If you expect the price of the stock to rise, buy a call option at a predetermined price, which is lower than the rise you expect in the stock's market price at the time of exercise of option.
However, if you expect the price of the stock to fall, buy a put option at a predetermined price, which is higher than the fall you expect in the stock's market price at the time of exercise of the option. If your judgment goes wrong, simply let the option lapse and you just lose the premium you have paid to buy the option.
Suppose an investor is bullish and buys a call option on Infosys shares at the strike (exercise) price of Rs.5,250 at a premium of Rs.150 where the time to exercise the option is 1 month. The investor will earn profits if the price of Infosys crosses Rs.5,400 (Strike Price + Premium i.e. Rs.5250+ Rs.150). Suppose stock price touches Rs.5,700, the investor should exercise the option to buy the share at the exercise price of Rs.5,250 and then sell it in the market at Rs.5,700 making a profit of Rs.300 (selling price of Rs.5,700 minus purchase cost of Rs.5,250 minus premium cost of Rs.150). If at the time of expiry of the 1 month, the stock price falls below Rs.5,250, the buyer of the call option should not exercise his option. In this case he loses only the premium paid i.e. Rs.150.
Similarly, if the investor anticipates a fall in the price of Infosys, he should buy a put option to gain if his expectation turns out to be true.
Options offer three significant benefits:
Versatility: Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. An investor can use options in as conservative or as speculative a manner as his investment personality dictates.
High Leverage: Option contracts allow the investor to control the full value of the underlying shares for a fraction of the actual cost. For instance, though Infosys trades at Rs.5,600, an investor can get full exposure to it by investing only the premium of Rs.150.
Risk Management: T he buyer can only lose what was paid for the option contract (i.e. the premium), which is a fraction of what the actual cost of the asset would be.
World over the derivative markets are bigger than the equity markets and options are the most favored instruments because of the unique combination of unlimited return-limited risk offered by them.
courtesy: Finance Insights which is a rich source of information on Finance