An options contract is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) and on or before a certain date (expiration date). There are two types of options: Call options and Put options.
Call Options: A call option gives the buyer the right to buy an underlying asset at a specified price within a specified time frame. This is beneficial if the market price of the asset rises above the strike price of the option.
Put Options: A put option gives the buyer the right to sell an underlying asset at a specified price within a specified time frame. This is beneficial if the market price of the asset falls below the strike price of the option.
Option trading strategies involve combining multiple options contracts to create a specific risk/reward profile. Here are some popular options trading strategies in the Indian stock market:
Covered Call Strategy: In this strategy, an investor buys a stock and sells a call option on the same stock. The premium received from selling the call option provides downside protection for the stock, but limits the potential upside.
Protective Put Strategy: In this strategy, an investor buys a stock and buys a put option on the same stock. The put option provides downside protection for the stock, but limits the potential upside.
Straddle Strategy: In this strategy, an investor buys a call option and a put option on the same stock with the same strike price and expiration date. This strategy profits from significant price movements in either direction.
Strangle Strategy: In this strategy, an investor buys a call option and a put option on the same stock with different strike prices but the same expiration date. This strategy profits from significant price movements in either direction, but requires a larger price move than the straddle strategy.
Butterfly Strategy: In this strategy, an investor buys one call option with a lower strike price, sells two call options with a middle strike price, and buys one call option with a higher strike price. This strategy profits from a narrow range of price movements, and has limited downside risk.
Here's an example of the straddle strategy:
Suppose a stock is trading at Rs. 1000, and an investor buys a call option with a strike price of Rs. 1000 for Rs. 50 and a put option with a strike price of Rs. 1000 for Rs. 50. The total cost of the options is Rs. 100.
If the stock price moves significantly in either direction, the investor will make a profit. For example, if the stock price rises to Rs. 1100, the call option will be worth Rs. 100, and the put option will expire worthless. The investor will make a profit of Rs. 50 (Rs. 100 - Rs. 50).
Similarly, if the stock price falls to Rs. 900, the put option will be worth Rs. 100, and the call option will expire worthless. The investor will again make a profit of Rs. 50 (Rs. 100 - Rs. 50).
If the stock price remains unchanged, both options will expire worthless, and the investor will lose the entire premium paid (Rs. 100).
Covered Call Strategy
Assume that you own 100 shares of XYZ company at Rs. 500 per share. You believe that the stock price is unlikely to go up significantly in the near future, but you don't want to sell the stock because you think it's a good long-term investment.
To generate some income from your stock holdings, you can sell a call option on your 100 shares of XYZ company. Suppose that you sell a call option with a strike price of Rs. 550 for Rs. 20 per share. This means that you receive a premium of Rs. 2,000 (Rs. 20 x 100) for selling the call option.
If the stock price stays below the strike price of Rs. 550, the call option will expire worthless and you will keep the premium. If the stock price rises above Rs. 550, the buyer of the call option will exercise the option and buy your 100 shares of XYZ company at Rs. 550 per share. In this case, you will make a profit of Rs. 50 per share (Rs. 550 - Rs. 500) plus the premium of Rs. 20 per share.
Protective Put Strategy
Assume that you own 100 shares of ABC company at Rs. 1,000 per share. You are concerned that the stock price may fall in the near future, but you don't want to sell the stock because you believe that it will rebound eventually.
To protect your stock holdings from a potential price decline, you can buy a put option on your 100 shares of ABC company. Suppose that you buy a put option with a strike price of Rs. 950 for Rs. 20 per share. This means that you pay a premium of Rs. 2,000 (Rs. 20 x 100) for buying the put option.
If the stock price falls below Rs. 950, the put option will become valuable and you can exercise the option to sell your 100 shares of ABC company at Rs. 950 per share. In this case, you will limit your loss to Rs. 50 per share (Rs. 1,000 - Rs. 950) plus the premium of Rs. 20 per share. If the stock price stays above Rs. 950, the put option will expire worthless and you will lose the premium.