What To Know For Trading Options In Derivative Market?
We are now entering the options world of the stock market. Let's try to understand What is the option. Options trading is a part of a derivative segment of the stock market and accounts for a large amount of trading overall.
Understanding options is very important in order to enhance our learning and explore the different world of trading and hedging in the stock market. Also probability of making money increases with that.
Well, without having any further delay, let’s jump on the topic.
Understanding Options!
Option Agreement With Land Deal!
Let’s assume we have land and as usual two parties involved in the business; a buyer(Bob) of the land and a seller(Sandy) of the land. As per the current market rate the valuation of the land is USD 1,000,000.
Bob is interested in the land because he has the information that in the next 6 months, a new metro line project is going to be approved close to the land that Sandy owns. Obviously, if the metro project indeed gets started the value of the land is going to be higher and it will be a profitable investment if he buys the land today.
However, if the metro project news turns out to be rumor, Bob will be stuck with the loss-making investment.
Bob is smart and wants to play a safe bet. Hence he proposes a deal that he thinks is a win-win for both of them and puts it forward to Sandy. Below are the deal details:
Bob will pay the amount USD 100,000 to Sandy which will be non-refundable.
Sandy will agree to sell the land to Bob after 6 months due to the amount paid.
The price of sale (expected 6 months later) is fixed today at USD 1,000,000.
As Bob has paid an upfront amount, only Bob can call off the deal at the end of 6 months if he wishes. Sandy can not do that.
If Bob calls off the deal after 6 months, Sandy gets to keep the USD 100,000.
 |
| Courtesy unsplash.com |
Lets understand the Bob’s deal step by step:
In return of paying the USD 100,000 to Sandy, Bob is binding Sandy into an obligation and forcing him to lock the land for him for next 6 months.
Bob is fixing the price based on today’s current market rate i.e USD 1,000,000 which means no matter what the price of the land after 6 months, he can buy the land at today’s price.
After 6 months if Bob doesn't want to buy the land, he has right to say NO to Sandy. However Sandy can't do that as he has taken the agreement amount from Bob.
The agreement amount is non-refundable and non-negotiable.
Now, whatever happens to the metro line project, there are only three possibilities:
Once the metro line project comes up, the price of the land would shoots up to USD 2,000,000.
The said project was a rumor and land price goes down to USD 700,000
Nothing happens in 6 months and price stays same at USD 1,000,000
CASE 1 : Price goes to USD 2,000,000
Current Market price of the land = USD 2,000,000
Sale agreement value = USD 1,000,000
Bob now enjoys the right to buy the land at USD 1,000,000 while the same land’s price in the market is USD 2,000,000.
Add. Agreement amount = USD 100,000 (non-refundable amount)
Total Expense = 1,000,000 + 100,000 = 1,100,000
Current Market Price of the land = USD 2,000,000
Hence his profit is USD 2,000,000 – USD 1,100,000 = USD 900,000
CASE 2: Price goes down to USD 700,000
A metro line project turned out to be a rumor.
In this case, Sandy the seller would be keeping the upfront amount of USD 100,000 as Bob would not going to buy the land(exercising his right to execute the deal) by paying USD 1,100,000 for the land which now worth USD 700,000.
CASE 3: Price stays at USD 1,000,000
No matter what the reason is, suppose the price of land does not change. In this case below is the simple math:
Cost of Land = USD 1,000,000
Agreement Amount Paid = USD 100,000
Total = USD 1,100,000
Price of the land in market = USD 1,000,000
It does not make sense to pay USD 100,000 extra for the land worth USD 1,000,000. However, Bob still can exercise his right to buy the land if he wants but he will end up paying USD 100,000 extra in the process.
Let’s convert the above terms in the option’s language.
Option Terms
The payment to Sandy ensures that only Bob can call off the deal and Sandy is under obligation(If Bob demands, Sandy has to sell the land).
Land = Underlying(Security/Stock/Index)
Agreement that Bob proposed = Options Agreement
Bob = Option Buyer
Sandy = Option Seller(Writer)
Amount which Bob paid(USD 100,000) = Option Premium
6 Months Time = Expiry
The amount that Bob fixed(USD 1,000,000) = Strike Price
Here we saw Land as only one quantity but we will see something called as a Lot(Fixed number of shares). Eg. 1 Lot = 50 Shares.
**In Options Agreement buyer always has the right and the seller always has the obligation.
Two styles of option followed worldwide: American and Europian.
NSE follows Europian style options.
Option Types
Options includes two types: CE(Call Option) and PE(Put Option).
When your view on the market is bullish, you will buy a Call Option. When you think stock market is bearish, you will buy a Put Option. Of course, it has to be based on other parameters(Moneyness of the options) that we will see later.
However, until now, we are thinking from the buyers point of view in the stock market. Sellers thinking is something different than this which we will discuss in future posts.
In order to trade in options, we must be able to read and analyse something called as the option chain. Nothing fancy, option chain includes the terms we have already seen above with Bob and Sandy land deal example.
Option Chain
Here is the pic of Option Chain from NSE:
You can search any stock or index in above screenshot on site to see its Options Contract. Currently we have searched for NIFTY which has weekly(on Thursday) and monthly(last Thursday) expiry of contracts. Stocks have only monthly expiry in options.
 |
| Courtesy nseindia.com |
In above pic. you will see all the terms we went through on both CALL & PUT side. In option chainone important term is Open Interest. We have seen OI and Price relationship in our
Stock Market: An Volume And Open Interest blogpost.
Price & OI Relationship
Lets summarize it one more time:
1. Price is UP, OI is UPPrice action increasing in an uptrend and open interest on the rise are interpreted as new money
coming into the market (reflecting new buyers) and is considered bullish. This is a sign of a strong
market.
2. Price is DOWN, OI is DOWNIf the price action is falling and open interest is coming down with it, then long positions are being
liquidated as whoever bought is now covering his positions. This is sign of a weak market.
3. Price is DOWN, OI is UPIf price action is coming down and open interest is rising it means new money is flowing into the short
positions. Positions are being built to the downside. It is short build-up and sign of a strong market.
(Strong here refers to the trend and not the bearish or bullish aspect of market).
4. Price is UP, OI is DOWNIf price action is going up and open interest is coming down, it means short positions are being closed
and money is flowing out of the market. It is short covering and sign of a weak market.
In addition to the 4th point above, there is also a concept called SHORT SQUEEZING.
0 Comments
Please do not enter any spam links in the comment box