Nitty-gritty of derivatives market

In the derivatives market you may want to buy shares or sell them at a specific price in the future. On this basis there are two types of options available in the derivatives markets - call options and put options. Call options are those contracts that give the buyer the right but not the obligation to buy the underlying shares or index in the future.

When you purchase a call option, you purchase the right to buy a certain amount of shares or an index at a predetermined price on or before a specific date in the future expiry date. The predetermined price is called the strike price while the date until which you can exercise the option is called the expiry date. To avail this facility, you have to pay premium to the seller/ writer of the option.

The writer of the call option assumes the risk of loss due to rise in the market price beyond the strike price on or before the expiry date of your contract. The seller is obligated to sell the shares at the strike price even though it means making loss.

The premium payable is a small amount that is also market-driven. As a trader, you would choose to purchase an index call option if you expect the price movement of the index to rise in the near future. Indices on which you trade include the CNX Nifty 50, CNX IT and Bank Nifty on the NSE 30 share Sensex on the BSE.

Let us understand this with the help of an illustration of an index call option. Suppose the Nifty is quoting around 11,600 points today. If you are bullish about the market and foresee this index reaching 11,700 within the next one month, you may buy a one-month Nifty call option at 11700.

Assume this call is available at a premium of rupees 125 per share. The current lot size of the Nifty is 75 units so you will have to pay a total premium of Rs 9375.

If the index reaches 11700 as you expected, you have the right to buy at 11700 levels. You will start making profits once the Nifty crosses 11700 levels. So, it makes sense to exercise your option at these levels only if you do not expect the index to rise further, or the contract reaches its expiry date at these levels.

Now let’s observe how the seller of this call option is faring. As long as the index does not cross 11700 he benefits from the option premium received from you. Once the index rises above 11700 his losses are equal in proportion to your gains and both depend upon how much the index rises.

In a nutshell, the option writer has taken the risk of a rise in the index for a sum of rupees 75 per share. Further, while your losses are limited to the premium that you pay and your profit potential is unlimited the writers' profits are limited to the premium and his losses could be unlimited.

To maximize profit, you buy at lows and sell at highs. A call option helps you fix the buying price. If you are expecting a possible rise in the price of the underlying assets so you would protect yourself by paying a small premium.

In simple words, you buy a call option if the market is bullish and you sell a call option when the market is bearish. (The author is a homemaker who dabbles in stock market investments in free time)