Option Trading (For Beginners)
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Almost everyone has heard about stock trading, where you can buy or sell shares of a company or an index in real time, meaning the transaction happens instantaneously at that very moment.
But I think you’ve rarely heard about futures and options. It’s not normal trading. Here, you actually have something like an insurance policy on a bet you think might play out. For example, what is insurance in the first place? Having insurance means paying a frequent monthly amount to cover some risk you think might happen in your future. And if something bad does happen, the insurance company pays out that whole amount on your behalf, covering hospital bills, flight tickets, hotel bills, etc. Options trading works in a very similar way. Let’s understand how it works overall.
Let’s take an example. An option is essentially a kind of bet. You place a bet with the system and pay some amount for them to consider it valid. If you win that bet, you make profits. But if you lose, you only lose the money you paid as a premium, nothing more.
Assume you want to buy a home in Mumbai but don’t have the money right now. You plan to buy it sometime in the future once you have the funds. As someone who understands the market, you know that the price of that house will rise over time. Let’s say the house owner is an old person who doesn’t have much knowledge of how the market works and isn’t thinking too hard about it. He just wants instant money and his only goal is to sell the house.
Knowing how the market works, you go to that person and tell him you plan to buy the house after 5 years. The current price is ₹2 crore. Based on your research, you believe the price will rise to around ₹2.5 crore in 5 years, but the seller doesn’t know that. So you propose to him that you’ll buy the house later at ₹2.3 crore, and you pay him ₹5 lakhs right now as a commitment. From the seller’s perspective, he sees two big wins: instant money without actually handing over the house yet, and a buyer willing to pay ₹30 lakhs more than the current market price. He sees instant money and profit, so he agrees immediately and hands you the contract.
You, on the other hand, have intelligently set yourself up for a profit of around ₹15 lakhs. The expected market price will be ₹2.5 crore and your contracted price is ₹2.3 crore, so the gain is ₹20 lakhs. Subtract the ₹5 lakh premium you paid upfront and your net profit is ₹15 lakhs. On top of that, you can invest whatever remaining money you have elsewhere in the meantime, so either way you’re in a good position.
Now, you might wonder what if the house price doesn’t rise? What if it stays the same or even falls due to a market crash or some other reason?
- Price stays the same at ₹2 crore. In that case, you’d be buying the same house 5 years later at ₹2.3 crore, which means you’re paying ₹30 lakhs more than its actual value. Add the ₹5 lakh premium you paid upfront and the total net loss comes to ₹35 lakhs. That’s massive. But in options trading, you’re not obligated to go through with the purchase. You can simply cancel the contract, and your net loss becomes only the ₹5 lakh premium you paid upfront.
- Price falls below ₹2 crore, say to ₹1.8 crore. Completing the deal now would mean paying ₹2.3 crore for a house worth ₹1.8 crore, which is a ₹50 lakh loss, plus the ₹5 lakh premium, making it a total net loss of ₹55 lakhs. In such a case, it’s always better to walk away from the deal and accept the ₹5 lakh loss instead.
Options in the stock market work exactly the same way, just with stocks and indexes instead of real estate. There are two types of options one can trade: the Call Option and the Put Option. We’ll be covering those in the next blog.