Options can be broadly classified into two types - Call Option and Put Option.
Call option is that you feel a stock/index price is going in good direction, that is rising up. So you make a call to buy that stock at current price and you feel that after the stock price has risen to a higher value, later you can sell it. Similar to going long in equity shares.
Put option is that you feel bad about a particular stock and you feel share price will fall down, so you want to put away the stock from your portfolio and get rid of it at current price, may be if later the share price falls down to a significant lesser value, you may think of buying it. Similar to going short in equity shares.
Here you should understand the difference between equity shares and options. Equities are only two types but options are 4 types.
1. Buying Equity - Going Long
If you are long in equity shares, it means you need to buy the shares immediately and keep it with you and later when share price rises, you sell it off in profits.
2. Selling Equity - Going Short
If you are short in equity shares, you need to sell the shares immediately and later buy when the share price falls. (Usually in intra day)
But in options market, call option means,that you are agreeing to buy the shares at current price (called as strike price) but NOT today, but at a later date (expiry day),since you hope the share price will rise. For this you need to pay only a booking fee called premium and not the entire share price. This premium is a non-refundable deposit. So when expiry day comes you buy all the shares at strike price and if share price has gone up considerably, then you sell those shares in open market and get a good profit. The person who is feeling exactly opposite (bearish view on the stock) will short a call option and keep the premium with him. Shorters are sellers to whom your premium will be paid and from whom you can buy the option contracts.
Put option is little tricky. Since you expect the share price to go down, you feel now it is the right price (called as strike price) to sell the shares (and you dont have the shares in your demat, remember that), so you enter into a contract agreement with someone, who wishes to buy those shares at strike price but NOT today but at a later date called the expiry day. So on expiry day, if the share price has gone down as you have expected, you buy the shares from open market at lower price and sell it to the contract agreement guy at the strike price which is higher and earn a profit. While you are making this contract you need to pay a non-refundable premium. The person who is feeling the opposite (having a bullish view) will short a put option and get the premium from you and keep with him.
Example: Assume TCS current price is 2598.95. The nearest strike price is 2600 (strike price are fixed by the exchange) Refer this link
1. Buying a call option
You expect the TCS price to go to 2700 during this Nov expiry. So you buy a call option TCS2600CE14NOV contract and pay a non-refundable premium of 42 rupees per share.
If TCS goes to 2700 you make a profit of rs 100/share.
Your Net Profit will be 100 rs - 42 rupees you paid for the contract. = Total 58 rupees per share
If TCS price stays below 2600, you not interested in honoring your contract and you will simply forgo your premium 42 rupees. This kind of functionality (either you take it or just leave it) is the main reason these contracts are called OPTIONs, meaning it is optional for you to honor the contract or dishonor it.
2. Selling/Shorting/Writing a call option
You expect the TCS price to go to 2500 during this Nov expiry. So you sell a call option TCS2600CE14NOV contract at keep the premium with you 42 rs per share.
If TCS price goes to 2500, you got to keep all the 42 rupees as your profit. But unfornately if if it goes up to 2700 rupees, you will make a 100 rupees loss.
Your net loss = 100 rupees - 42 rs premium which you received initially. = 58 rupees loss totally
Unlike option buyers, Option sellers cannot escape from the contract and dishonor it. It is compulsory the option will be exercised on them. In other words they dont have any choice/option ( since they have already sold it :) lol )
3. Buying a put option
You expect the TCS price to go to 2500 during this Nov expiry. So you buy a put option TCS2600PE14NOV contract and pay a premium of 36 rupees
If TCS price goes to 2500 you get a profit of 100 rupees and Net profit will be 100-36 = 64 rupees
If price goes to 2700, you make a choice to dishonor your contract and forgo all the 36 rupees you have spent on the option contract.
4. Selling/Shorting/Writing a put option
You expect the TCS to go to 2700 during this Nov expiry, So you short a put option TCS2600PE14NOV and got to keep all the premium 36 ruppes with you (which will be credited to your account).
If TCS price goes to 2700, no problems, if it goes to 2500, then you are in 100 rupees loss and your net loss will be 64 rupees per share.
The option seller has to compulsory honor his agreemnet and take up whatever losses he get.
P:S: The strike price is not necesaarily be the one closer to current market price. It can be any other strike price on which you can buy or sell an option contract. These things you will understand once you are OK with the concepts I explained above.
Should I allow it to expire or if the premium changes from 100 to 102 then can I sell and make a profit of 2% ?