Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance.

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. ‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.
Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

There are two types of options:
· Call Options
· Put Options

Call options

Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.
Illustration 1:
Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8
This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares).
The buyer of a call has purchased the right to buy and for that he pays a premium. Now let us see how one can profit from buying an option.
Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.
Let us take another example of a call option on the Nifty to understand the concept better.
Nifty is at 1310. The following are Nifty options traded at following quotes.
Option contract Strike price Call premium
Dec Nifty 1325 Rs 6,000
1345 Rs 2,000
Jan Nifty 1325 Rs 4,500
1345 Rs 5000
A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.
In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).
He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000).
If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish.

When you expect prices to fall, then you take a short position by selling calls

Put Options

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time.
e.g.: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200
This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.
Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’.
By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium).
So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.
Illustration 3: An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro. Quotes are as under:
Spot Rs 1040
Jan Put at 1050 Rs 10
Jan Put at 1070 Rs 30
He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.
1. Jan Spot price of Wipro = 1020
2. Jan Spot price of Wipro = 1080
In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put,
which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.
In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire
unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.