Introduction to Option Trading
Introduction to Options
What Is an Option?
An option is a contract. It 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.
Think of it like putting a deposit on a house you want to buy. You pay a small fee to the seller, and they agree not to sell the house to anyone else for the next 30 days at a price you both agree on today. You now have the option to buy that house. If you decide not to, you just lose your deposit. If you decide to buy, you exercise your option.
In the financial world, that deposit is called a premium, and the underlying asset is usually a stock or an ETF.
Think of options as an agreement, a contract giving you the right, but not the obligation, to buy or sell an underlying asset – typically shares listed on the NSE or BSE – at a predetermined price (called the strike price) on or before a specific date (the expiration date).
Every options contract has two sides: a buyer and a seller (also called the writer).
- The Buyer: Pays the premium for the rights the contract provides.
- The Seller (Writer): Receives the premium and has the obligation to fulfill the contract if the buyer decides to exercise their right.
Calls and Puts
Options come in two basic types: calls and puts. They're opposites.
A call option gives you the right to buy an asset. You buy calls when you think the price of the asset is going to go up.
A put option gives you the right to sell an asset. You buy puts when you think the price is going to go down.
| Option Type | Your Right | Your Belief |
|---|---|---|
| Call Option | To buy an asset | The price will go up |
| Put Option | To sell an asset | The price will go down |
Key Terms
To trade options, you need to know the language. These are the core terms for every contract.
Strike Price
noun
The price at which the underlying asset can be bought or sold, as specified in the option contract.
The strike price is fixed. It doesn't change, even if the stock's market price swings wildly.
Expiration Date
noun
The date on which an option contract becomes void. The buyer must exercise or sell the option on or before this date.
Options have a limited lifespan. After the expiration date, the contract is worthless.
Premium
noun
The current market price of an option contract. It is the amount the buyer pays to the seller.
The premium is the cost of the option. For the buyer, it’s the maximum amount they can lose. For the seller, it's the maximum profit they can make.
Let's test your understanding of these core concepts.
An options contract gives the buyer the...
In an options contract, the seller (or writer) receives the premium and in return, takes on the __________ to fulfill the contract if the buyer exercises it.
These building blocks are the foundation for everything else in options trading.