Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-28T15:49:39+05:30
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Introduction

Are you new to the stock market? If so, you must know about one of the most famous investment tools – stock options. Gone are the days when companies used to pay cash or funds as compensation or bonuses. Instead of cash or funds, they provide stock options to their employees. 

Having a proper idea of ‘what are stock options,’ how it works, and the advantages of options stocks will assist you in picking the ideal compensation package and using your options prudently. In this blog post, you’ll learn all about stock options, their benefits, and several other related aspects. 

So, stick to the end. 
 

What Are Stock Options? How Do They Work?

Today, organizations are using stock options as a luring asset to retain the existing best employees and attract the good, prospective ones. Suppose a company offers stock options as a part of an incentive to a prospective employee. In that case, it means that an individual gets ownership of the company’s stock at a discounted price. 

The prospective employee will pay much less than what they’d have paid to buy this stock on the open market. A technique known as vesting is used to retain employees by offering them stock options. 

Vesting is an excellent tactic that helps organizations influence and motivate their employees to stick with them through the vesting phase to hold possession of the options stocks offered (rather granted) to them. Once you meet the requisites of the vesting schedule, you’ll get to truly hold possession of the options. 

For instance, let’s say that your company granted 5,000 shares to you. They set the vesting schedule to be of four years, which means that you get 1250 shares at the end of every financial year. It implies that you must stick with the company for at least a year to exercise your initial 1250 options. 

To exercise the entire 5,000 options, you’ll have to stay with the company till the end of the fourth financial year. So, it’s clear: stick with your organization for the entire vesting schedule and take 100% of your options stocks list grant. 
 

Stock Option Parameters

American vs. European Styles

Options are of two different styles: European and American. You can exercise American options between the date of purchase and expiration, no matter the time or place. However, you can exercise the not-so-popular European options only when it’s the expiration date. 

Expiration Date

The expiration date is the predefined date when an investor anticipates their stock value to either decline or increase. Before you determine the expiration date, it’s crucial to research and study the market trends while analyzing the market’s historical performance. 

Based on the type of stock options, you can exercise the option to make a profit and predict and theorize when the asset’s value will surge or decline to determine the expiration date. 

Contract Size

Contracts resemble a particular number of shares that an investor intends to buy. One hundred shares of any underlying stock are equivalent to one contract. Let’s take an example where an investor is predicting that Infosys’s stock will surge above INR 10,000 by the mid of February. This will let them buy a February INR 10,000 call.  

Let’s assume the trader or investor wants to buy four call contracts. This will let the investor own four February INR 10,000 calls. 

In the event that the stock surges high above INR 10,000 by the end of the expiration date, the investor will get the choice to buy or exercise 400 shares of Infosys’s stock at INR 10,000, no matter what the latest stock price may be.  

If the value of the stock price falls below INR 10,000, there will be valueless expiration of the options. Plus, the investor will be at a great loss as they will lose the whole sum of money invested in buying the options.

Premium

The stock price you pay for any option is known as the premium. To calculate the premium, you must multiply the price of the call by the number of contracts, and subsequently multiply the result by 100. 

In the case where the options stocks expire worthlessly, the trader will lose every penny they invested in purchasing the option. This sum of money is called the premium. 
 

Trading Stock Options

Numerous exchanges enlist the best stocks for options trading in India. These exchanges include the Bombay Stock Exchange, National Stock Exchange, and more. The NSE option stock list is one of the most popular in India. 

The strategy used by a trader determines what options they can buy or sell. By keeping the above example in mind, if an investor considers Infosys shares are confident of increasing or rising, they can either decide to write or sell the put or buy the call. 

In that event, the put seller will require no premium payment. Instead, the seller will get the premium. A whopping INR 40,000 would be received by the seller of four Infosys February INR 10,000 puts.  

If the stock trades more than INR 10,000, the option will expire without any value enabling the put seller to retain all the premium. Nevertheless, if the stock closes or falls below the strike price, the seller will be needed to purchase the underlying stock at INR 10,000 (which will be the strike price). 

If this turns out to be true, there will be a loss of the additional capital and the premium as the investor now holds ownership of the stock at INR 10,000 per share, irrespective of trading at low levels. 

Trading option spreads yet another excellent, ideal equity options tactic. If you want to take the least amount of risk but capitalize through the option premiums, there’s a solution. You can easily take combos of long and short option holdings with various expiration dates and strike prices to achieve that. 
 

Example of Stock Options

Let’s say Mr. Kumar buys Adani Power December 2017 call options. He bought the call options at a strike price of INR 9,000. For a single contract of 100 shares, the price of the option contract premium is $90,000. During the purchase period, Adani Power stood at INR 9,300. 

In the event that Mr. Kumar exercises the option, he gets entitled to 100 Adani Power shares at INR 9000 the following trading day. Adani Power opened at INR 9,800 on a subsequent day. When Mr. Kumar sells these shares at market price, he will earn revenue worth (INR 9,800 - INR 9000)*100 – INR 90,000 = - INR 10,000. 
 

Employee Stock Options

Various companies may include stock option plans in their compensation packages for employees. Every employee is given a stake in the company through an employee stock option plan (ESOP), a type of equity pay. 

Employees who hold stock in their organization have a greater motivation to contribute to its growth because a successful business will result in higher stock option payouts. The majority of businesses provide these alternatives to their employees without charging a fee upfront. In contrast, others even increase the number of shares offered the longer a staff works for the business. 
 

Why Would You Buy an Option?

In essence, the best option stocks enables a trader to wager on the increase or decline of a certain stock by a specified date in the near future. Big organizations frequently buy stock options to reduce their overall risk to a given financial instrument. Contrarily, options also give investors an opportunity to optimistically speculate on the direction of a stock’s price, generally escalating the risk involved.

What Are the 2 Main Types of Stock Options?

There are two sorts of stock options in the mainstream exchange-traded or listed stock market:

●  Put options: Put options are securities that profit the investor if the stock’s or asset’s value declines in the upcoming future. To make a profit, a trader can sell the shares or assets at a fixed price within a specified time period.

●    Call options: When a trader or buyer anticipates that the stock’s value will rise in the near future, they are in this situation. When the asset or stock hits the strike price, a trader has a limited window of time to purchase it at a fixed price.
 

Factors to Consider Before Choosing the Best Stocks for Options Trading

You can use the following information to decide how and when you’ll use the employee stock options:

Range of Maturities

India boasts one of the largest options markets on the globe. On the spot market only, there are more than 100 types of trading options, including many exotic and complicated contracts like calendar spreads, iron condors, and short straddles. This makes it simple to select a contract that corresponds to your requirements, whether you’ve been searching for an uncommon or straightforward arrangement.

Volatility

Options trading is more unpredictable than conventional stock trading techniques, which is one of the key factors why individuals pick it in India. Options are perfect for traders who wish to gain a competitive edge by profiting from unforeseen occurrences like global trends or economic swings that might lead prices to spike or drop suddenly until their expiration date. 

Moreover, several researchers concur that there isn’t a better method for generating profit than by utilizing options to anticipate fluctuation levels.

Intrinsic Value

The worth of a financial asset that is irrelevant to its present market price is known as intrinsic value. It is frequently referred to as the “intrinsic” value since it is unrelated to the price the market is already charging for an item. Future earnings from the put option, which are often estimated using a payout chart, decide the option’s intrinsic value.

Value at Time

The rate of increase in the price of an option over time is known as time value. Since the purchaser of a call option has much more time before they must use their ability to purchase anything at a specified price—and consequently additional time to earn their income from invoking their option before any expiry date rolls around again—it has an extended time value than a put option.

No Obligation 

Options Trading is a young industry in India and is not an excellent long-term investment. In light of this, you must only trade options when you’re willing to incur risks and profit. You should be informed that this sector does not provide any assurances or commitments, and you’re solely accountable for any losses resulting from your speculative trading.
 

Conclusion

A thorough grasp of the value of your stock options and how they belong to your diverse portfolio is crucial, just as it is with any kind of employee equity compensation. We typically advise clients to consult thoroughly with their investment advisor when assessing their plans with stock options because doing so puts them in a somewhat speculative stance.

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