What Is Option In Stock Market? Explained With Real Life Example

I know thousands of retail investors came to heard about Options and Futures but being an investor myself, I know SEBI is trying hard to keep new retailers away from Options.

It’s only because, Options just make your risk unlimited when you don’t know what it is.

Well, now in this post, I am going to teach you what exactly are the Options and how they are Risky for the retailers or the beginners.

I myself remember my brother screaming over in the room one morning. I went on to check and was amazed to find out that he lost Rs 17,000 in a matter of 5 minutes.

Later, I came to know that he was trading Options of BankNifty Index.

I will be taking my brother as an example in this article as we move towards the good part.

What Is Option?

Options belong to the derivatives market. In simple and sweet words, a Derivative is financial security in which the price is derived from the underlying asset or group of assets.

Now Options are based on both stocks and indices. Right now in India, there is options for NIFTY, BANKNIFTY (Top Banks), and NIFTYFIN (Top Financial Company).

Also all major stocks have options as well. Let’s understand what exactly are the options.

For Example,

There is a town, and in that town there is a piece of land. By some connections and contacts from my family, I get to know that the area near the land is going to get developed since a huge project there is going to happen by some big companies.

There is a total of 80 acres of land and the current price is Rs 20,000 per acre. Therefore, the price of all 20 acre of land is around Rs 16,00,000.

Since the news of development isn’t out yet, the price of land is less and I expect it to increase when the news is out.

Now I will go to the people selling this land and make a contract with them that they will sell me their land at Rs 20,000 per acre that is the current price after 6 months by paying some extra amount, let’s say Rs 5,000.

This amount is now known as Premium.

Now after 6 months, let’s see what happens,

  1. Huge Project Development news is true and land prices increases

    In this case, when the prices of land increase, I still get to buy the land at the same price it was 6 months back because I have the contract done and premium paid, and have rights to buy it and they get to keep the premium but they have to sell land in loss.
  2. Huge Project Development news wasn’t true and the land price remains same

    In this case, obviously, I won’t buy the land from them now since the development isn’t going to happen and the land price won’t increase which won’t give me any profits. Now, the people with land get to keep the Rs 5,000 and I am in loss of Rs 5,000 I paid as premium.

Hope you understood what is option and how the option work. Let’s get more practical with stocks.

How Option Works In Stock Market?

In Stock Market, we deal with stocks instead of land. Before we get started, let me tell you,

  • CE – Stands for Call Option (You buy CE when the market seems to be bullish)
  • PE – Stands for Put Option (You buy PE when the market seems to be bearish)

In the Indian Stock Market, we deal with European Style Options. Therefore, the letter E is found. The full form of CE is Call Option European-Style and similarly for PE.

Option prices increase or decrease as per the share price. The more the price comes near to your strike price for CE, the price of your options increases. While the more the price moves away from your strike price for PE, the price of your options increases.

In Stock Market, you can do both sells and buy options. We will start with Option Buying then cover Option Selling.

Option Buying (20% Success Rate)

Let’s say I am bullish on Reliance and think that by the end of May 2021, it will reach a price of 2000.

What I do is, make a contract with an Option Seller (Writer) and pays him a premium by buying an option of Reliance myself.

In this case, I’m option buyer and the counter party is option writer or seller.

Since I analyzed that Reliance shares will go 2000 by the end of the month, I will buy the Call Options of Strike Price 2000.

As of writing this post, Reliance Call Option For Strike Price of 2000 is trading at Rs 16.20

The Reliance lot size set in the market is 250 shares. Note that you cannot buy 1 or 2 shares in options, you need to buy lots in the Option Market.

Now, the premium for Reliance 2000CE I have to pay is Premium * Lot Size.

i.e, 16.20 * 250 = Rs 4050

To buy Reliance 2000CE, I have to pay a premium of Rs 4050.

The Current Trading Price of Reliance is around Rs 1913.

Now, Option is a contract between buyer and seller, therefore there is an expiry of this contract. This expiry date is always the Last Thursday of the month which in our case is 27 May 2021.

Before, expiry the Reliance share price should trade on 2000 or above it in order for me to be profitable on expiry date.

It is unnecessary that you need to wait until expiry, since options give you the right to buy, but it is not obligatory, you can always transfer this contract to someone else. In short, Options Contracts are tradable.

Option Buying has lower success rate because it’s a clean probability. You just have 1 out of 3 probability in Option Buying as I mentioned above that the success rate is just 20%.

In option buying as discussed, the share price should increase and comes closer to your strike price before the expiry date and if it fails to come then you loose the premium.

I hope you now understand how exactly the option works.

Option Selling (80% Success Rate)

I will take same example as above as I’ve same views with Reliance as above, but we will now Sell Option instead of buying to increase our success rate.

Let’s say I am bullish on Reliance and think that by the end of May 2021, it will reach a price of 2000.

What I do here is a bit different than the previous example above, I will of course make a contract but this time I will be Option Seller/Writer instead of the Buyer. So, I will sell the contract to the buyer and get a premium from him.

In this case, I’m option seller and the counter party is option buyer.

Since I analyzed that Reliance shares will go 2000 by the end of the month, I will sell the Put Options of Strike Price 2000.

Why? It’s because I am selling, the more the price falls I make money, in this case, the Put Option prices fall if the Reliance will go bullish.

As of writing this post, Reliance Put Option For Strike Price of 2000 is trading at Rs 99

The Reliance lot size set in the market is 250 shares. Note that you cannot buy 1 or 2 shares in options, you need to buy lots in the Option Market.

Now, the premium I will recieve from the buyer is around Premium * Lot Size

I will recieve a premium of Rs 24750 if the Reliance went bullish and close above 2000 and even if it didn’t I will still get some of the Premium.

In selling Options, you have 2/3 probabilty hence making a success rate of 80%. These 2 probabilities are,

  1. The share price of Reliance went as expected to Rs 2000.
  2. The share price of Reliance stays the same or move very slowly there itself.

In both cases above, I will still be in profit. However, only in 1 cases I will be in loss, i.e Reliance went bearish and fell even more.

Closing Thoughts!

I hope you understood how option works in the stock market. Options is amazing financial instrument and well can make you the richest if you know what are you doing, and even wipe out everything if you have no idea of what you’re doing.

In this article, you got the idea and concept of how Options works. However, there is much more than the concept like, Time Decay, Gamma, Theta which in short, how exactly the premium is determined for options.

I will cover more in detail later on this blog and till then stay tuned. Please take a moment to share this article, if you really like this article and now understand what are options.

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Emad is the founder of this blog and is the sole writer & editor on this blog. He has been learning about finance and the stock market for the past 2 years and sharing his experience on his blog and explain complicated topics in simple layman terms.