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Q&A For Stock Market Newbies”, to spread the basic stock market knowledge to the
beginners.
This is your go-to resource for demystifying
the stock market from the scratch. Each day, we will present 10 carefully
curated questions with answers that will cover essential concepts, strategies,
and terminologies. Whether you have just entered into the market, or trying to
starting your stock market journey, or looking to strengthen your foundation,
our weekly post will guide you through the basics and beyond, making investing
accessible and understandable for everyone. Happy reading.
Day 22: Basic Stock Market Concepts
Fundamentals of Futures and Options Trading:
1. What is Options Trading?
Options trading is a
type of speculative trading method which is popular among the traders due to
its potential to make huge profits as well as to safeguard their portfolio
through hedging. When a newbie enters into the stock market to indulge himself
into options, he generally gets confused with the complexities of options
and its different jargons like Call, Put, ATM, ITM, OTM, Premium, Intrinsic
Value etc.
In simple language, options are the derivatives that gives the options buyers the right to buy the
underlying security at a pre-decided price from the options sellers on or
before the expiry day. The option buyer has the right to buy not an obligation
to honour the contract, the option seller is obligated to honour the option
contract.
The option buyer gives
a fee to the seller to buy the contract which is known as the premium. The
option buyer looses only the amount of premium if he doesn't want to buy the
security from the seller. The buyer has limited risk (upto the amount of
premium he paid) but has a chance of unlimited profit. The seller has limited
profit probability, but limited risk of loosing money.
2. Who is an Option Buyer?
An option buyer is the
trader who buys the option contract from the seller by giving a premium. It
means that the buyer buys the right to buy an underlying security or an asset
at a pre decided price on or before the expiry day. As the buyer pays a premium
to the seller, so he doesn't have the obligation to honour the contract unlike
the seller.
The buyer has limited risk,
but unlimited potential for profit.
3. Who is an Option Seller?
Option seller is the
trader who sells the option to the buyer receiving the premium from the buyer
and hence is obligated to exercise the contract on or before expiry. Option
seller has limited profit potential, but unlimited risk of loss. Option sellers
are also called as option writers.
4. What is Call Option?
A call option is a
type of option which gives the buyer the right but not the obligation to buy an
underlying security or asset at a pre decided price within a certain time
period. The buyer of a call option gets profit when the price of the underlying
asset is increasing.
Call option buyers believe the stock price will increase. On the other hand, a call option
seller believes that the price of the underlying asset will decrease or take a
pause.
5. What is a Put Option?
A put option is a type
of option which gives the buyer the right but not the obligation to sell the
underlying security or asset at a pre decided price within a certain time
period. The buyer of a put option gets profit when the price of the underlying
asset is falling.
Simply, a buyer of a
put option expects that the stock price will fall. On the other hand, a put
option seller expects that the price of the underlying asset will not go below
the decided price or pause.
6. What is an Expiration Date in Futures and
Options Trading?
The expiration date is the specific date on which a future or option contract ceases to exist, and any remaining positions must be settled. For options, this is the last day on which the holder can exercise their right to buy or sell the asset. Expiration date is the last date of a contract till which the holder of the contract may exercise his right. In India, options contracts are expired at the end of every Thursday for weekly expiry and on the last Thursday of every month.
7. What is the Strike Price in an Option Contract?
The strike price is
the price that is pre-decided at which the option buyer and the option seller
agreed upon a contract. It is the crucial element that determine the option
value.
The call option buyer
makes money if the spot price is above the agreed strike price. On the other
hand, the put option buyer makes money if the spot price is below the agreed
strike price.
8. What is a Spot Price in Options?
The spot price or we
call it underlying price in options is the current market price of an asset
from which the option is derived. It is the normal existing price of an
asset.
Suppose, a certain
company is trading at Rs.525.Someone buys a call option of that company of 500
call option at Rs.50.Here the spot price or underlying price is Rs.525, strike
price is Rs.500,and premium is Rs.50.
9. What is Options Premium?
Options premium is the price that the buyer of an options contract pays to
the seller for the rights granted by the option. It is essentially the cost of
purchasing the call or put option and represents the compensation the seller
receives for assuming the potential obligation of fulfilling the contract.
The
premium is influenced by several factors, including intrinsic value, time
value, interest rates, volatility etc.
The
premium is paid upfront and is non-refundable, regardless of whether the option
is exercised or expires worthless within the expiry date.
10.
How do Options Differ from Futures?
While both futures and options are
derivative contracts, the key difference is that in an option, the
buyer has the right but not the obligation to buy or sell the underlying asset.
On the other hand, a futures contract obligates both parties
to fulfill the contract terms at expiry.
No upfront cost, except for margin
requirements for futures.
The buyer must pay a premium for the
option.
Unlimited risk for both buyers and
sellers as prices can move unfavorably in futures.
Risk is limited to the premium paid
for buyers in options, while sellers in options have unlimited risk.
Profits/losses are unlimited
depending on the price movement of the underlying asset in futures.
The buyer's profit is unlimited, but
sellers have limited profit (the premium) in options.
If you have any other questions in your mind relating to stock market basics or need any clarification, please put your query into the comment box, We will try our best to clarify the same
Disclaimer: The information provided on MoneyWiseMind is for educational and informational purposes only. It is not intended to be financial advice, and you should not rely on it as such. Before making any financial decisions, you should consult a licensed financial advisor.
