How Call and Put Options Work in India? – What are Stock Options?

Today’s article will discuss: How Call and Put Options Work in India? Before that, we will understand what it is with an example of the same.

Call and Put Options in Stock Market

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Stock options are a type of financial contract between a buyer and seller that give the holder the right, but not the obligation, to buy or sell a stock at a predetermined price (strike price) on or before a specified date (expiration date).
These options can be used for a variety of purposes, including as a form of compensation for employees or as a way to hedge against market fluctuations.

When a stock option is granted, the option holder has the right to buy or sell the underlying stock at the strike price, regardless of the market price of the stock at the time of exercise.
This allows the option holder to potentially profit from favorable market movements, or to protect against unfavorable movements.

The value of a stock option is derived from the underlying stock, and is influenced by several factors including the current market price of the stock, the strike price, the expiration date, and the volatility of the stock.
The option’s intrinsic value is equal to the difference between the market price and the strike price, while its extrinsic value is made up of the time value and volatility.

Stock options can also be used to incentivize employees by linking their compensation to the performance of the company’s stock.
This can help align the interests of employees with those of the company and its shareholders.

Overall, stock options are a flexible and powerful tool for managing risk and leveraging market movements, but it is important to understand their complexities and potential consequences before entering into such contracts. Now let’s discuss how Call and Put Options work.

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How Call and Put Options Work?

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Call and Put options are two types of stock options in India. They work as follows:

Call Options:

  • A call option gives the buyer the right, but not the obligation, to buy a stock at a specified price (strike price) on or before a specified date (expiration date).
  • If the stock price rises above the strike price, the buyer can exercise the option to buy the stock at the lower strike price and sell it at the higher market price, making a profit.
  • If the stock price remains below the strike price, the option will expire worthless, and the buyer will not exercise it.

Put Options:

  • A put option gives the buyer the right, but not the obligation, to sell a stock at a specified price (strike price) on or before a specified date (expiration date).
  • If the stock price decreases below the strike price, the buyer can exercise the option to sell the stock at the higher strike price, avoiding a potential loss.
  • If the stock price remains above the strike price, the option will expire worthless, and the buyer will not exercise it.

However, It's important to note that there are also risks involved when trading call and put options, including the possibility of losing the entire premium paid for the option, and a thorough understanding of the stock market and options is recommended before entering into such contracts.

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Example

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For instance, Let's say John works for an Indian tech company and is granted stock options as part of his compensation package.
The company offers him the option to buy 1,000 shares of company stock at a strike price of ₹3,000 per share, with an expiration date of two years from now.

Fast forward one year, and the company's stock price has increased to ₹4,200 per share.
John decides to exercise his option to buy the 1,000 shares at the strike price of ₹3,000.
He can then sell the shares for ₹4,200 each, making a profit of ₹1,200 per share, or ₹1.2 million in total.

However, if the company's stock price had decreased to ₹2,400 per share, John may choose not to exercise his option and avoid a loss.

This example illustrates how stock options can allow individuals to potentially profit from favorable market movements or protect against unfavorable ones.
However, it is important to note that there are also risks involved, and a thorough understanding of the stock market and stock options is recommended before entering into such contracts.

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FAQs

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  1. What are call and put options?

    Call options give the holder the right, but not the obligation, to buy an underlying asset at a specified price. Put options give the holder the right, but not the obligation, to sell an underlying asset at a specified price.

  2. What is the risk associated with call options?

    Call options carry the risk of the price of the underlying asset not reaching the strike price before the option expires. If the price does not reach the strike price, the option will expire worthless and the holder will lose the premium paid for the option.

  3. What is the risk associated with put options?

    Put options carry the risk of the price of the underlying asset rising above the strike price before the option expires. If the price rises above the strike price, the option will expire worthless and the holder will lose the premium paid for the option.

  4. Can options be used to manage risk?

    Yes, options can be used to manage risk. They are often used as a form of hedging, where the holder of an underlying asset buys a put option to protect against a potential decrease in the price of the asset.

  5. What is the maximum loss in options trading?

    The maximum loss in options trading is limited to the premium paid for the option. The premium paid is the cost of buying or selling the option, and it cannot exceed the amount paid for the option.

  6. What is volatility risk in options trading?

    Volatility risk in options trading refers to the risk of the price of the underlying asset experiencing sudden and large price movements. This can lead to unexpected and large losses for options holders.

  7. What is the purpose of trading in call and put options?

    Call and put options are used for various purposes such as hedging, speculation, and income generation. Hedging is done to reduce the risk of loss from the underlying asset. Speculation is done to benefit from price changes. Income generation is done by selling options.

  8. What is the expiration risk in options trading?

    Expiration risk in options trading refers to the risk of the option expiring worthless if the price of the underlying asset does not reach the strike price. This can result in a loss equal to the premium paid for the option.

  9. Is trading in call and put options regulated in India?

    Yes, trading in call and put options in India is regulated by the Securities and Exchange Board of India (SEBI). The trading is done on the stock exchanges that are recognized and regulated by SEBI.

  10. What is the difference between call and put options?

    Call options give the holder the right to buy an underlying asset, while put options give the holder the right to sell an underlying asset. The difference in price movement of the underlying asset affects the price of the options differently.

  11. How is the price of an option determined?

    The price of an option is determined by various factors such as the price of the underlying asset, time to expiration, volatility, interest rates and dividends. These factors are used in mathematical models to calculate the price of the option.

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