What is options trading?

Options are a form of derivative contracts that enable the contract buyer- known as the option holder, to trade financial security for a determined price. The option buyer has to pay a sum of money called a ‘premium’ in order to do this. If the options buyer finds the deal unfavourable, they can choose not to sell, to keep their loss below the premium. The options writer/seller on the other hand has to bear the risk in that case-which is why they list the contract with a premium.

There are two types of options contracts

Call option- The call option allows the contract purchase buyer to acquire the asset after a predetermined time in the future at a fixed price (called the strike price).

Put option-The put option is similar in terms of the fact that the asset trade can happen after a predetermined time period, but the buyer gets access to sell the underlying asset at a fixed price.

With the surge of work from home and pandemic-infused change in investment behaviours, there has been a rise in the number of first-time investors who have only a little capital demarcated for investing. Good thing is, Options trading for beginners can happen with small capital- that is, less than Rs 2 lacs.

Option trading strategies for small capital can include buying options that can be both call and put options. However, options traders have to consider a lot of different rules and complexities, which are outlined below.

1. Deciding on the holding period

As an options trader, you need to have a short fixed maximum holding period. This is important because as time passes, the chances of getting a profit out of your security fall pretty rapidly. The idea is to keep your holding period around 3-7 days. Don’t hesitate to cut your losses and bow out instead of stretching out your time because it will directly affect your returns.

2. Outline stops and targets for yourself

There are forecasting studies on the underlying financial instruments which can help you align your option trades to your chosen targets and stops. You can even use an option calculator (available freely online) to convert your pre-determined stops to options stops. By calculating your option levels beforehand, you can make sure you’re not going to make some last-minute miscalculations and make a mistake.

3. Don’t go for the stocks in the news

While it might feel like a smart thing to go after the popular stocks in the news- the presence of stocks in the news actually has a more complex impact on the actual value of the stock in the market. Stock valuations matter very little to an options trader because your concerns are more short-term which is largely determined by demand and supply intricacies rather than fundamental analysis factors.

4. Know what you are getting into

Making non-studied choices about where to invest is as close to blind-gambling as you can get. The only way you can preserve your money and get returns in any form of trading is if you are taking known and considered risks, not arbitrarily relying on luck like on a craps table. Avoid events you don’t know very well, because you cannot predict how the market is going to react and might end up incurring heavy losses.

5. Fix the number of open trades you are doing at once

If you take up too many trades together, you will end up making mistakes and losing more than you gained. Therefore, whenever you are thinking of adding a new options trade, try letting one of your current open trades go. This helps control the total amount of capital you have invested and not overwhelm yourself, especially for options traders who are beginners.

Having outlined some general rules of going into options trading with small capital, we will now look further into some Option trading strategies

  1. You doubled your money, now what? – In the rare event that you end up getting a 100% return, sell and take that profit instead of milking it for more. Also, know the quick techniques for calculating profit potentials by noting how the fluctuations in the price of stocks influence the price of Options.
  2. The stock price of the underlying asset surged, now what?- If you are sitting on a potential profit because the asset’s value has increased, you could consider selling half your options for gain. The idea is to protect your own money and get its returns as fast as you can. Options are like ticking timebombs and called ‘wasting assets’ because every day that passes makes them lose their value.
  3. What is your spread strategy? Even if you get good profits off a certain option, fight the urge to hold onto it till it expires to get maximum Think objectively about how much better it could get and know when to sell and take some losses in order to preserve your gains.
  4. Keep moving- If you want to be an options trader, you need to keep trading. You cannot keep holding onto a position hoping for a particular outcome. Instead, just take what comes and take immediate decisions that align with your larger trading objectives.

Conclusion

Options trading is a way for investors to potentially get profit off their underlying securities in complex, different ways. It involves a lot of different strategies, all of which serve particular purposes and are designed for certain types of options traders. The most common strategies for option trading for beginners  include:

  • Buying calls- for confident traders looking to take advantage of a particular stock.
  • Buying puts- for those who are looking to take advantage of a particular stock but cannot afford too much risk.
  • Covered Call- for those traders who don’t see a significant opportunity for gain in potential trades.
  • Protective put- this is especially for the option traders who also own the underlying asset and are looking for an additional layer of assurance.

There are both advantages and disadvantages to options trading, but as long as you consider your options and keep the rules and intricacies of the trade-in in mind, they become easier for some traders.