Part 3 Learn Institutional Trading

1. Introduction to Options Trading

Options trading is one of the most versatile and complex areas of financial markets. It offers traders and investors the ability to hedge, speculate, or generate income. Unlike stocks, which represent ownership in a company, options are financial contracts giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame.

Options are derivatives, meaning their value derives from an underlying asset such as equities, indices, commodities, or currencies. They are widely used by institutional traders, retail investors, and hedgers to manage risk and leverage positions efficiently.

2. Types of Options

There are two primary types of options:

Call Options

Gives the holder the right to buy an underlying asset at a specified price (strike price) before or on the expiry date.

Used by traders who expect the price of the asset to rise.

Put Options

Gives the holder the right to sell an underlying asset at a specified price before or on expiry.

Used by traders who expect the price of the asset to fall.

Key Terms in Options Trading

Strike Price (Exercise Price): The predetermined price at which the asset can be bought or sold.

Expiry Date: The date by which the option must be exercised.

Premium: The cost of buying the option.

Intrinsic Value: The actual value if exercised immediately (difference between market price and strike price).

Time Value: Extra value reflecting the possibility of future price movement before expiry.

3. How Options Work

Options can be exercised in two styles:

American Style Options: Can be exercised anytime before expiry.

European Style Options: Can only be exercised on the expiry date.

Example:

You buy a call option for stock XYZ with a strike price of ₹1,000, expiring in 1 month.

Current market price is ₹1,050, and the premium paid is ₹50.

If the stock rises to ₹1,200, you can exercise the option and make a profit:

Profit = (Stock Price − Strike Price − Premium) = 1,200 − 1,000 − 50 = ₹150 per share.

4. Factors Influencing Option Prices

Option pricing is influenced by multiple factors:

Underlying Asset Price: The most direct influence; options gain value when the underlying asset moves favorably.

Strike Price: Determines the intrinsic value of the option.

Time to Expiry: More time generally means higher premiums because there is more chance for price movement.

Volatility: Higher volatility increases the likelihood of profitable movements, raising option premiums.

Interest Rates and Dividends: Affect option pricing for longer-term contracts.

The widely used Black-Scholes model calculates theoretical option prices, taking these variables into account.