Thursday, November 20, 2008

Introduction to Options

There are two fruits, say banana and apple, in a basket. If you were given an OPTION to take one of the fruit, which one will you take?
Notice the word OPTION in the above sentence. You are given a choice between two fruits.

Say, now a security is at Rs.5000/-. You think it will go to Rs.5500/- in a month.
If you have Rs.20000/- for trading, you can buy only 4 now and sell it after a month. If you opt for OPTIONS, you can buy at a lesser price and gain more. For Rs.20000, you could get an option for buying 80 (approx.) securities (each Rs.5000/-).

CASE I:
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After a month, if the security price is Rs.5500/-,
You would gain => (5500 - 5000) * 80 = 40000.
But you have already given 20000 to get the option.

So, your profit would be Rs. 20000/- => 100% return in just a month :-)


CASE II:
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After a month, if the security price is Rs.4000/-
you have already spent Rs.20000/- on getting the option.

Total Loss: Rs. 20000/-
(Already spent on getting option. You will not execute this one.)

You will be given an option to execute it. You will execute only in the case of CASE I and not CASE II.

If you are executing the options, you will end up paying brokerages for buying and selling the securities.

Coming to the JARGONS of Options.
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(1) CALL - Right to buy.
(2) PUT - Right to sell.

If you think, the security is going to go down, you can BUY PUT.
If you think, the security is going to go up, you can BUY CALL.

Let me tell you, the OPTIONS are always riskier. Most of them will be illiquid.
One of the highly liquid instrument is NIFTY Options.

When you BUY CALL, to get out of options before the date of expiry, what should you do?
If your answer was BUY PUT, Please don't try trading options. You should WRITE/SELL CALL.

Brokerages on Options:
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Buying/Selling an option - Rs. 100/- or 1% (whichever is higher)
While exercising an option - Intra-day brokerage charges. (vary depending on the customer and brokerage houses.)

The real advantage of OPTIONS, you can gain more from less money. Even 100% Return on Investment is easily possible (Beware, the reverse is also possible :-P)
There is a cap on the downside but there is no cap on the upside.

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