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Option trading can be a little daunting if you are a new investor. It can appear to be a little complicated compared to the old, familiar asset classes like regular share trading, bonds, and mutual funds. However, there are several advantages of options trading, and if you go into it armed with information, there are opportunities here that you may want to exploit. Moreover, it could be a good addition to a diversified portfolio.
Key Takeaways
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An option is a contract in which the buyer has the right but no obligation to buy or sell an underlying asset at the specified price or by the mentioned date.
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In a Call Option, you get the right to buy (considered when a rise is expected) and in a Put Option, you get the right to sell (considered when a fall is expected).
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The buyer pays a non-refundable premium, which represents the potential maximum loss for them.
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Call options are generally used when there is speculation of short-term price movements as it helps in hedging against market volatility.
Before going into topics like option trading tips, let’s first understand what an option is. An option is a derivative whose value derives from an underlying asset. There are two kinds of derivatives – futures and options. A futures contract is an obligation to buy or sell a certain asset at a fixed price at a future date. An options contract gives you the right, but not the obligation to do so.
An example of an options contract will make this clearer. Suppose you expect the share price of ABC company, currently at ₹100, to fall. You then buy an options contract to sell the share at ₹100 (this is called the `strike price’). If the ABC price then falls to ₹90, you would have made ₹10 minus the premium paid on each option. If share prices were to rise to ₹110, then naturally you wouldn’t want to sell at ₹100 and incur a loss. In that case, you have the choice of not exercising your right. So, you don’t have to suffer any loss.
Here are some concepts you should understand before you go in for options trading:
Premium:
Premium is the price you pay for entering into the options contract to the seller of the option or `writer’. You pay the premium to the broker, which is passed on the exchange and thereon to the writer. Premium is the price paid for the option and is determined by various factors, including the intrinsic value of the options contract, time to expiry, and volatility. Premiums keep changing according to whether the option is in-the-money or out-of-the-money. They’re higher when it’s in-the-money and lower when not.
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In-the-money: An options contract is when it would generate an intrinsic profit if exercised immediately (though total profit depends on the premium paid).
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Out-of-the-money: This situation occurs when the options contract has no intrinsic value if exercised immediately.
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Strike price: This is the price at which the options contract is struck.
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Expiration date: An options contract is for a fixed period of time. It could be one, two or three months.
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Underlying asset: This is the asset on which the option is based on. It could be stocks, indices or commodities. The price of the option is determined by the price of the underlying asset.Options and futures are freely traded on the stock exchange. Even ordinary investors can go in for options trading and, if lucky, they can make profits from doing so. Here are some option trading tips that should help you get started.
Bullish or Bearish?
In options trading, you are betting on the movement of stock prices. So, your choice of option will depend on whether you expect prices to rise or fall. There are two kinds of options – call and put.
A call option gives you the right, but not the obligation, to buy a certain stock at a certain price. A put option gives you the right to sell a stock. If you expect stock prices to increase, a call option should be your preferred choice. If prices are falling, a put option would be a better choice.
How Much Will it Move?
The amount you can make from option trading is the difference between the strike price of the options contract and the market price of the underlying asset (like stocks) minus the premium paid. So you have to gauge the extent of the price change. Higher the price change, more your profit will be. This requires keeping a close watch on the developments in the market.
Various factors influence stock prices, and you have to take into consideration these factors while options trading. There are external as well as internal factors that affect the stock price. External factors include changes in government policy, international developments, monsoons, and so on.
Internal factors are those that affect the workings of a company, like a change in management, in its profits etc. In short, it’s not all that different from trading in stocks. The same factors come into play here too. The only difference is that you are not putting your money in the underlying asset, but only on the price changes.
So the success of option trading depends on choosing the right strike price and correctly predicting price movements.
What is the Premium?
When trading options, one important thing to understand is the premium, which is the price you pay to buy an options contract from the seller. The premium depends on several factors, but one key factor is its moneyness, which shows whether the contract can make a profit right now.
In-the-money options have higher premiums because they already have some profit built in. Out-of-the-money options have lower premiums but come with higher risk, as it is uncertain if they will become profitable later.
In simple terms, the higher the premium you pay, the lower your potential returns. So, while buying in-the-money options feels safer, out-of-the-money options can offer higher profits if the market moves in your favour.
Time Horizon
Another thing to remember about options trading is that it’s not a long-term investment. An option is an instrument to make the opportunities presented by short-term movements in prices. All options have a specific expiration date at the end of which settlement is done, either through physical delivery or cash. However, you cannot choose the expiry date at random. In India, the expiry date is on the last working Thursday of the month. Options are available for near-month (1 month), next month (2) and far month (3).
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Of course, you can buy an options contract any time before the expiration date. So there’s scope to trade in options for even a day or two. Of course, this is far riskier than options contracts for longer-term periods.
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The best options trading strategy will depend on a variety of factors like your investment goals, and risk appetite. But you would do well to consider the above factors before you venture into options trading.
How to Trade in Options in India
Now that you have an idea of how to trade options, you can take the plunge. Derivatives were introduced in Indian stock markets around 20 years ago, including options and futures. The National Stock Exchange provides trading in futures and options contracts on nine major indices, and over 100 securities.
You can trade in options through your broker, or using your trading portal or app. However, there may be additional financial requirements for options trading, like minimum income. You will have to provide additional details like income-tax returns, salary slip, and bank account statements.
When you are well-versed on how to trade options, there are sophisticated options trading strategies in India, like a straddle, strangle, butterfly and collar, which you can use to maximise returns. Broking companies like Angel One offer option trading services, which you can avail to your advantage.
Understanding Options Trading
Options trading involves contracts that give traders the right to buy or sell an asset at a predetermined price by a future date, without the obligation to fulfill that contract. Due to this unique characteristic, options trading is a tool to book profits during market volatility. It also works as a good risk management mechanism, and is used for hedging by traders.
Options trading contracts are available for several assets like indices, equities and even commodities. Traders can choose between call options which means to buy and put options, which means to sell.
How Does Options Trading Work?
To understand how does options trading work, it is critical to know that while traders can take a put or call option in an options contract, they are not obligated to fulfil that contract on or before expiry date. An important factor is that in case a buyer chooses to fulfil the contract, the seller is obligated to do so too.
Call options are generally exercised when expecting a bullish trend and put options are used when expecting a bearish trend. Buyers must pay a premium to sellers for acquiring this right.
In options trading for beginners, booking of profit or loss is heavily dependent on the price action. Entering or exiting a trade at the correct time can make the trader book high profits with limited upfront capital.
Strategies in Option Trading
All kinds of trading need a robust trading management plan to be profitable. Let us discuss some strategies we can use in Options trading to manage risks and boost profits. One of the most commonly used methods is Index Options, where traders speculate on the movement of entire market indices like Bank Nifty and Nifty 50 to hedge against risks.
Traders use a mix of call and put options to use strategies like Index option strangles, straddles and spreads. Each of these strategies are used during different market conditions. For example, the straddle strategy offers opportunities for traders to make money from sharp price swings in either direction, while a put option will provide the trader some protection during sudden downtrends.
Understanding these strategies and including them in the trading plan can help traders make informed decisions that align with their trading goals and risk appetites even during fluctuating markets.
Participants in Options
The two main participants in options trading are the buyers and sellers who trade in Call Options contract and Put Options contract. A call option buyer speculates that the price of the traded asset will rally, so they pay a premium for the right to buy it at a predetermined price. The seller anticipates the price to stay below the strike price; this speculative move allows them to keep the premium.
Put Options contract buyer expects the price of the asset to see a downtrend and purchases the right to sell at a fixed strike price, while the seller anticipates prices will remain in the same range or see an uptrend.
Options trading is primarily driven by its buyers and sellers, who trade, hedge and indulge in speculative trading across assets like stocks, indices and commodities.
Notable Terms in Options Trading
It is crucial for traders to understand important key terms to be efficient with index option trading, they are:
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Strike Price: This is the predetermined price at which the contract will be executed on or before expiry. The movement of the asset away from this price, in any direction, determines the profit and loss of the trade.
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Premium: The cost paid by a trader to gain the right to buy or sell an asset in Options Trading Contracts on or before the day of expiry without the obligation to execute the order is a premium.
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Expiry Date: The date by which a contract must be executed or cancelled is called expiry.
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Lot Size: The number of units or shares needed to be bought in each contract while index option trading is its lot size.
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Open Interest: This is the exact number of active options contract in options trading contracts. This is indicative of the market’s sentiment towards the asset being traded.
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Volatility: A measure of how much the index price fluctuates, directly impacting option premiums in index option trading.
Profitability Scenario in Options
When trading in option contracts trading, profit or loss depends on how far the price of the traded asset moves away from the strike price. A call option becomes profitable when the underlying asset price rises above the strike price (plus premium paid). Conversely, if the price falls below or remains at the strike price, the call option results in a loss. This is how we can calculate trading profit and loss account in options contracts.
A trader who purchases a call option, books profit when the cost of the asset exceeds the strike price added with the premium paid. Similarly, a put option buyer makes money when the price of the asset falls under the strike price and deducts the premium. When an option buyer chooses not to exercise the contract or lets it expire worthless, the seller retains the premium paid.
Keeping a track of trading profit and loss account helps traders know their risk exposure, potential returns, and breakeven points.
Advantages of Option Trading
Options Trading gives traders a unique opportunity to book profits in ways not possible with conventional stock trading. Options contracts give traders the right to buy or sell assets like stocks, indices, and commodities without the obligation of fulfilling them on the expiry date. It also allows traders to use leverage in their trading accounts. Traders can pay a fixed percentage of the entire traded value. This allows traders to take large trades with small upfront capital to maximise returns on investment.
Option Contracts also allow traders to earn through premiums deposited by buyers. Investors typically combine calls and puts to make strategies suited for bullish, bearish, or consolidating markets. With limited downside risk (premium paid) and significant profit potential, Options Trading is well suited for speculative trading, hedging and risk management.
Difference Between Options Trading and Other Instruments
Stock Options are starkly different from other traded assets like stocks, futures contracts, or bonds with regard to how much they cost and the earning possibility. Unlike other assets like equities, where price movement determine profit or loss; options trading allows the trader to choose between buying the right to trade in the assets but not having the legal obligation of executing the delivery. This unique setup allows traders to make money during bull runs, bear runs or markets that are moving sideways.
Unlike futures contracts, an option buyer's risk is limited to the premium paid, with no potential for losses beyond this amount. However, option sellers may face margin requirements and unlimited risk exposure. Bonds offer fixed returns but carry risks related to interest rate changes, credit quality, and market conditions. Hence, Stock options can be safer than futures (with risk limited to premium paid), while also offering flexibility, profit potential, and limited downside for buyers.
Conclusion
Options contract give traders the right to buy or sell assets like stocks, indices and commodities without the obligation of delivery. Options trading is a flexible form of trading that allows traders to profit from price swings without the obligation to fulfill the contract. This makes it a less risky option, helps in booking profits, use leverage and hedge in volatile markets. Options trading is also a good for portfolio diversification. The other avenue for income through options is collecting premium on trades that do not get fulfilled at the time of expiry.