Options (right to buy or sell without obligation) have become the most popular and actively traded products in the stock market. It has actually emerged as a big segment of stock markets in the last 10 years. Today index options and equity options put together account for over 85% of the total volumes on the NSE on a daily basis. The regulator has been trying to constantly caution retail investors about the merits and demerits of the F&O market. Here are some basic things that you must know when you buying options (either index options or stock options) in the market…

What you must ideally take care of when you are buying options in the market?

You must be careful in selecting the maturities. Options are available in a wide range of maturities. You can get options that expire in 1 month, 2 months and 3 months. There are also long term options in case of indices and you also have the choice of weekly options on the Bank Nifty. Of course, liquidity is still concentrated in near month contracts.

Know when to use calls and when to use puts. Call options give you a right to buy and put options give you the right to sell. In both the cases, the buyer of the option only has the right but not the obligation to buy or to sell. For this right without obligation the buyer pays a premium to the seller of the option. This premium is a sunk cost for the buyer of the option.

You are protecting your loss in buying options so no margin worry. Since the premium paid by you on a call or put option becomes effectively your maximum loss, there is only a premium margin that you need to pay initially. As an option buyer you do not have to worry about MTM margins; unlike in the case of futures.

No option is a perfect profit opportunity. You need to trade off between risk and returns. At times even liquidity! Every option purchase is a trade-off. If your options have a lower outstanding maturity then it will be available at a lower premium. But the lower outstanding maturity also means that the prospects of your making money on the options stands sharply reduced.

If you want to buy options you must understand volatility. The most important factor driving the value of an option is volatility. Normally in case of call and put, the relationship is positive. When the volatility in the market goes up, both calls and puts become more valuable. There is a simple logic behind this. When markets become volatile there is a higher probability of the stock moving sharply either ways. Since options are non-linear, you make profits when the movement is in your favour but you do not lose money when the movement is against you.

You get a major STT advantage on options as it is premium based and not notional value based. The big advantage in options in India is that the securities transaction tax (STT) is not charged on the notional value of the option but on the premium value. This is an advantage in options over futures, where the STT is charged on the notional value. What is this concept? If RIL has a lot size of 500 and you buy a 1700 strike call option at a premium of Rs.10, then the notional value of one lot will be Rs.850,000 (500*1700) but the premium value will be Rs.5,000 (500*10). One of the main reasons for options trading growing in a big way in India is that the STT is imposed on the premium value and not on the notional value. The new rules of STT on ITM options are also a big boost.

Option value needs to be broken up into components to understand pricing better. When you see the option price of a particular strike on a stock, remember it comprises of two components; the intrinsic value and time value. An understanding of these 2 concepts is extremely important for any options trader. Let us go back to the RIL example. Assume that the call option of RIL 1650 strike is quoting on the NSE at Rs. 38. If the spot price of RIL is Rs.1660, then out of the premium of Rs.38, Rs. 10 will be intrinsic value of the option (1660-1650) while the balance of Rs.28 will be the time value of the option. If the stock price of RIL is less than the strike price then the entire premium will be time value.

It is time value that really determines the value of most options. The distinction between time value and intrinsic is crucial to your understanding of trading in options. Remember, an option is a wasting asset and therefore the time value of the option keeps reducing as the date of maturity approaches and almost comes close to zero by the time the maturity approaches. Hence as an option buyer it always makes more sense for you to buy options in the beginning of the contract as it will give you more time value and volatility prospects to play with.

Options are flexible and dynamic products and hence can be used for a variety of purposes. If you expect the stock of RIL to go up then you can speculate on the stock with a call option. Similarly, if you expect the stock of SBI to go down then you can speculate by buying put options. You can also hedge your risk in the market. If you have a portfolio of equity holdings, you can hedge the risk by buying put options on the Nifty. The non-linear nature of options gives a lot of flexibility from a buyer’s point of view.

The biggest advantage of options is that they can be used to create hybrids. Options can be combined to cater to a whole range of market situations. For example, if you expect the market to be volatile you can buy a combination Straddle or a Strangle. Conversely, if you expect the market to remain range-bound, you can play the market by selling a Strangle or Straddle. You also have specific spreads strategies known as butterflies and covered calls where you can play for a moderate bullishness or moderate bearishness in the market. The choice is entirely yours.

If you are better informed about some of the above unique features of options, the more are your chances of profiting from buying options.