Understanding Options From Basics PDF

This document provides an overview of options contracts. It defines an option as a derivative contract that derives its value from an underlying asset, usually a stock. There are two main types of options contracts: call options, which give the owner the right to buy the underlying asset at a specific strike price, and put options, which give the owner the right to sell the underlying asset at a specific strike price. The document provides an example of how buying a call option works and explains the risks and potential profits for both option buyers and option sellers. Key terms related to options contracts like premium, strike price, expiry date, and contract size are also defined.

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Understanding Options From Basics PDF

Uploaded by

A P Naghul Krishna

Available Formats

Download as PDF, TXT or read online on Scribd

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Understanding

Options
From Basics
1

What is an Option?

An Option is a type of derivative contract that

derives its value from the underlying asset or
security. The underlying usually stocks.

An option contract gives its owner the right but

not the obligation to buy or sell an underlying
stock at a specific price (Strike Price) in the
future.

To get this right, the option buyer pays a small

premium to the option seller.
2

Types of Options Contract

Call Option:
The owner of the call option has the right to buy
the underlying at a specific strike price for a
specific time period.

Put Option:
The owner of the put option has the right to sell
the underlying at a specific strike price for a
specific time period.
3
Let's understand with Example:

Let's say you believe that the stock price of ITC

currently trading at ₹ 200 will increase in the
near future.

You decided to buy the one-month call option of

ITC with a strike price of ₹ 205 by giving a
premium of ₹ 2 to the call seller/writer.

If ITC reaches ₹ 215 next month you can exercise

the option and buy the ITC stock for ₹ 205 only.
4
If the price doesn't increase or decrease in the
next month. You have a choice to not exercise
the option.

In the first case when it reaches ₹ 215, your

profit will be (215 - 205 -2 )=(₹ 8). ₹ 2 will be
subtracted since it is already paid as a premium.

In the second case, you do not exercise the

option. The loss is only the premium that you
paid which is ₹ 2.

It works exactly the opposite for the put option

where you only exercise the option when it
reaches below the strike price.
5

Option Buyer

The option buyer pays a premium to the option

seller for the right to buy or sell the underlying.

Buyer of an option has limited risk up to the

premium paid and can earn an unlimited profit.

The biggest risk for option buyers is time decay

and a drop in volatility.

Due to these risks, the option buyer loses most

of the time in the trade.
6

Option Seller/Writer
The option writer only receives a premium
and has an obligation to perform if the buyer
exercises the option.

The risk is unlimited for the seller and profit

is fixed to the value of the premium.

Although the risk is high, the option seller has

a high probability of success due to factors
like time decay and volatility.
7

Option Terminologies
Option Premium:
The option buyer pays a small amount as a
premium to the seller to get the right to buy or
sell the underlying. It is also called the price of
the option.

Strike Price:
It is the price at which the buyer buys the
underlying in the future if he decides to
exercise the option.
8

Expiry Date:
It is a date on which an options contract expires
and becomes invalid. It only expires if it is not
exercised.

Contract Size:
Contract size represents a specific number of
underlying shares that a trader may be looking
to buy.
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