You probably know what a stock/share of a company is - in the simplest of terms, a single share represents a solitary unit of ownership of a company.
Companies offer their shares for sale to raise capital for themselves and such shares (also referred to as equities) are listed and traded in a stock exchange.
In a stock exchange, many high profile shares that trade in huge volumes may also have derivatives associated with them. A derivative is a contract between two or more parties in which the contract ‘derives’ its value from an underlying security such as a stock or an index.
Unless you need cataract surgery, you probably know that the most commonly traded derivatives in the stock market are Futures and Options. They are also commonly referred to as F&O.
Futures contracts are relatively easier to understand when compared to options, but they carry more risk and are less flexible.
An option is defined as a type of contract, sold by one party to another that gives the buyer of the option, the right, but not the obligation, to buy or to sell the underlying stock at a pre-determined price.
Options cannot exist indefinitely and every option has an expiry date. The option buyer of a specific option may have a right to exercise his/her option only at the time of expiry of the option, or he/she may have a right to exercise the option at any point in time till the date of expiry.
Note: Derivatives can also be based on various other underlying securities such as commodities. However, throughout this book, all examples and scenarios are limited to options trading based on underlying stocks and indices only.
There are fundamentally two different types of options. They are:
Call Options – These options give the buyer the right to buy the underlying security at a fixed price.
Put Options – These options give the buyer the right to sell the underlying security at a fixed price.
The most important thing to know here is that in the case of a call option, the buyer of the option can only start profiting from that option when the value of the underlying stock/index goes up.
On the other hand, in the case of a put option, the buyer of the option can only start profiting when the value of the underlying stock/index goes down.