Ajitansh Kar, Gurugram, 20th August 2023
In April 2021, I experienced my initial foray into the lucrative world of option trading. My limited understanding of buying a call when the market is rising and buying a put when the market is falling prompted me into buying a call option as Nifty had opened with a marginal gap up. My initial investment of Rs. 4,000 luckily increased to Rs. 8,000 within the same hour. This time, I fell into greed and spent Rs. 4,000 additionally on call options at a different strike price. To my amazement, this investment also returned about 20% of the principal. I thought I had figured out how to make a lot of money quickly and easily. I made a costly error of doubling my investment and placing Rs. 8,000 into a put contract when Nifty opened the next day 30 points in the red. Unfortunately, my beginner’s luck had run out and the transaction began to move sideways. I kept it till it expired (Thursday of the week for weekly contracts and last Thursday of the month for monthly contracts for Nifty) in the hope of making a profit; but the value of the contract had eroded completely the following Thursday leaving me penniless. This experience demonstrated that, while trading stocks is like playing chess with another human, trading options is like playing 3-D chess with a computer algorithm.
Options are a type of financial product known as derivatives. Derivatives are products whose value is derived from an underlying asset, as the name implies. Futures and Options are the two most common derivatives on Indian stock markets. Option contracts based on commodities, currencies, equities, and stock market indices are very common in India. The largest derivatives exchange in the world is in India, where most derivatives are traded globally. Options allow consumers to lock in prices for different commodities or goods.
To better understand them (call and put), let us examine a few examples. Consider a scenario in which a real estate agent wants to market a house for Rs. 5 crore that is in your best interest as well as the interests of multiple other parties. However, you are unable to proceed with the sale owing to personal problems and limitations. In this situation, you may offer the seller a tiny premium of, say, Rs. 10 lakhs in order to request that he refuse to consider any other group’s desire for the sale. After six months, the property’s price rises to, say, Rs. 7 crore, at which point you have the option of purchasing the home for Rs. 5 crore, making a profit of Rs. 2 crore for yourself. On the contrary, you would only lose the premium you paid if the price of the house dropped to, say, Rs. 2 crore. A call option functions in a similar way.
To better comprehend put options, let us use another example. Let us begin by saying you want to sell your car worth Rs. 10 lakhs after a month. You are concerned that by the time you finalize the transaction, the car would have decreased in value. You agree with the buyer to have the option to sell your car for Rs. 10 lakhs after a month in order to prevent potential loss in the future. To make the offer appealing, you must provide the buyer a specific premium. If the car’s value falls to Rs. 4 lakhs at the end of the month, you would still have the right to sell the car for Rs. 10 lakhs. On the contrary, if the price of the car rises to Rs. 12 lakhs, you would only loose the premium paid. Put options operate in this manner.
I hope you now have a basic grasp of how options work. However, I would like to point to the fact that these instruments are quite difficult to comprehend, which is one of the reasons why high-frequency trading (HFT) companies, large banks, and quantitative fund houses dominate the market for them. Trading options can be extremely profitable if done correctly, but it can also cause significant capital erosion over a short period of time.
