I lost Rs 2,00,000 in the last correction" was the sorrowful response I got from my friend Ketan when I asked him how much money he had made in the stock market.

Shahid, on the other hand, could not wipe the grin from his face. He made a killing. I was not surprised. He is a shrewd stock market player. And I am not just referring to smart stock picks, he smartly utilised Options to make his money. 

To understand what Options are, we first need to talk about derivatives.

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Derivatives! What's that?

A stock exchange has what is called a cash market segment. Over here, stocks are bought and sold for delivery immediately.

This cash market segment, where you buy/ sell shares, is also called the spot market.

Likewise, derivatives are bought and sold in a derivatives segment.

Very simply, a derivative is a financial instrument whose value is based on the performance of another underlying asset.

For example, the value of a stock derivative will be derived from certain shares.

How do these shares get their value? The value of a share is derived from the assets (factories, land, machinery) that the company owns, the money reserves it has, its profits and future earning prospects.

The value of an index derivative will be based on the index, say the Sensex. The Sensex gets its value based on the 30 stocks that comprise the index.

Two common types of derivatives are Futures and Options.

Future is a contract covering the sale of financial instruments for future delivery.

It is an agreement to buy (or sell) shares at a fixed price on a fixed date. If the price rises, you still buy at the earlier agreed price (you win). If the price falls, you still sell at the earlier agreed price (you win).

Option is a contract. It gives you the right to buy (or sell) shares at a specific price, on or before a specific date. If you do not get the specific price, you have the option of not buying (or selling). This means you have no obligation to complete the transaction. 

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Let's talk about Options

Let's say you saw a house you would love to buy, but don't have the money right now. You will need to borrow from your family or friends, take a home loan, sell some investments or, maybe, even sell your current home to come up with the cash.

So you talk to the owner and tell him that, in two months, you will have enough money to buy the house. Both of you negotiate and close the deal. You can buy the house in two months for a price of Rs 10 lakh (Rs 1 million). If you change your mind or cannot come up with the cash, you are under no obligation to buy the home.

However, there is a catch. You will have to pay the owner a non-refundable advance of Rs 30,000 to enable him to give you this option.

Now let's apply this to shares.

An option is a contract giving the buyer the right, but not the obligation, to buy an underlying asset at a specific price on or before a certain date. Ditto for the seller selling an asset.

It is a binding contract with strictly defined terms and properties.

Now that this is clear, let's take another example.

Situation I

Suppose a real estate developer bought the property opposite the house you are going to buy. And, thanks to his ambitious project, the value of real estate shoots up. The owner cannot hike up his rate because he has promised to sell it to you for Rs 10 lakh.

His loss, your gain.

Situation II

No real estate developer comes scouting for land in the vicinity. Instead, the government decides on a slum rehabilitation project opposite your prospective house. The price of land plummets.

If you still go ahead and buy it, you will have to pay Rs 10 lakh though the market value will now be much less.

Or, you can decide you don't want to buy it and forfeit Rs 30,000 -- the price of the option.

He gains, either because you buy the property at the high rate or you forfeit the Rs 30,000.

You either lose the Rs 30,000 or buy the property because you are convinced the price will go up later.

Apply the same principle to shares.

You make a deal with a seller that you are going to buy a certain number of shares at a particular rate on a particular day. If the price of the shares go up, you benefit because you get them at a lower rate. If the rate plummets, you can either buy them at the higher rate, thinking they will go up later. Or you could forfeit the price of the option and walk away.

So, when you buy an option, you have a right but not an obligation. You can always let the expiration date go by, at which point the option is worthless. If this happens, you lose the money you have paid to buy the option.

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Types of Options

There are two types of options: Call and put.

Call

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Buyers of calls hope that the stock price will increase substantially before the option expires.

Put

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Buyers of puts hope the price of the stock will fall before the option expires.

A call or put option contract will specify three things:

1. The price, also known as the Strike Price, at which the asset will be bought or sold.

2. The time. The date of settlement will ensure there is a time frame.

3. The quantity, which simply means the number of shares you plan to buy or sell.

How does this affect you?

Back to Shahid, the guy to made money on the stock exchange.

Shahid doesn't believe in taking huge risks.

Sometime back, he decided to buy shares of GE Shipping.

Number of shares he bought = 1,350 shares

Price he paid = Rs 140.5 per share

Simultaneously, he also bought a Put Option for GE Shipping.

Premium to buy the Put Option = Rs 3 per share

Strike price = Rs 140 per share

His total investment = (1350 shares x Rs 140.5) + (1350 shares x Rs 3) Rs 1,93,725

What if the market price of the stock fell from Rs 140.5?

If the market price of GE Shipping falls, and goes down until it reaches Rs 100, Shahid has already agreed to sell it at Rs 140.

Shahid bought the shares at Rs 140.5.

He agreed to sell them at Rs 140. It would appear like a loss.

But he would rather make a small loss and pay the premium than make a bigger loss if the share price tumbled (as it has to Rs 100).

The only catch is that he would have to pay Rs 4,050 (1350 shares x Rs 3) as the price of the Option.

What if the market price of the stock rose from Rs 140.5?

If the stock did well and its market price rose to Rs 160, Shahid can chose not to exercise his Option. In this case, he will not sell it at Rs 140 when the market price is higher.

Once again, the only catch is that he would have to pay Rs 4,050 (1350 shares x Rs 3) as the price of the Option.

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Ready?

Before you decide, there is something you must realise.

You invest in shares which are assets.

You do not invest in derivatives because they are essentially contracts to buy and sell; you trade in them.

If you are a long-term investor who does not believe in trading, avoid this option.

Do so only if you have already invested in shares or equity mutual funds and are willing to try something innovative.

Remember, it is quite a risky game you are playing because you have no idea in what direction the share price could move.