Strategy - Buying a Call

Let us start with the simplest of Option trading… plain vanilla buying of Options.

So let us say that your analysis shows (not just you feel) that there is a good probability (not certainty… isn’t it?) of NIFTY increasing in value by the target expiry date. Since you do not want to bet on one of the 50 stocks of NIFTY, you simply buy NIFTY Call Option. Let us say you buy NIFTY 5000 Call at 100 Rs Premium (100 x 50 lot size = 5000 Rs) and then you forget it… you do not square it off or sell your position. You wait till the expiry date for exchange to auto settle your option. Graph below tells you what is your profit or loss from this transaction depending on various levels of NIFTY.

As you will see, if NIFTY is below 5000, you have lost your premium in total because Call option below strike price expires worthless. If NIFTY is between 5000 and 5100 then you recover some of your premium. Let’s say NIFTY is at 5070, so exchange gives you 3500 Rs (70 x 50 lot size) and your loss if 1500 Rs. In case, your analysis is correct and NIFTY increased much more than 5100 then your trade is in profit at expiry and your profits are directly proportional to NIFTY level above 5100. E.g. if NIFTY is at 5200, exchange will give 10000 Rs (200 x 50) and you would have made 5000 profit on 5000 premium. That is a whopping 100%.

This brings us to another important factor in Derivative trading; Leverage. If you were to invest 5000 in a stock and wait till it doubles it would probably take few years. In case of derivatives it can happen in a very quick time. There were times when I have made more than 200% profits on trades. Not to forget, it is not rosy picture all the time on this path. Downside of leverage is you can lose money equally fast. So instead of making 5000 Rs you can simply lose entire 5000 Rs if NIFTY is below your strike in this case. I have been through such situation too.

When you are buying option you cannot lose more than 100% of your Premium and hence you know the worst case scenario right away. But you are exposed to much higher risk when you sell the Options. That is why it is recommended to start with buying options as you experiment and learn the tricks of the trade.

Life is anyway short to make all the mistakes yourself and learn from them. It is worthwhile to learn from other's mistakes too. I have made many and observed many more. Let's shorten our learning curve.