Payoff diagram for buying a call option
Hence before we get deeper into options, it is important to have a strong foundation on these four variants of options. For this reason, we will quickly summarize what we have learnt so far in this module. Arranging the Payoff diagrams in the above fashion helps us understand a few things better. Let me list them for you —. Going by that, buying a call option and buying a put option is called Long Call and Long Put position respectively. Going by that, selling a call option and selling a put option is also called Short Call and Short Put position respectively.
However I think it is best to reiterate a few key points before we make further progress in this module. Buying an option call or put makes sense only when we expect the market to move strongly in a certain direction.
If fact, for the option buyer to be profitable the market should move away from the selected strike price. Selecting the right strike price to trade is a major task; we will learn this at a later stage. For now, here are a few key points that you should remember —. The option sellers call or put are also called the option writers. Selling an option makes sense when you expect the market to remain flat or below the strike price in case of calls or above strike price in case of put option.
I want you to appreciate the fact that all else equal, markets are slightly favorable to option sellers. This is because, for the option sellers to be profitable the market has to be either flat or move in a certain direction based on the type of option. However for the option buyer to be profitable, the market has to move in a certain direction. Clearly there are two favorable market conditions for the option seller versus one favorable condition for the option buyer.
But of course this in itself should not be a reason to sell options. This means to say that the option writers earn small and steady returns by selling options, but when a disaster happens, they tend to lose a fortune.
Well, with this I hope you have developed a strong foundation on how a Call and Put option behaves. Just to give you a heads up, the focus going forward in this module will be on moneyness of an option, premiums, option pricing, option Greeks, and strike selection. Once we understand these topics we will revisit the call and put option all over again.
This information is highlighted in the red box. Below the red box, I have highlighted the price information of the premium.
If you notice, the premium of the CE opened at Rs. Moves like this should not surprise you. These are fairly common to expect in the options world. Assume in this massive swing you managed to capture just 2 points while trading this particular option intraday. This translates to a sweet Rs. In fact this is exactly what happens in the real world. Traders just trade premiums. Hardly any traders hold option contracts until expiry. Most of the traders are interested in initiating a trade now and squaring it off in a short while intraday or maybe for a few days and capturing the movements in the premium.
They do not really wait for the options to expire. These details are marked in the blue box. Below this we can notice the OHLC data, which quite obviously is very interesting. The CE premium opened the day at Rs.
However assume you were a seller of the call option intraday and you managed to capture just 2 points again, considering the lot size is , the 2 point capture on the premium translates to Rs. However by no means I am suggesting that you need not hold until expiry, in fact I do hold options till expiry in certain cases. Generally speaking option sellers tend to hold contracts till expiry rather than option buyers.
This is because if you have written an option for Rs. So having said that the traders prefer to trade just the premiums, you may have a few fundamental questions cropping up in your mind. Why do premiums vary? What is the basis for the change in premium? How can I predict the change in premiums? Who decides what should be the premium price of a particular option? Well, these questions and therefore the answers to these form the crux of option trading.
To give you a heads up — the answers to all these questions lies in understanding the 4 forces that simultaneously exerts its influence on options premiums, as a result of which the premiums vary. Think of this as a ship sailing in the sea.
The speed at which the ship sails assume its equivalent to the option premium depends on various forces such as wind speed, sea water density, sea pressure, and the power of the ship.
Some forces tend to increase the speed of the ship, while some tend to decrease the speed of the ship. The ship battles these forces and finally arrives at an optimal sailing speed. Crudely put, some Option Greeks tends to increase the premium, while some try to reduce the premium. Try and imagine this — the Option Greeks influence the option premium however the Option Greeks itself are controlled by the markets. As the markets change on a minute by minute basis, therefore the Option Greeks change and therefore the option premiums!
Going forward in this module, we will understand each of these forces and its characteristics. We will understand how the force gets influenced by the markets and how the Option Greeks further influences the premium.
We will do the same in the next chapter. A quick note here — the topics going forward will get a little complex, although we will try our best to simplify it. While we do that, we would request you to please be thorough with all the concepts we have learnt so far. Thanks a lot for sharing learning material, it is really helpful for beginners like me to understand the concept and strategy of share market..
We are trying out best to complete the modules as fast as we can. European option means the settlement is on expiry day. However, you can just speculate on option premiums…and by virtue of which, you can hold the position for few mins or days. Also we have potential of unlimited profit in long call or long put and even we can trail stoploss of premiums. Thank you so much for your articles sir. Cause sitting in front of computer is not possible. Even if we r there we may miss the trade id doing some thing else at the time we are suppose to trade or squareoff the tyrade.
Till now it has been very clear and crisp. Thanks for that and hope that further chapters will also come the same way.
We will be discussing SL based on Volatility very soon. Request you to kindly stay tuned till then. We certainly hope to keep the future chapters as easy and lucid as the previous ones have been.
Hi Really nice initiative sir. Hello Sir, if I buy a lot of , call option of strike price at a premium of Rs 2 with a spot price of Now if the price moves to and premium is now at 3 so would be my profit?? Firstly, if the spot moves from to , the premium of the Call option will certainly be more than Rs. Your profits would be —. Hello Sir, I am still confused with the way the profit is calculated. Might be, I am not able to get what u explained and I am really sorry for asking it again.
In some of your replies, you mentioned that the profit is calculated as per the difference of spot price and strike price and in some replies u mentioned that it is as per the difference of premium. In case of 1 lot of shares the profit would be. So which of the above options are correct??? Is there a difference if I am closing my position before expiry or excersize it at expiry? For all practical purposes I would suggest you use the 2nd way of calculating profits…i.
Do remember the premium paid for this option is Rs 6. Irrespective of how the spot value changes, the fact that I have paid Rs. This is the cost that I have incurred in order to buy the Call Option.
Please note — the negative sign before the premium paid represents a cash out flow from my trading account.
This lead to my confusion. Got your point, see if you are holding the option till expiry you will end up getting the amount equivalent to the intrensic value of the option. I have explained more on this in the recent chapter on Theta…but I would suggest you read up sequentially and not really jump directly to Theta. The calculation provided by karthik in chapter 3 is for expiry calculation on expirt date.. Hope this clears your doubt..
The minimum value for this option should be STT stands for Security Transaction Tax, which is levied by the Government whenever a person does any transaction on the exchange. More about here — https: Hi Karthik, Thanks a lot for these wonderful modules. A ocean to learn!! I have a situation here.
I go long on call option of the underlying stock A. I enter a contract for buying a lot of shares at the time of expiry. After three days I find that the premium for the same call has moved to Rs. I feel that I should make a profit out of it. So here is my doubt. To make profit should I sell the same contract for a higher premium say Rs. If I am doing so, should I do that by writing a put option? In the event of writing should I have the required margin in my trading account?
Please bare with me if the question is so dumb… thanks a lot. If you bought a call option 1 and the premium for the same is now trading at 3, then you can square off your position and make a profit of 2. Its just like buying a share at 10 and selling the same at When you sell, someone in the market will buy it from you and you are completely out of the trade. Thanks for the immediate reply. This means that the person who buys the contract from me premium Rs.
In that case am I writing an Call option? Yes you are right, it becomes the counterparties obligation. You are just squaring off the position. There is a difference between writing options and squaring off…you need to be aware of this. Thanks for the great explanation. Please clarify me on this. What is square off in options? When he sells, the person buying from it becomes the holder of the contract. Traders can consider going long on Reliance Communication and Mcleod Russel India for intraday purpose as these stocks have attracted bullish bets.
Here is the article — http: Now sure which data points you are talking about. So if you have access to the same along with volumes and maybe open interest you are good to go. I have read so many books but was still apprehensive to try Options.
Now I will certainly try Options. Simple, thorough, to the point and more importantly most practical guide Congrats. Hi Karthik, Thanks to Zerodha and specially you , the content, flow of information and the examples given by you to make varsity as simple but effective practical guide. I am sill learning the dynamics of Option, Just started trading a week ago. I would like to know the following things.
A Karthik can the premium be for this call? Which one to select current month, next month or far month? In the money or at the money or out of money? Hi Karthik, I am beginner in call and put options, trying to learn this.
My one friend explained one strategy in which one can earn money surely if nifty aggressively move upward or downward. I am explaining this, please let me know what loopholes are in it. Hi Karthik, I have never ever bought or sold options, because I did not know anything about it. But after reading your article I have developed basic understanding about it. Thanks to you and your team I want to share one strategy regarding options. Rohit in the upcoming module I will lay down a structure where you will be able to analyse such strategies yourself.
Firstly, I convey my heartily thank for this type of wonderful effort. Here, I made the simplify excel document, what i learn from here.
This may be use someone. Hence, I uphold the part of excel Sheet screen short image here. I use some colour for make sense for the logical view. Saravana — you have summarized it quite well. I hope people will benefit from the same. Rohit, this is a classic bull call spread. Determining this value is one of the central functions of financial mathematics. The most common method used is the Black—Scholes formula.
Importantly, the Black-Scholes formula provides an estimate of the price of European-style options. Adjustment to Call Option: When a call option is in-the-money i. Some of them are as follows:. Similarly if the buyer is making loss on his position i.
Trading options involves a constant monitoring of the option value, which is affected by the following factors:. Moreover, the dependence of the option value to price, volatility and time is not linear — which makes the analysis even more complex.
From Wikipedia, the free encyclopedia. Below the strike, the payoff chart is constant and negative the trade is a loss. For example, if underlying price is Same as scenario 1 in fact. Finally, this is the scenario which a call option holder is hoping for. Because the option gives you the right to buy the underlying at strike price If you bought the option at 2.
You can also see this in the payoff diagram where underlying price X-axis is Initial cash flow is constant — the same under all scenarios.
It is a product of three things:. Of course, with a long call position the initial cash flow is negative, as you are buying the options in the beginning. The second component of a call option payoff, cash flow at expiration, varies depending on underlying price. That said, it is actually quite simple and you can construct it from the scenarios discussed above.
If underlying price is below than or equal to strike price, the cash flow at expiration is always zero, as you just let the option expire and do nothing. If underlying price is above the strike price, you exercise the option and you can immediately sell it on the market at the current underlying price.
Therefore the cash flow is the difference between underlying price and strike price, times number of shares.