Part 1 Candle Stick Pattern Understanding Option Trading
Option trading is a segment of financial markets that allows investors to buy or sell the right to buy or sell an underlying asset at a predetermined price within a specific time frame. Unlike traditional stock trading, options provide leverage, flexibility, and risk management tools, making them appealing for both hedging and speculative purposes.
Options are derivatives, meaning their value is derived from an underlying asset, such as stocks, indices, commodities, or currencies. An option does not grant ownership of the asset itself but gives the holder the right to engage in a transaction involving the asset.
Types of Options
Options are broadly categorized into two types:
Call Options
A call option gives the buyer the right (but not the obligation) to buy the underlying asset at a specified price, called the strike price, before or on the expiration date.
Buyers of call options generally expect the underlying asset’s price to rise, allowing them to purchase the asset at a lower price than the market value.
Sellers (writers) of call options receive the option premium upfront but take on the obligation to sell the asset if the buyer exercises the option.
Put Options
A put option gives the buyer the right (but not the obligation) to sell the underlying asset at the strike price before or on the expiration date.
Buyers of put options generally expect the underlying asset’s price to fall, allowing them to sell the asset at a higher price than the market value.
Sellers of put options receive the premium but face the obligation to buy the asset if exercised.
Key Components of Options
To understand option trading, one must know the following components:
Underlying Asset – The security or asset on which the option is based (e.g., a stock like Apple or an index like Nifty 50).
Strike Price (Exercise Price) – The predetermined price at which the option can be exercised.
Expiration Date – The date on which the option expires. After this date, the option becomes worthless.
Premium – The price paid by the buyer to the seller for the rights conferred by the option.
Intrinsic Value – The difference between the underlying asset’s current price and the strike price, representing the real, immediate value of the option.
Time Value – The portion of the premium that reflects the possibility of the option gaining value before expiration. Time decay reduces this value as the expiration date approaches.
How Options Work
Let’s illustrate with an example:
Suppose a stock is trading at ₹1,000, and you buy a call option with a strike price of ₹1,050, expiring in one month, paying a premium of ₹20.
If the stock rises to ₹1,100 before expiration, you can exercise the option to buy at ₹1,050, making a profit of ₹50 per share minus the premium, i.e., ₹30 per share.
If the stock stays below ₹1,050, you would not exercise the option, losing only the premium of ₹20.
This example highlights two key advantages of options:
Leverage: You control more assets with less capital compared to buying the stock outright.
Limited Risk: The maximum loss for the buyer is the premium paid, unlike stock trading where losses can be higher.
