Stock options are central in the stock market investment, particularly CE (Call Options) and PE (Put Options).
But what are Stock Options, and what are CE and PE in the Stock Market?
Let's first start by understanding the stock options.
What Are Stock Options?
Stock options are contracts that allow the buyer the right, but not the obligation, to buy or sell an underlying asset, typically a stock, at a predetermined price within a certain timeframe.
To trade a stock option, you must first decide on the option type (call or put) and then select the strike price.
The strike price is the predetermined price at which you can buy or sell stocks.
Additionally, you must choose an expiration date for the option and pay the seller a premium (fee). The premium cost depends on the stock's volatility and the time left until expiration.
Here are the steps to trade stock options:
- Decide whether to trade a call or a put option
- Select the strike price
- Select the expiry date for the option
- Pay a premium
To further understand these steps, let's take an example:
Consider Reliance Industries Limited, a leading NSE company currently trading at ₹2,000. You believe Reliance's stock will rise next month. So, you pay a ₹50 premium to buy a call option at a strike price of ₹2,100 with a 30-day expiration.
If, by the end of the month, Reliance's stock trades at ₹2,300, you can exercise your option to buy the stock at the strike price of ₹2,100. Your profit on each share will be ₹200 (₹2,300 - ₹2,100). After subtracting the premium of ₹50, your net profit will be ₹150 per share.
The Importance of Stock Options
Stock Options are invaluable for traders. They not only help them protect against potential market price shifts but also let them speculate on stock price movements without directly owning the stocks.
For example, if you are bullish on Wipro's future performance, you might buy a call option instead of purchasing the stock.
Buying the Wipro stock option will require less capital (just the premium) than buying actual stocks. So, a rising stock price could result in huge profits if you buy a Wipro stock option. Now, let's understand CE and PE in detail.
What is CE (Call Option)?
CE or a call option gives its holder the right, but not the obligation, to buy an asset at a predetermined price within a set timeframe. It is essentially betting that the stock's price will increase.
For example, say Tata Motors is trading at ₹300 per share. You believe Tata's upcoming product launches will boost its stock price in three months. So, you pay a premium of ₹1000 to buy a call option contract (100 shares) at a strike price of ₹320.
Your analysis was right; the stock price rose to ₹350 in three months due to strong sales. Now, your call option allows you to buy the stock at ₹320 and make huge gains.
Benefits of Buying (CE) Call Options
Call options enable traders to control more shares for a fraction of the cost. It offers an opportunity to benefit from the growth of blue-chip stocks without big investments.
Consider Bharti Airtel, one of India's top telecommunications companies. You expect the stock to rise from its current ₹500 per share. So, you pay a premium of ₹10 to buy a call option with a strike price of ₹510.
If the stock rises to ₹540, you can exercise the option, effectively paying ₹520 (including the premium) for a stock worth ₹540, realizing a net profit of ₹20 per share, minus the premium.
What are PE (Put Options)?
A put option grants its holder the right, but not the obligation, to sell an asset at an agreed price within a designated period. It is essentially a wager that a stock's price will fall.
Consider Infosys, a tech giant in the Indian market. If you anticipate a temporary decline in its stock price from ₹1,400 due to market factors, you might buy a put option with a strike price of ₹1,380.
If the stock drops to ₹1,350, you can exercise your option by selling at the higher strike price.
Benefits of Put Options
Put options can be a haven for investors expecting a stock to decline. It allows them to profit from a downturn without short-selling the stock.
For example, if you anticipate a price drop in Dr. Reddy's Laboratories due to regulatory challenges. So the stock price is currently at 4500, and you purchase a put option for a premium of 50 with a strike price of 4400.
Now, if the stock price drops to 4200, you can exercise the option by selling the stock for 4400 and making a profit of 200 per share.
Using CE and PE Together
Using call-and-pull options helps traders plan for different market situations.
For instance, if you think HDFC Bank's price might drop soon but will go up later, you could buy a short-term put option (PE) and a longer-term call option (CE). Or, if there's an election coming and you're not sure how it'll affect companies like TCS, you might use both CE and PE to protect against big price changes.
This approach gives you more ways to handle whatever the market might do next.
Potential Risks with Stock Options
Stock options inherently come with certain risks despite the potential for huge returns. Let's go through some of these risk factors.
Expiry Risk
Stock options come with expiration dates. If the stock price does not exceed the strike price before the option expires, the call or the put option will expire worthless.
For instance, if you bought a Tata Motors call option with a strike price of ₹320 with a one-month expiry and the stock remains at ₹310, the call option will expire without value.
Likewise, if you bought a Reliance Industries Ltd. put option with a strike price of ₹2,200 expiring in one month and the stock remains at ₹2,250, the put option will also expire worthless.
Premium Loss
Investors pay a premium to purchase a put or call option. So, the entire premium will be lost if the stock doesn't move in your favor. Therefore, always avoid over-investing in stock options.
Liquidity Issues
In stock markets, options are not always highly liquid. Especially, engaging with less volatile options can lead to wider bid-ask spreads, making trading less rewarding and challenging to exit.
Market Volatility
For the seasoned options traders, volatility can be a friend or a foe. Rising volatility can increase the premium of call options. Likewise, a subsequent drop in volatility can reduce the option's value.
Complexity
Options trading is exciting. However, factors like time decay, implied volatility, or even dividend payouts can result in substantial losses.
Leverage Risk
In Stock Options, the leverage can lead to greater gains or losses with small price fluctuations. This double-edged sword requires careful handling.
External Factors
Factors such as regulatory decisions, fiscal policies, political events, and other macroeconomic indicators influence stock markets. These factors usually profoundly affect stock options and the stock markets at large.
Key Considerations When Trading Options
For successful options trading, especially in Indian markets, always consider the following factors.
Market Analysis: Thoroughly Analyze market trends. Pay attention to events like budget announcements, quarterly results, and political events, as they can significantly impact stock prices in India.
Risk Management: Start with a clear risk plan. Decide the amount you can risk in options trading and continually assess the situation.
Continuous Learning: Stay informed by attending seminars, reading expert insights, and following that can influence your target stocks.
Broker Selection: Wisely select a stockbroker in India or anywhere else, ensuring the broker has a strong platform, top-notch research, and reliable customer service.
Final Word
CE and PE are key to trading in the Indian or other stock markets. By using them correctly and knowing the risk, you can earn more from stock options and better handle market ups and downs. Start from basics, learn what stock options are, understand CE and PE in the stock market, and use them to your advantage. You will be better set up for strong investments in stock markets.