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Learn Basics in Stock Options

Primary objective of entering into stock market is to make profit. There are different kind of instruments/strategy one can adopt depending on the risk profile of the individual and duration of the trade.

For people trading in stocks and who understand stock movement well and are not happy with the kind of returns stock provide and at the same time do not want to risk huge loss that stock can incur, on a extremely bad day, then they have another choice called Options trading. Please note that options are complex instruments and requires lot of expertise and knowledge to make good returns in the market.

Whats is Options Trading?

Options is a bi-party (Two party) contract that sets the price of financial instrument (like stock) in such a way that the buyer can buy it at that price at any time on or before the contract period.

Buyer can also decide not to buy it at all (buyer is not obligated to buy) Well, this looks highly in favor of buyer, then why seller should sell it or enter in such a contract? To enter in such a contract, buyer needs to pay seller a price called small portion of the cost (called premium). In case buyer does not buy (or exercise the option) then the premium is forfeited.

How does Options Trading work?

For example:
Stock Current Price100
Buyers One Month Expected Price110
Sellers One Month Expected Price102
Strike Price105
Premium (or Buyers Investment)2

Various scenarios after one month

examples of option trading with various scenario

Few Important observation

1. Maximum Profit for buyer unlimited. Refer to scenario 4.
2. Maximum Loss to the buyer is premium amount 2. Refer to scenario1 & 5.
3. Maximum Profit for seller is 7, Scenario 2 & 4.
4. Maximum loss to the seller 100% of capital. Refer scenario 5.

Inference - Buying option can give you extraordinary profits but limits your loss. Selling option can expose your entire capital at risk and the profit is limited.

Does it sound familiar to you now? Do you use this regularly in your life? Still didn't get it. Let me explain. We do play with option in our life regularly. For example we buy health insurance and pay a regular premium. In case of any illness, insurance company pays the bill irrespective of the amount. In such case, you are buyer of the option, insurance company is the seller and takes all the risk.

Basic Terminology involved in options trading
1.Strike Price - The price at which buyer and seller agreed on option price.
2.Premium - The amount buyer pays to seller to enter into contract.
3.Option Expiry date - It is the date up to which option contract Any time within options contract period buyer can exercise option.
4.Option exercise- It is the step in option trading when buyer actually buys the security at the strike price. Buyer can buy on or before option expiry date.
5.Underlying Security - Options are derivatives. They derive the value from the underlier(Stock). Price of option (premium) fluctuates with change of price of underlier.

Note :We have kept these definition as very simple and added most basic ones. We will have full fledged explanation in subsequent tutorials.

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