the underlying asset at the strike price.
 

How Do Call Options Work?

A call option contract is formulated on a securities exchange where an option seller or writer transacts with an option buyer. Here, the option seller provides the right to the buyer to acquire a specific security at a specified price. However, there is no obligation associated with the same.

When it comes to equity call options, the number of shares per contract is typically 100. This means the buyer of the call option contract is capable of exercising that option to purchase 100 shares. Fortunately, the same can be done from the underlying stock at the specified strike price.

On the other hand, the investor who buys a call option contract is required to pay the price - Option Premium. This needs to be paid to the seller or writer of the call option contract.

Please note that the buyers and sellers thoroughly determine the market value of options. However, the options are typical derivatives of the underlying security.

Furthermore, if the underlying security price is beyond the contract’s strike price, then there will be value at expiry. Thus, the call option is very likely to possess intrinsic value or trade-in money. In fact, the exercising option will enable the option holder to purchase the stock at a significantly lower price.

During expiry, a call option’s intrinsic value represents a benefit to the buyer and a cost to the seller. Remember that the call options are very likely to offset each other.
 

Example of Call Option

Here’s a remarkable call option example:

Let’s assume that the stocks of Gammon India are at Rs. 100 for each share. Investor B holds such 100 shares and looks forward to generating income beyond the dividend. And stocks are not likely to increase beyond Rs. 150 in the following month.

B assesses call options and finds a call trading of Rs. 150, where each contract is at 50p. So the investor sells one call option and receives Rs. 50 as the premium amount.

If the shares’ price exceeds Rs. 150, the buyer option will increase the right. Further, B will need to deliver the shares at Rs. 150 per share. But if the price doesn’t go beyond Rs. 150, B gets to hold the shares while not affecting any sale.
 

What Is a Put Option?

The put option provides a buyer with the right to sell the underlying asset at the specified strike price. However, there is no obligation for the buyer to do the same. But the ‘ put option' seller has to buy the asset when the put buyer starts exercising their option.

The majority of investors purchase ‘puts’ only when they’re determined that the underlying asset’s price will decrease. Likewise, they sell puts once they know that the underlying assets will increase.
 

How Do Put Options Work?

There are innumerable ways to complete or close out the option trade according to the circumstances. So, when the option expires profitable, the option stands a chance of being exercised. But if the option expires unprofitable and nothing happens, then the money paid for the option is particularly lost.

A put option has remarkable chances of increasing in value. This means the premium of a put option rises as the price of the underlying stock decreases. Alternatively, when the premium of a put option declines, the stock price rises considerably.

Put options offer a selling position to the investors in the stock when it’s exercised. Thus, a put option is often used to protect from the downward moves within a long stock position.

While put options can be used for speculation or hedging, it works a little differently when it comes to the basics. In a nutshell, the value of a put deliberately increases while the underlying stock value decreases and vice versa.

When you buy a put option, you bet that the value of the underlying stock will decrease. And when you sell a put option, you place a bet that the value of the underlying stock will increase.

Example of Put Option

For instance, A purchases one Rs.100 put option on Ford Motor Co. And while each option contract is worth 100 shares, he has the right to sell 100 shares of Ford at Rs. 100. However, this privilege remains valid before the expiration date.

If A already holds 100 shares of Ford, then his broker will sell these shares at Rs. 100 strike price. So, to complete the transaction, an option writer will purchase the shares at the same price.
 

Basic Terms Relating To Call And Put Options

Now that you know what are call and put options, let’s look into the basic terms:
Spot Price
It is the current price of the underlying asset within the stock market.
Strike Price
This price is where the buyers and sellers decide to buy or sell the underlying asset after a specific period.
● Option Premium
It is the non-refundable amount that the option buyer pays upfront to the option seller.
● Option Expiry
Options contracts are deemed to expire on the last Thursday of the month.
● Settlement
In India, options contracts are settled as cash.
 

What is the Difference Between Call Option & Put Option?

Some of the major differences between the call option and put option are:

Parameters

Call Option

Put Option

Meaning

Call option provides buying rights to the buyer, but without any obligation of buying

Put option provides selling rights to the buyer without any obligation to sell

Expectations of the Investors

Buyers of call option expects that the stock prices will increase

Buyers of put option is determined that the stock prices will decrease

Gains

There are unlimited gains for a call option buyer

The gains are limited for a put option buyer since the stock prices won’t become zero

Loss

The loss is typically limited to the premium paid for a call option buyer

The maximum loss for a put option is the strike price minus the premium amount

Reaction Towards Dividend

While the dividend date nears, the call option loses value

As the dividend date nears, the value of the put option increases

 

How to Calculate Call Option Payoffs?

In the call and put option NSE, the call option payoff refers to the profit or loss made by an option buyer or seller. There are three distinctive variables such as expiry date, strike price, and premium, for evaluating call options. Furthermore, these variables are used for calculating the payoffs which are generated from Call options.

Call option payoffs can be classified into two cases:

●    Payoffs for Call Option Buyers

Let’s assume that you purchase a call option for a company for a premium of Rs. 100. The strike price of the option is Rs. 500 and has an expiration date of 30th November. Even if the company’s stock price reaches Rs. 600, you’re likely to break on your investment.

And if any increase is above the said amount, it is considered a profit. Therefore the payoff value becomes unlimited when the company’s share price increases.

The payoff and profit amount are calculated by using the following formulas:

●    Payoff = Spot Price - Strike Price
●    Profit = Payoff - Premium Paid

●    Payoff for Call Option Sellers

Please note that calculating payoff for the call option in the case of a seller is not quite different from the buyers. If you sell a particular options contract with a similar expiry date and strike price, then you can gain when the price declines. And as per the character of your call option, your losses could be limited or unlimited.

Also, your losses are likely to be unlimited whenever you are forced to purchase the underlying stock at spot prices. However, in this case, your sole income is limited to the premium that is collected after the option contract expires.

The payoffs and profit amount for sellers are calculated using the following formulas:

●    Payoff = Spot Price - Strike Price
●    Profit = Payoff + Premium Paid
 

How to Calculate Put Option Payoffs?

The total profit or loss of a put option trade entirely depends on two distinctive things:

●    Firstly, the things you are likely to receive while exercising the option
●    Secondly, the amount paid for the option in the beginning.

Please note that the first component is equivalent to the difference between the strike price and the underlying price. When the underlying price gets lower in comparison to the strike price, the higher your cash gain becomes during expiration.

●    Payoffs for Put Option Buyers

A put option provides the right to the buyer to sell the underlying asset at the specified strike price. In fact, the profit or loss made by the buyer on the option completely depends on the spot price of the underlying.
But if the spot price is below the strike price during expiry, the buyer can make a significant profit. In a nutshell, the lower the spot price becomes, the greater profit the buyer makes. But if the underlying spot price is greater than the strike price, then the buyer enables his option to expire.

This is typically done by the buyer while keeping his option unexercised. So, in this case, the loss of the buyer is the premium paid for buying the put option.

●    Payoff for Put Option Sellers

When it comes to selling the put option, the seller of the option charges a premium amount. And the profit or loss made by the buyer on the put option entirely depends on the spot price of the underlying.
So whatever profit the buyer makes is typically the loss of the seller. And if the spot price is lower than the strike price during expiry, the put option will be exercised on the seller. But if it's vice versa, the buyer enables his option un-exercised while the seller keeps the premium amount.
 

Risk vs Reward – Call Option and Put Option

Here, we have compared and listed the risks and rewards of both call and put options:

Parameters

Call Option Buyer

Call Option Seller

Put Option Buyer

Put Option Seller

Maximum Profit

Unlimited

Premium amount received

Strike Price - Premium Paid

Premium amount received

Maximum Loss

Premium paid

Unlimited

Premium Paid

Strike Price - Premium Paid

Zero Profit - Zero Loss

Strike Price + Premium Paid

Strike Price + Premium Paid

Strike Price - Premium Paid

Strike Price - Premium Paid

Ideal Action

Exercise

Expire

Exercise

Expire

 

What Happens to Call Options on Expiry? – Buying Call Option

In call and put options, when you buy a call option, a few things can happen during expiry:

●    Market Cost/Price < Strike Cost/Price = Out of Money call option = Loss 
●    Market Price > Strike Price = In the Money call option = Gains/Profits
●    Market Price = Strike Price = At the Money call option = Break – Even (Zero profit, zero loss)
 

What Happens to Call Options on Expiry? – Selling Call Option

In call and put options, when you sell a call option, certain things are likely to happen upon expiry:

●    Market Price < Strike Price = Out of Money call option = Gains/Profits
●    Market Price > Strike Price = In the Money call option = Loss
●    Market Price = Strike Price = At the Money call option = Profit in the form of premium
 

What Happens to Put Options on Expiry? – Buying Put Option

In call option and put option, when you buy a put option, several things are likely to happen during expiry:

●    Market Price < Strike Price = In the Money put option = Gain / Profits
●    Market Price > Strike Price = Out of Money put option = Loss
●    Market Price = Strike Price = At the Money call option = Loss of premium paid
 

What Happens to Put Options on Expiry? – Selling Put Option

In call option and put option, whenever you sell a put option, a few things can probably happen during expiry:

●    Market Price < Strike Price = In the Money put option = Loss
●    Market Price > Strike Price = Out of Money put option = Gains / Profits
●    Market Price = Strike Price = At the Money call option = Profit in the form of premium
 

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More About Derivatives Trading Basics

Frequently Asked Questions

As an investor, you can purchase the call and put options only when the prior anticipates a stock rise and the latter expects a stock fall. You can learn to call and put options and use them best as a typical investment strategy. While the call-and-put options are inherently risky, it is not recommended for the average retailer investor.

Neither of the call & put options is particularly better than the other. However, it entirely depends on the investor's investment objective and risk tolerance. But most of the risk ultimately depends on the fluctuation in the underlying asset's market price.

You should note certain things if you are wondering which is riskier in the call and put options. For a significantly longer time, put options have been historically riskier. It is probably because the stock prices tend to rise higher in comparison to all other assets.

Whenever your implieds are different, then you might need to do more work to identify the reason behind the imbalance. However, interest and dividends are the most obvious culprits that make the call and put options to have different IVs. Please note that the interest rate assumptions can vary over expirations, stocks, and strikes.