In volatile equity markets, many investors rely on option-based strategies to limit their downside. A stock option is a security whose price is derived from the price of the underlying share. Investors can either buy an option or write an option. Writing an option is the origin of the contract and requires an in-depth understanding of market dynamics as the risk is very high. Buying or holding an option is simpler and limits the risk.
In the domestic equity market, option contracts are available on 223 securities as directed by the Securities and Exchange Board of India (Sebi).
Call and put options
Essentially, there are two kinds of plain-vanilla options—call and put options. A call option gives you the option to buy a share at a predetermined price, whereas a put option entitles you to sell a share at a predetermined price. You have the option but are not obliged to do so. The predetermined price is called the option strike price and may or may not match the current market price of the share.
You have to pay a premium or fees to the option writer for owning the option. If you buy a call option, you are fixing a buy price and expecting the market price of a share to rise so that you can benefit from the profit made by selling in the market at a higher price. On the other hand, in case of a put option, you fix a sale price and are expecting the subsequent market price to fall resulting in a profit when you exercise the option (you can buy the share from the market at a lower price).
Contract term: Options have a maximum of three-month trading cycle. At the expiry of one-month contracts, new contracts are introduced at new strike prices for both call and put options on the trading day following the last Thursday (expiry day) of the month. If you don’t exercise the option, you can continue into the new contract that comes the following month by paying a fresh fee. If the last Thursday is a trading holiday, they expire on the previous trading day.
What do you pay?
Margin money: To take the buy or sell position on stock options, you have to place a certain percentage of order value as margin money. So if you want to buy options worth Rs 5 lakh you will have to keep a proportion of that amount in your trading account as margin money. This is in addition to the fee for buying an option.
Brokerage and tax: Brokerage houses, typically, charge a flat fee per contract size as opposed to a percentage in case of buying shares. Over and above the brokerage you will have to pay a service tax on the total value of brokerage and a securities transaction tax at 0.017% on the option fee in case of sell trades and 0.125% on settlement value where option contracts are exercised.
What’s the advantage?
You get the option to buy or sell a share at a cost much less than the actual share price, you can simply forgo the option if the market does not move as per your expectation and not incur a loss higher than the fees paid no matter how much the price of the underlying share fluctuates.