Part 2 Support and Resistance

1. Introduction to Option Trading

Options are one of the most versatile financial instruments available in the world of trading. They are derivatives, meaning their value is derived from an underlying asset such as stocks, indices, commodities, or currencies. Unlike buying or selling the underlying asset directly, options provide traders with the right, but not the obligation, to buy (call option) or sell (put option) the asset at a predetermined price (strike price) within a specified time period (expiration).

Options are unique because they allow traders to leverage small capital into larger potential gains, manage risk with hedging strategies, and create income through option writing. At the same time, they carry high risk when misused, particularly due to time decay, volatility fluctuations, and complex pricing models.

2. The Basics of Options: Calls and Puts

The two fundamental building blocks of option trading are Call Options and Put Options:

Call Option: Gives the buyer the right to buy an asset at a fixed strike price before or on the expiration date. Traders buy calls if they expect the price of the asset to rise.

Put Option: Gives the buyer the right to sell an asset at a fixed strike price. Traders buy puts if they expect the price of the asset to fall.

Example: If stock XYZ is trading at ₹100, a call option with a strike price of ₹105 expiring in one month gives the buyer the right to buy the stock at ₹105. If the stock rises to ₹120, the option becomes profitable. Conversely, a put option with a strike of ₹95 would benefit if the stock fell below ₹95.

3. Understanding Option Premiums

An option buyer pays a premium to acquire the rights. This premium is determined by several factors:

Intrinsic Value: The actual in-the-money value (e.g., if stock is ₹120 and strike price is ₹100 call, intrinsic value = ₹20).

Time Value: The extra value based on time remaining until expiration. Longer time = higher premium.

Volatility: Higher expected price fluctuations increase premiums.

Interest Rates & Dividends: Play a minor but measurable role in pricing.

This pricing is mathematically modeled by the Black-Scholes Model and Binomial Option Pricing Model.

4. European vs. American Options

Options differ in terms of when they can be exercised:

European Options: Can be exercised only at expiration.

American Options: Can be exercised any time before expiration.

Most index options in India are European style, while stock options in the U.S. are often American style.

5. The Greeks – Risk Measurement Tools

To manage option risk, traders rely on Option Greeks, which quantify how premiums move with changes in price, volatility, and time:

Delta (Δ): Sensitivity of option price to changes in underlying price.

Gamma (Γ): Rate of change of Delta.

Theta (Θ): Time decay effect on options.

Vega (ν): Sensitivity to volatility changes.

Rho (ρ): Sensitivity to interest rate changes.

Understanding Greeks is like having a navigation map for option strategies.