Dummy’s guide to options

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Options…What Options?

It is a derivative… or never mind, let us spare ourselves the theory, because if you wanted that you would have already read that up in an exchange website or elsewhere. Since you are here, let us cut to the chase. It is a lottery. It gets you rich, with much better odds than lottery. And quickly at that, and at the lowest cost. Mostly.

Cool. Where can I buy some lottery?

Choose a stock of your choice, and look for its options in that same trading platform that you use for trading stocks or indices. It will not be hard to find, as they are named after stocks/indices/currencies. For convenience sake, let us stick our little chat to the stock, Reliance.

Why would I buy options, if they are like stocks itself?

Good question, dummo…I have the perfect answer for you. But a question first.

Why do people normally buy stocks? First and foremost is the expectation of capital appreciation. But besides this, the romantics would tell you about the pride of ownership, which it literally is because, by buying a share we are indeed becoming an owner of the company, albeit with limited rights. Apart from this, the ownership of stock also gives you the claim on profits of the company, by way of dividends. And if you are lucky, you might be awarded rights and bonus shares commensurate to what you already hold. Now, all these and more, do not happen in a jiffy, like all things good in life, meaning that you might have to hold the stock for a long period to see all these happening, to see your wealth multiply.

Huh! Who wants to wait!!

Look at you, you are not much of a romantic, are you? Yes, yes, I know, you are here for the money.

Just strip the stock of its long term growth story et all, and what you get is an “option”. Two options actually. Twin personality, if you may. Since a stock can go either go up or down, a set of options called “calls” lets the traders take a view on the possibility of stock going up whereas you can buy a “put” option if you feel that the stock could go down in the near term. Unfortunately, or fortunately, we do not have an option for sideways expectations. Well, for that you could buy both call and put simultaneously, but that is a discussion for later.

Shelf life

Things are a bit more structured here than in stocks. ie, you don’t just jump in and buy just any call or put, but you need to make up your mind as to how high you expect the stock to go up, if you are buying a call and how low you expect the stock to fall, if you are buying a put. To help you with that, the makers of this interesting instrument have something called “strike” which is nothing but the stock price at regular steps. For example, Reliance options are listed in steps of 20, and hence you will be able to see strikes 2100, 2120, 2140 and so on for both calls and puts. When I said “structured”, I wasn’t just referring to the strikes alone. These options also have, an expiry period, i.e. a September option will expire in September, and an October option will expire in October and so on. Usually the expiry day is the last Thursday of every month. Well that suits you, doesn’t it, as you don’t like to wait much. The other difference is the minimum lot size of each stock option. For example, the lot size of Reliance is 505, meaning, your position of 1 option would be worth in value equal to 505 stocks, and that is the minimum that you can buy in options market. Further, not all the stocks have options. For example, in NSE, only those from the top 500 stocks which satisfy certain characteristics are included in the option segment. Currently there only 139 stocks listed under futures and options segment in NSE.

Wow. This must be very popular then right? All buy the lottery?

Many, but not all sir. There are also some who takes a view on “you”.

On me?

Well, who do you think sells, when you want to buy? Those are more seasoned players who have a better idea as to how option buyers behave and the price at which they are normally inclined to buy. But that’s not it alone. Imagine, you have a stock portfolio that has a high correlation to Nifty. If you feel Nifty is about to see a correction, you have the choice to sell everything off, wait for the correction to be over and then buy them all back. Or, keep the portfolio as it is, and buy a Nifty put option. By buying Nifty put options you can hedge your risk of loss in portfolio, as Nifty puts will gain, when Nifty falls.

Let us get our discussion back to “you” and how you, unknowingly becomes a key participant in the option trade. Let us do that by doing a quick profile of you. You, as an option buyer, have the following characteristics, more or less.

  1. The expectation of quick gains – The longer it gets, the more nervous!
  2. You look for cheap.
    1. You look for OTMs because, they are priced less.
    1. You look to buy because the investment is limited to a small premium, as opposed to bigger margin money required for option selling.
    1. For equivalent amount of stocks, options cost lesser, in terms of both expenses as well as investment.
  3. Even if your view on the stock is correct, your position in options may not end up in profit if taken closer to expiry, and the stock’s view takes longer to mature.

In other words, your preference for cheaper instruments, the time point when you enter a long, and knowledge of how herd mentality works etc. make your responses predictable, putting the seller in a dominant position.

Hmm… It isn’t a lottery, after all.

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Chief Market Strategist, Geojit Anand James extensive expertise in financial markets including equities, derivatives and commodities. A Certified Financial Technician (CFTe), Anand James holds an MBA as well as B.Tech degrees. Anand James heads a research team that provides Investment/Trading advice in Equities, Equity derivatives, Index Futures & Options and Currency Derivatives to clients, applying advanced technical and derivative analysis.He provides Technical outlook of Nifty-Sensex Outlook and writes on equity markets in India and market outlook.

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