The derivative is financial security whose value is dependent on an asset or a group of underlying assets. It is a contract between two or more than two parties. Its price is determined by the fluctuations in the value of the asset. Derivative Contracts are of two types. They are Futures Contracts and Options Contract. These contracts are standardized and can be traded freely on the exchange in the derivative market.
The Futures Contracts are a type of contract wherein you can buy or sell a commodity or an asset at a predetermined price on a specific date in the future. An Options Contract is a type of contract where you do not have the obligation to buy or sell. In this contract, you only get the right to buy or sell an asset or commodity.
Trading in Options Contract requires keen knowledge of the market. Options Trading has gained a lot of popularity among investors. Here we list a few important things which you should know before you buy Options contract.
1.Extensive Range of Maturities
Options Contracts are available for a varied amount of validities. There are contracts which expire in a month or 2 months or 3 months. These are short term variations. There are long term variations too. There is concentrated liquidity in options which have a near month contract.
The maximum loss that you may incur is the premium that you have to pay on a call or put option. At the initial stage, there is only a margin of premium which you have to pay.
In options contract, a call option gives you the right to buy an option and ‘put’ gives you a right to sell the options. As mentioned before, the buyer only gets a right and not the obligation to buy or sell. For this right, the buyer has to pay a premium to the seller of the option. The premium turns into a sunk cost for the buyer.
4.Each Purchase is a Trade-Off
Every Option contract that you purchase is a trade-off. An option which has low outstanding maturity will be available at a low premium. This sharply reduces your money-making prospects.
Volatility is what drives an Option. It is a positive relationship for both, call and put options. As the volatility rises so does the value of the call and put. When markets become volatile there is a high chance that the stock market can sway either way. If the movement of the market is in your favor when you make profits. If it is against your favor even, then you do no lose the money.
6.Securities Transaction Tax
In India, unlike the futures contract, the Securities Transaction tax is charged on the premium value instead of the notional value of the Option.
If L&T has a lot size of 400 and you chose to buy a 1000 strike call option at a premium of Rs. 10 then the notional value becomes Rs. 4 Lakhs (400*1000) for one lot and the premium value becomes Rs. 4,000 (400*10). Here the STT will be imposed on the premium value and not on the notional value.
7.Intrinsic Value and Time Value
Intrinsic Value and Time value are two important components which every options trader should know. If the strike price is higher than the stock price, then the entire premium will be taken as time value. As the option is a waiting asset, its time value keeps reducing as maturity approaches. It is advisable to buy options at the start of the contract as you have a wider time frame.
If the call option for L&T’s 1500 strike is on NSE at Rs. 60 and if the spot price of L&T is Rs. 1510 then out of the premium of Rs. 30, Rs. 10 will be the intrinsic value. The balance of Rs. 20 will be the time value.
8.Cater to Different Market Situations
In Futures and Options trading, Options are a dynamic as well as a flexible product. A combination of these Options can be used to cater to different market situations. If you speculate that the market is going to be volatile, then you can choose to buy a combination of a Straddle or a Strangle. If you feel that the market will be in the range, then you can choose to sell the Straddle or Strangle. If you wish to be moderately bullish or bearish then you can use strategies such as butterflies and covered calls.
Options are non-linear in nature. Hence a buyer gets a lot more flexibility. The buyer can use these Options for a variety of purposes. If you feel the stock of L&T will go up, then you can choose the call option. If and RIL stock is expected to fall, then you can choose a buy option. It is all about making the right choices at the right time. Futures and Options trading or derivative trading is taking up a huge space in the stock market. The above mentioned inputs will help you trade better in Options Contracts.