Options are contracts traded on different exchanges around the world like stocks. Options come in the derivative category i. These are known as underlying for the options. Formal definition for option is given as follows: An option is a contract that gives the buyer the right, but not the obligation , to buy or sell an underlying asset at a specific price on or before a certain date Let's look at all the keywords one by one: It means a person owning an option can exercise it if he wishes to do so.

However if he decides not to exercise the option no one can force him to do so. If the person does not exercise the option before the expiry date the value of the option becomes zero. Option in itself is not an instrument like stock that gives you something like a unit of ownership in a company.

It is only a contract which gives you the right to buy or sell such instruments that are already being traded. These instruments are known as underlying for the option. Options derive their value from the value of its underlying assets specific price: Each Option has a strike prike price. A strike price is the price at which you get the right to buy or sell the underlying certain date: Unlike stocks which continue to exist as long as the company is running, options have an expiry date after which they are not traded anymore and their value becomes zero Anything that is traded on an exchange can have corresponding option contracts also being traded provided they meet certain regulatory criterias like minimum daily traded volume, etc.

You can have an option on a particular stock like Google, Microsoft as ubnderlying or on an Index like DIJA, NIFTY acting as underlying.

Any such instruments or a combination of such instruments can be used to construct an Option contract. Options are said to mirror the movement of its underlying but there is a premium attached to it. This premium is the value attached to the optionality of the options.

Stocks are valued based on several factors like the company earnings, fixed assets, book value. There are certain factors that add premium to the value of the stocks like the fundamentals of the company, market monopoly in the product and services offering by the company, expected future growth of the company. Similarly Options have a fair value and a premium value. Calculating the fair value of option is simple.

We will look at the fair value of the options using the example of NIFTY options which are options to buy or sell NIFTY Index contracts on NSE India.

Although the second Option is worthless at the current NIFTY price, it can be of some value if NIFTY goes above before the option expiry date. Options are not traded at its fair value. The price of the option only tends towards its fair value as the expiry date comes closer.

There is always a premium attached to its fair value. For example if the NIFTY index is at , it does not mean that you can buy the option for zero dollars, you will still have to pay some dollars to get this option depending upon the expected level of NIFTY on the option expiry date.

However if NIFTY stays at levels then the option value will tend to zero towards the expiry date. Note that the option value will tend to zero even if the NIFTY falls way below the mark i. On the positive side the option value will keep increasing as long as the NIFTY is moving above Thus at least in theory options offer limitless profit and limited loss.

Option trading is more a game of numbers than fundamental analysis. For the same instrument there can be multiple options for different trading levels. Add another dimension to it and you have put and call options at each level.

Add one more dimension to it and you can either go long or short on these options. So many dimensions can get intimidating at first for a new investor, but options are interesting. In the table given below we have an actual market snapshot for FEB expiry NIFTY options.

Let's try to understand it with the help of two simple charts given below. From the Put Options chart it is easy to understand that the price of the put option is close to its fair value for higher index levels in the range of to Option premium over fair value increases for lower NIFTY levels in the range of to , indicating that the market expects the NIFTY index to fall from the current level of to From the Call Options chart the premium over fair value for higher index levels in the range of to , is extremely high because all the theoretical negative fair value adds up as premium.

However practically the option value can at minimum be zero and not negative and hence the premium for these options will be close to zero which is the price at which these options are being traded. For lower NIFTY levels in the range of to the option price is close to its fair value. Thus the value of call options is either zero or close to its fair value. After making adjustments for the negative put and call premiums the charts would look more like what we usually see in the financial text books as given below NIFTY Index: Both the charts point towards a bearish market.

The market expects NIFTY which is currently at to tend to levels by the option expiry date. The high value of put options in the Index region of to shows that the market expects that this level will not be reached by the Index, hence investors are selling the index at this level hoping to cover it by squaring off at lower levels. Similarly the high value of call options in the Index region of to suggests that the market expects the Index to reach above this lower level, hence investors are buying at this level hoping to square off when the index reaches above this level.

Thus from the above argument we can conclude that the NIFTY index will trade below level and above levels. Also note that a higher premium in the to put and call options indicate that these options are relatively expensive to their fair value, but most probably these are the levels at which most of the trading is happening and the market is most interested in.

If the Index continues to fall towards the put options will gain more premium while the call options will tend more to zero. If the market turns around and starts moving towards then the call options will start adding premium while the put option premium will start going down. Trading in options would then simply mean to guess correctly the direction in which NIFTY will move and take a corresponding position where you can earn more premium.

Another interesting column in the above table is Open Interest which indicates how many contracts are still open for the respective option.

Higher Open Interest indicates more liquid option. Increasing open interest at a particular level is also considered as an indication of market expectation that the index will reach that level by the contract expiry date. One of the factors influencing the value of the options is the volatility index VIX.

Options Trading eBook

VIX value provides the expected fluctuation perceived by the market over the next 30 calendar days. When the market is range-bound or has a mild upside bias, volatility is globally observed to be typically low. On such days, call option buying a position taken on the view that the market will move higher generally outnumbers put options buying a position taken on the view that the market will move lower.

This kind of market may indicate lower risk.

Conversely, when the selling activity increases significantly, investors rush to buy puts, which in turn pushes the price of these options higher. Investors also buy puts to hedge their stock exposure in the market against generally negative market trends.

This increased number of investors willing to pay for put options shows up in higher readings on the volatility index. High readings indicate a higher risk in the market place. As far as options trading goes it always pays to be well aligned with the long term market trend. In the short term the market may flip - flop between bullish and bearish market causing the option values to fluctuate widely. However if an investors position is well aligned with the long term trend then he need not worry about these short term fluctuations.

One of the indicators of the long term trend is NIFTy future values. If the NIFTY index is being traded at a discount in the futures market then the long term trend in bearish. On the other hand if the NIFTY index is being traded at a premium in the futures market then the long term trend in bullish.

We have seen in the Option Valuation section how to analyze options from the table of numbers giving strike price, traded price and open interest for different option levels. We have also seen how to spot the most active options using option premium and open interest. Trading in options is all about taking the right position and squaring it off at the right time.

Also option premium values tend to zero close to expiry date. It is important for all option traders to keep a close tab on their investments. One cannot simply take a position in options and forget about it because its value is bound to be zero and non-tradable after the expiry date.

Hence, squaring off at the right time is of utmost importance.

You can make good money in options if you play it statistically correct rather than trying to perfect each buy like we do for stocks. There are many factors that contribute to the pricing of the options like price of underlying, volatility, open interest, time to expiry, market expectations. The price changes wildly based of news flows into the market, which is not in our control. An investor needs to learn the trick of the game by gaining experience from trading with small investments in the begining.

Market specific research and trade execution skills is required to make money in the options market. This article is only meant to serve as a basic introduction to understanding and analyzing option quotes.

What is the best strategy that one can follow always in options index trading - General - Trading Q&A by Zerodha - All your queries on trading and markets answered

A combination of put and call options can be used to trade several more complex innstruments that can earn profits depending on the market conditions. More details regarding these can be researched using other wiki articles. From the makers of. Retrieved from " http: Track your investments automatically. Use of this site is subject to express Terms of Service , Privacy Policy , and Disclaimer. By continuing past this page, you agree to abide by these terms.

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Metals Energy Meats Grains Softs. Currencies Geographies Exchanges Rates. How To Invest Personal Finance Options Definitions. Contents 1 Options 2 Options Valuation 2.