Part I – Getting Started With Trading Options – How does an Options Trade Work?

These series of Options Trading is in continuation to Part VII – Getting Started With Trading – How to Trade Options? where we have detailed out all the information regarding Options Market – What are Options? What are Calls & Puts? Rights & Obligations of Options Buyers & Sellers? Key Concepts & Terms used in Options Market? and finally Why a trader trades Options?

So, those who are new to the Options Trading please visit the above article to understand the core concepts and working of Options in Trading.

Trader of futures market are limited to trading small number of instruments, while in case of options the trader is exposed to a wide range of contacts. Every time, there are three different expiration month contract, with each month different exercise prices, with both calls and puts available for each exercise price.
So, the trader have to have valid parameters and reasons to decide which options contract can provide him/her profitable opportunities.

In the beginning, start with understanding the normal individual buy and sell strategies then extend it further to combination of options.

How does an Options Trade Work?

Lets illustrate the case of BankNifty Options in the month of Jan, 2016 when the underlying value of the BankNifty future as on Jan 8th, 2015 is 16150 and the contracts for both calls and put for Jan 2016 expiry are available as under:-

Suppose, we assume that the Bank Nifty will rise to 16700 by the Jan expiry then on the expiry, the above call options will be trading at the below prices :-

So from the above, any call option below strike price of 16600 will be profitable to trade in. Suppose, if we are buying the 16200 call for Rs. 290. As the market is trading at 16150 and the 16200 call is available at Rs. 290 so the option has own value or its intrinsic value of Rs. 50 (16200-16150) and the time value of Rs. 240 (290-50).
(Premium = Intrinsic Value + Time Value).
If on the expiry, the index does rises to say 16700 then the 16200 call option will be trading at its real or intrinsic value of Rs. 500. So, our profit from the call option will be 500 – 290 = Rs. 210 i.e. (the intrinsic value of the 16200 call minus the price we paid).

But what about the Calls above the Strike Price of 16700?

If we believe that the bank nifty will rise max. to the level of 16700 by the January expiry, then we can even prefer selling the Calls above strike price of 16700.

Suppose, if we sell the 16800 strike price call for Rs. 88 then we are selling short it at Rs. 88 and on expiry the value of this 16800 will expire worthless (i.e. Zero) as the intrinsic value will be zero for this call option and we can keep the full premium of Rs. 88 as profit.
Similarly, if we sell the 16900 strike price call for Rs. 70 then on expiry this will expire worthless and we can keep the full premium of Rs. 70 as profit.

From the above, we can conclude that the buyer of the call option will be in profit if

Intrinsic Value of Call Option > Cost Price

While the sellers of the call option will be in profit if

Strike Price of Call Options => Underlying Value on Expiry

Lets illustrate the same case of Bank Nifty with the Buyers & Sellers of the Put Options.

Suppose, we assume that the Bank Nifty will rise to 16700 by the Jan expiry then on the expiry, the put options will be trading at the below prices :-

So from the above, buyer of any put option will be is loss. Suppose, if we are buying the 16200 put for Rs. 330. As the market is trading at 16150 and the 16200 put is available at Rs. 330 so the option has own value or its intrinsic value of Rs. 50 (16200-16150) and the time value of Rs. 280 (330-50).
(Premium = Intrinsic Value + Time Value).
If on the expiry, the index does rises to say 16700 then the 16200 put option will be trading at its real or intrinsic value of Rs. Zero. So, our loss from the put option will be Rs. 330 (the price we paid to buy).

But what about the Sellers of the Put Options?

If we believe that the bank nifty will rise to the level of 16700 by the January expiry, then we can even prefer selling the put below the strike price of 16700 as these put options will expire worthless on expiry.

Suppose, if we sell the 16200 strike price put for Rs. 330, then we are selling short it at Rs. 330 and on expiry the value of this 16200 put will expire worthless (i.e. Zero) as the intrinsic value will be zero for this put option and we can keep the full premium of Rs. 330 as profit.
Similarly, if we sell the 16400 strike price call for Rs. 445 then on expiry this will expire worthless and we can keep the full premium of Rs. 445 as profit.

From the above, we can conclude that the buyer of the put option will be in profit on expiry if

Intrinsic Value of Put Option > Cost Price

While the sellers of the call option will be in profit if

Strike Price =< Value of Underlying on Expiry

KNOWLEDGE IS POWER!

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