Call and Put options are key concepts in options trading. An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a set price before a specific date. There are two main types of options: call options and put options.
A call option gives the buyer the right to purchase an asset at a predetermined price, known as the strike price, before the option expires. Investors buy call options when they believe the price of the underlying asset will rise. For example, if an investor buys a call option on a stock with a strike price of Rs. 100, and the stock’s price rises to Rs. 120, the investor can buy the stock at Rs. 100 and sell it at Rs. 120, making a profit.
A put option gives the buyer the right to sell an asset at the strike price before the option expires. Investors buy put options when they expect the price of the underlying asset to fall. For instance, if an investor buys a put option on a stock with a strike price of Rs. 100, and the stock’s price falls to Rs. 80, the investor can sell the stock at Rs. 100 and buy it back at Rs. 80, making a profit.
Options trading involves buying and selling these contracts on various assets like stocks, indices, commodities, or currencies. The prices of call and put options are influenced by factors such as the current price of the underlying asset, the strike price, the time until expiration, market volatility, and interest rates.
Suppose an investor believes that Tata Motors’ stock price will rise. They purchase a call option with a strike price of Rs. 300, paying a premium of Rs. 10 per share. If Tata Motors’ stock rises to Rs. 350, the call option’s intrinsic value is Rs. 50 per share (350 – 300). After deducting the premium paid, the investor’s profit is Rs. 40 per share.
Conversely, if an investor expects the stock price of Reliance Industries to drop, they might buy a put option with a strike price of Rs. 2000, paying a premium of Rs. 20 per share. If the stock falls to Rs. 1900, the put option’s intrinsic value is Rs. 100 per share (2000 – 1900). After deducting the premium, the investor’s profit is Rs. 80 per share.
| Bull Call Spread | |
|---|---|
| Strategy | Bull Call Spread |
| Description | A bull call spread involves buying a call option at a lower strike price and selling another call option at a higher strike price, both with the same expiration date. This strategy limits both the potential profit and the potential loss. |
| Objective | To profit from a moderate rise in the price of the underlying asset. |
| Example | Suppose a stock is trading at Rs. 100. You buy a call option with a strike price of Rs. 90 for Rs. 15 and sell a call option with a strike price of Rs. 110 for Rs. 5. The net cost of the spread is Rs. 10. If the stock price rises to Rs. 110 at expiration, the profit is Rs. 10 (20 - 10). If the stock price is below Rs. 90, the maximum loss is Rs. 10 (the net cost). |
| Risk/Reward | Limited risk and limited reward. The maximum loss is the net cost of the spread, and the maximum profit is the difference between the strike prices minus the net cost. |
| Bear Put Spread | |
|---|---|
| Strategy | Bear Put Spread |
| Description | A bear put spread involves buying a put option at a higher strike price and selling another put option at a lower strike price, both with the same expiration date. This strategy limits both the potential profit and the potential loss. |
| Objective | To profit from a moderate decline in the price of the underlying asset. |
| Example | Suppose a stock is trading at Rs. 100. You buy a put option with a strike price of Rs. 110 for Rs. 15 and sell a put option with a strike price of Rs. 90 for Rs. 5. The net cost of the spread is Rs. 10. If the stock price falls to Rs. 90 at expiration, the profit is Rs. 10 (20 - 10). If the stock price is above Rs. 110, the maximum loss is Rs. 10 (the net cost). |
| Risk/Reward | Limited risk and limited reward. The maximum loss is the net cost of the spread, and the maximum profit is the difference between the strike prices minus the net cost. |
| Butterfly Spread | |
|---|---|
| Strategy | Butterfly Spread |
| Description | A butterfly spread involves buying one call (or put) option at a lower strike price, selling two calls (or puts) at a middle strike price, and buying one call (or put) at a higher strike price, all with the same expiration date. This strategy is used to limit both gains and losses within a specific range. |
| Objective | To profit from low volatility in the price of the underlying asset. |
| Example | Suppose a stock is trading at Rs. 100. You buy one call with a strike price of Rs. 90 for Rs. 15, sell two calls with a strike price of Rs. 100 for Rs. 10 each, and buy one call with a strike price of Rs. 110 for Rs. 5. The net cost of the spread is Rs. 0 (15 - 20 + 5). If the stock price is Rs. 100 at expiration, the profit is Rs. 10. If the stock price is outside the range of Rs. 90 to Rs. 110, the maximum loss is the net cost. |
| Risk/Reward | Limited risk and limited reward. The maximum loss is the net cost of the spread, and the maximum profit is the difference between the middle strike price and the lower/higher strike prices minus the net cost. |
| Short Straddle | |
|---|---|
| Strategy | Short Straddle |
| Description | A short straddle involves selling both a call option and a put option at the same strike price and expiration date. This strategy is used to profit from low volatility in the underlying asset. |
| Objective | To profit from low volatility and the passage of time. |
| Example | Suppose a stock is trading at Rs. 100. You sell a call option with a strike price of Rs. 100 for Rs. 10 and sell a put option with a strike price of Rs. 100 for Rs. 10. The total premium received is Rs. 20. If the stock price remains at Rs. 100 at expiration, you keep the premium as profit. If the stock price moves significantly away from Rs. 100, the potential loss can be substantial. |
| Risk/Reward | Unlimited risk and limited reward. The maximum profit is the total premium received, and the maximum loss is potentially unlimited if the stock price moves significantly. |
Long Strangles vs Short Strangles involve different approaches to options trading. A long strangle entails buying both a call and a put option at different strike prices, usually out-of-the-money, with the same expiration date, aiming to profit from significant price movements with limited risk and unlimited reward. Conversely, a short strangle involves selling both a call and a put option at different strike prices, aiming to profit from low volatility and the passage of time, with limited reward and unlimited risk.
Option prices are influenced by several key factors. Understanding these factors is crucial for traders as they navigate the complex world of options trading. Here, we’ll elaborate on each factor with examples and tables where necessary.
The price of the underlying asset (e.g., a stock) significantly impacts the price of an option.
The strike price is the price at which the option holder can buy (call) or sell (put) the underlying asset.
The time remaining until the option’s expiration date affects its price. Longer durations generally mean higher premiums due to the greater chance of price movements.
Volatility refers to the degree of variation in the price of the underlying asset. Higher volatility increases the probability of the asset’s price moving significantly, which increases option prices.
Interest rates can affect the price of options, particularly longer-term options. Higher interest rates can increase call option prices and decrease put option prices due to the cost of carrying the underlying asset.
Expected dividends can impact option prices. Stocks that pay dividends might see a decrease in call option prices and an increase in put option prices, as dividends reduce the stock price when paid.
Calculating the payoff for call and put options is crucial for options traders to understand their potential profit or loss. In the Indian market, where options on indices like Nifty 50 and Bank Nifty are popular, it’s important to grasp these calculations. Here, we’ll elaborate on how to calculate the payoffs for both call and put options with relevant formulas and examples.
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified strike price before the option expires. The payoff for a call option depends on the price of the underlying asset at expiration.
Formula for Call Option Payoff:
Call Option Payoff = max (0,ST−K)
Where:
Example:
Suppose you buy a Nifty 50 call option with a strike price of Rs. 15,000, and the premium paid is Rs. 100. The Nifty 50 index at expiration is Rs. 15,200.
Call Option Payoff=max (0,15,200−15,000) = 200
Since you paid a premium of Rs. 100, the net payoff would be:
Net Payoff = 200−100 = 100
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified strike price before the option expires. The payoff for a put option also depends on the price of the underlying asset at expiration.
Formula for Put Option Payoff:
Put Option Payoff = max(0,K−ST)
Where:
Example:
Suppose you buy a Bank Nifty put option with a strike price of Rs. 35,000, and the premium paid is Rs. 150. The Bank Nifty index at expiration is Rs. 34,800.
Put Option Payoff = max(0,35,000 − 34,800) = 200
Since you paid a premium of Rs. 150, the net payoff would be:
Net Payoff = 200−150 = 50
| Option Type | Strike Price (K) | Price at Expiration (S_T) | Premium Paid | Gross Payoff | Net Payoff |
|---|---|---|---|---|---|
| Call Option | Rs. 15,000 | Rs. 15,200 | Rs. 100 | Rs. 200 | Rs. 100 |
| Put Option | Rs. 35,000 | Rs. 34,800 | Rs. 150 | Rs. 200 | Rs. 50 |
The Greeks are metrics that describe the sensitivity of an option’s price to various factors:
The Delta Probability Tool helps traders understand the likelihood of an option expiring in-the-money based on the current delta value.
Max Pain is the price level at which the greatest number of options contracts will expire worthless. It is often used to gauge market sentiment.
In India, profits from options trading are considered capital gains. Short-term capital gains (held for less than a year) are taxed at 15%, while long-term capital gains (held for more than a year) are taxed at 10% for gains exceeding Rs. 1 lakh.
Call and put options offer versatile strategies for investors to profit from market movements. Whether using basic strategies like buying calls and puts or more complex strategies like butterfly spread and straddles, understanding the underlying principles and factors influencing option prices is essential. Additionally, considering the tax implications and using tools like the Delta Probability Tool can help maximise profits and manage risks effectively. By mastering these concepts, investors can increase their trading acumen and manage the options market with confidence.
Beginners can start trading call and put options by following these steps:
Yes, it is possible to lose more money than invested, especially with certain options strategies:
Call and put options can enhance your investment portfolio by providing:
However, options can also introduce higher risk, particularly if market movements are not as anticipated.
Market conditions play a crucial role in the performance of call and put options:
To avoid common mistakes, keep in mind the following tips:
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