Options Explained-Intro, Types and How to trade

An option is a financial derivative contract that gives the buyer the right—but not the obligation—to buy or sell an underlying asset (like a stock or index) at a predetermined strike price before or at a specified expiry date. The buyer pays an upfront premium to acquire this right; the seller (writer) receives the premium and takes on the obligation to honor the contract if the buyer chooses to exercise.

Options are fundamentally different from stocks. When you buy a stock, you own a piece of a company. When you buy an option, you own a time-limited right to make a future decision. This time-limited nature creates unique characteristics including time decay, leverage, and asymmetric risk profiles that make options both powerful and complex.

All options fall into two categories: calls and puts. Understanding the fundamental difference between these two types is essential before attempting any options trade.

Every option trade is one of four basic positions. Understanding the risk profile of each is crucial before entering any position.

• Long Call (Buying a call): You pay premium for the right to buy. Profit when the underlying rises. Maximum loss is limited to premium paid. Best for bullish views with defined risk.
• Short Call (Selling a call): You receive premium and accept obligation to sell if exercised. Profit when underlying stays flat or falls. Maximum loss is theoretically unlimited as underlying can rise indefinitely. Requires high risk tolerance and margin.
• Long Put (Buying a put): You pay premium for the right to sell. Profit when the underlying falls. Maximum loss is limited to premium paid. Best for bearish views or portfolio protection.
• Short Put (Selling a put): You receive premium and accept obligation to buy if exercised. Profit when underlying stays flat or rises. Maximum loss is strike price minus premium received (large but limited). Often used for income generation or acquiring stocks at lower prices.

Every option's premium consists of two components: intrinsic value and extrinsic value. Understanding this breakdown is essential for evaluating whether an option is expensive or cheap.

Intrinsic Value is the immediate exercise value—the amount of profit you would realize if you exercised the option right now. For calls, it is max(0, Spot Price - Strike Price). For puts, it is max(0, Strike Price - Spot Price). Only in-the-money options have intrinsic value.

Extrinsic Value (also called time value) is the additional premium beyond intrinsic value that traders pay for the possibility of future movement. It consists of time value (more time = more possibility) and volatility premium (higher expected volatility = higher premium). As expiry approaches, extrinsic value decays to zero—a phenomenon called time decay or theta decay.

Moneyness describes the relationship between the strike price and the current underlying price. This concept affects every aspect of option behavior including delta, theta, premium, and probability of profit.

• In-The-Money (ITM): Has intrinsic value. For calls, strike is below spot price. For puts, strike is above spot price. Higher delta (0.60-0.90), behaves more like owning the underlying, lower time decay percentage.
• At-The-Money (ATM): Strike is approximately equal to spot price. Highest time decay, delta around 0.50, maximum extrinsic value. Most actively traded.
• Out-Of-The-Money (OTM): No intrinsic value, only extrinsic value. For calls, strike is above spot. For puts, strike is below spot. Lower delta (0.10-0.40), high leverage, high risk of total loss.

Option premiums are determined by multiple factors working together. The most widely used pricing model is the Black-Scholes model, though traders often think in terms of these intuitive drivers:

Time decay is one of the most critical concepts in options trading. Unlike stocks which can be held indefinitely, options lose value every day simply because time passes. This decay accelerates as expiry approaches, with ATM options experiencing the fastest decay rate.

A common mistake among beginners is buying options as "cheap" bets because the absolute premium is small. However, options may be relatively expensive due to high implied volatility, and time decay works against long option holders every single day. A ₹10 option that decays to zero in 7 days represents a 100% loss, which is anything but "low risk."

Options in India come in two exercise styles, which affect assignment risk and pricing:

• American Style: Can be exercised any time before expiry. Most stock options are American style. Creates early exercise risk, especially around dividend dates for short calls.
• European Style: Can only be exercised at expiry. Nifty and Bank Nifty index options are European style. No early exercise risk, simpler to manage for retail traders.

Before placing any trade, ensure you have a trading plan that answers these questions: What is my market view? What is my time horizon? How much am I willing to lose? What is my profit target? How will I manage the position?

1. Choose your underlying: Start with liquid indices like Nifty or Bank Nifty (European style, high liquidity, lower spreads).
2. Determine your market view: Bullish (buy call or sell put), Bearish (buy put or sell call), Neutral (spreads or iron condors).
3. Select expiry: Use weekly expiries for 1-5 day views, monthly for 1-4 week views. Avoid options with less than 7 days until you have experience.
4. Pick your strike: ATM for balanced exposure, ITM for higher probability/lower leverage, OTM for lottery-style high leverage (not recommended for beginners).
5. Check liquidity: Ensure bid-ask spread is less than 5-10% of option price, decent volume (100+ contracts), and reasonable open interest (500+).
6. Determine position size: Risk no more than 1-2% of your capital on this trade. Calculate: (Capital × Risk %) ÷ Premium per share = Maximum contracts.
7. Place your order: Use limit orders for better execution. Place between bid-ask midpoint. Avoid market orders in options.
8. Set your exit plan immediately: Define profit target (typically 30-50% gain for buyers), stop loss (usually 50-100% of premium for buyers), and time stop (exit before final week).
9. Monitor and manage: Track P&L daily, monitor Greeks if possible, be ready to adjust or exit if your thesis changes.

Start with simple, defined-risk strategies. Avoid selling naked options until you have significant experience and capital.

• Long Call or Long Put: Simplest directional strategy. Risk is limited to premium paid. Best for strong directional conviction with 2+ weeks to expiry.
• Bull Call Spread: Buy ATM call, sell OTM call. Reduces cost, defines maximum profit and loss. Good starter strategy for bullish views.
• Bear Put Spread: Buy ATM put, sell OTM put. Similar benefits as bull call spread but for bearish views.
• Protective Put: Own stock and buy put for insurance. Portfolio protection strategy. Costs premium but limits downside.

Remember: Complexity is not profitability. Master simple strategies first. Many professional traders use only 2-3 strategies their entire career.