1. What is an option?
An valid tradable instrument, the holder of which has the right, but no obligation to buy or sell the stock or underlying instrument. Generally the buyer will pay some price to get this right (called premium).
The seller of option will have OBLIGATION to buy or sell the underlying stock/instrument, if the owner of option decides to exercise their right.
2. What are the specifics of an option?
An option is made up of following
- Underlying stock or other instrument
- Strike price
- Option type as CALL or PUT
- Expiry date
The different combination of above 4 parameters gives us a unique tradable option chain. eg – NIFTY 5200 CALL 26-Apr-2012
3. What is a CALL option?
An option that gives you the RIGHT to BUY the underlying stock/instrument at agreed price (called strike price), before agreed date (called expiry date). The person who is selling you the CALL option carries the obligation to deliver you the stock/instrument, if you decide to exercise your right.
4. What is a PUT?
An option that gives you the RIGHT to SELL the underlying stock/instrument at agreed price (called strike price), before agreed date (called expiry date). The person who is selling you the PUT option carries the obligation to take the delivery from you of stock/instrument, if you decide to exercise your right.
5. What are the two considerations in determining the value of an Option?
The value of option is determined mainly by the volatility of the underlying instrument and the distance of option expiry date from today i.e.life of option. More volatile the instrument, or longer the life, costlier the options will be.
6. What are the 3 instruments for trading?
The underlying stock, CALL options on the underlying stock and PUT options on the underlying stock are the three types of instrument for trading.
7. What are the 6 actions that can be taken?
One each of the above 3 instruments, one can take BUY or SELL actions e.g. – Buy stock, Sell stocks, Buy Call option, Sell Call option etc. That gives us overall 6 types of actions.
8. What is an option chain?
An option chain is unique combination of 4 parameters given in question 2 above. Each combination is a tradable instrument on its own. eg Nifty 5200 CALL 26-Apr-2012 ang NIFTY 5300 PUT 26-Apr-2012.
9. I have small account size. Can I trade options and make big returns ?
Chances of this happening is very close to zero. Due to small account size, you might end up taking big risk as %age of the account with options. Options are traded in lot size (i.e. minimum quantity for buy or sell), hence the risk will always be in multiple of that lot size. If you trade stocks, this minimum quantity is 1 hence you have much better control on the risk. It is true that %age return can be large in option trade but this can also hit adversely as risk is also high %age term.
My suggestion will be to learn the basics of trading first. If account is small then, use stocks for this learning. Once you have consistent and profitable performance, then move into options trading. That too with appropriate account size.
10. How /where to learn option trading?
Please go through this post “How to learn options trading” where I have given my suggestions on how to get started in options trading. In case of any questions, feel free to leave comment or contact me.