Option is a legal contract between buyer of the option and its seller. Option is transacted in the form of buying and selling securities at an agreed price in a certain period of time. This flexibility is unique feature for options trading. Another unique aspect about options is you do not need demat account opening for options trading. Although for convenience, most traders prefer demat account to keep track in their portfolio.
Options is quite similar to insurance that you pay an amount of money in order that your property is protected by the insurance company. The difference between both of them is minor, based on their mode of operation; option can be traded whereas, insurance policy cannot be transferred or traded. There are two types of option contracts; call options and put options. We can buy call option when we expect the stock price to go up and buy put option when we predict the stock price to drop. We also can anytime sell call option if we predict the security price will drop sharply and vice versa if we want to sell put option. Usually, option is counted by units of contracts – one contract is equal to 100 unit options. 1 unit option protects 1 unit share. So, one contract protects 100 unit shares.
Before starting online trading in options, you must know most important factor that valuates the options. The trading is done based on the strike price.
What is Strike price in Options Trading
Strike price is the value that is agreed by both traders; buyer and seller of the option to deal with. That means if the determined strike price of the call option is 35, seller of this option abides to sell stock at this price to the buyer of this option even if the market price of the stock is higher than prevailing 35 if the buyer exercises the option. Buyer of this option is free to buy stocks with a price that is lower than the market value.
If the current market price is ₹39, the buyer will earn ₹4. If the stock value is lower than the strike price, buyer will try to hold the option and leave the existing option to expire worthless.
For strike price in put option, buyer of the option has the obligation to sell the stock at the strike price to the seller of the option. For example, if the put option strike price is ₹40, seller of this option abides to buy the security at this price from the buyer if he or she executes the option even if the market price is lower than this price. If the market is ₹35, the option buyer will earn ₹5. At first glance, it seems that a lot of transactions are involved; but actually, seller of the option will not purchase a security and sell it to the buyer.
The broker firm will perform all the transactions but the extra money incurred to buy the security has to be reimbursed by the seller. This means, if the seller loss ₹5, the buyer will earn ₹5.
Remember, in some cases, when the stock value equals the strike price, the option has apparently zero value.
This is how price is decided in options trading.