What Is Option Trading and How Options Trading Works?

How Is Risk Measured With Options?

Option trading is a form of financial derivatives trading that involves buying and selling an underlying asset at a particular time for a certain amount. It is basically a contract that gives the buyer or seller the right, but not the obligation to buy or sell the underlying asset. However, trading in options involves various factors such as understanding market dynamics, managing risk, and the usage of different strategies to maximize returns. This article will touch upon the basics of options trading, their working, and the pros and cons of trading in options.

What is Options Trading?

Options trading basically involves a contract that gives the holder right but not the obligation to buy or sell an underlying asset at particular time at a certain amount. Trading in options involves various factors such as the strike price of the option, the expiration date, and the premium. Options trading also involves one very important aspect that is implementing strategies that help you take various market positions to make gains or reduce risk while trading. Options can be used as leverage or a hedging tool. Though options trading has grown in popularity and may seem simple at first, in reality, it is complex and risky to trade in options compared to regular shares.

Example of Options Trading

Suppose you believe that the stock price of the company, ABC Limited, currently trading at Rs 100 per share, will increase in the next month. You decide to buy a call option with a strike price of Rs 110 that expires in one month. You pay a premium of Rs 5 per share for this call option. Two scenarios can happen now. We will look at them in one of the coming sections. Before that, let us understand how options trading works.

Understanding Options Trading

In order to understand options trading completely here are a few concepts or key terms you should know about:

1. Derivatives: Futures and Options are derivative contracts. Meaning that they are contracts that are set between two or more parties and derive their value from an underlying asset, group of assets or a benchmark in the market.
2. Call and Put options: A call option gives you the right but not the obligation to buy an underlying asset at a predetermined price at a certain expiration date, while a put option allows you to sell an underlying security at a future date and price.
3. Expiration Date: This is the date on which the options contract expires. On this day the trader can choose if they wish to exercise the contract at its strike price.
4. Strike Price: This is the predetermined price at which you can buy the options contract. The strike price decides if an option has an intrinsic value.
5. Premium: An options premium is the intrinsic value of the option plus time value. This is the price an options buyer pays to the seller for the right to buy the underlying asset. Premium is like a reward for the seller for taking the risk of selling an underlying asset at a future price and date. An options premium decreases over time as they enter deeply out-of-the-money or if near expiry date [Theta Decay].
6. At-the-money/ In-the-money/ Out-of-the-money: At-the-money [ATM] is when the current price and the strike price of the option are equal to each other, this normally indicates that an option has no intrinsic value. In-the-money [ITM] is when the current price and the strike price have a considerable comparison from each other. Out-of-the-money [OTM] is when the value of the underlying asset and the strike price have a considerable difference between each other. For example, if NIFTY is trading at 24,565 and you buy an option at that point of time then it is ATM, if NIFTY moves between 24,550 and 24,600 then it is ITM. However, if the market is highly volatile and NIFTY shifts up to 24,650 or 24,450 then it is OTM.
7. Theta Decay: This is a very important concept if you are dealing with F&O. The value of an option decreases over time or as it reaches expiry. Theta basically measures the inevitable loss in the value of the option as time passes. It is important to note that on the day of expiry both your options expire worthless due to theta decay.

How Does Options Trading Work

Options give you the right but not the obligation to buy/sell an underlying asset at a certain value and time. For example, let’s say you bought a contract for an underlying asset at ₹500 and now the price of the asset has risen to ₹600; you can choose whether or not to exercise your option. From the seller’s perspective, if the buyer chooses not to exercise their option, the seller earns money on the premium they have received from the buyer.

What Happens to Option Investment

Coming back to our example. Let us understand the two scenarios that can happen for our example earlier.

Scenario 1 (Profit):
If the stock price of ABC rises to Rs 120 before the option expiration, you can exercise your call option, buying shares at the lower strike price of Rs 110. Your profit would be Rs 120 (current stock price) - Rs 110 (strike price) - Rs 5 (premium paid) = Rs 5 per share.

Scenario 2 (Loss):
If the stock price remains below Rs 110, you may choose not to exercise the option, letting it expire worthless. In this case, your loss would be limited to the premium paid, which is Rs 5 per share.

Types of Options

As a trader, you have two types of options to work with. We have already taken up Calls. The second type is Puts. It is time to break them down before moving forward.

1. Call Options

It gives the holder, which is the buyer, the right, but not the obligation, to buy an underlying asset at a predetermined price (strike price) before or at the option's expiration date. It is used when a trader anticipates that the underlying asset price will rise. By purchasing a call option, the trader gains the right to buy the asset at a lower, predetermined price, potentially profiting from the price increase.

Call Options Examples

We have already discussed the Call option in the above example. You can revisit it again now that you understand the Call - what it means exactly

2. Put Options

A put option gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (strike price) before or at the option's expiration date. It is generally employed when a trader expects the price of the underlying asset to decrease. By acquiring a put option, the trader secures the right to sell the asset at a higher, predetermined price, allowing them to profit from a potential decline in value.

Put Options Example

Let us take another company, XYZ Limited, with a current stock price of Rs 80 per share. You buy one put option with a strike price of Rs 75 and a premium of Rs 4 per share. If the stock price falls to Rs 70 before expiration, you can exercise the put option, selling shares at the higher strike price of Rs 75. Your profit per share = Rs 75 (strike price) - Rs 70 (current stock price) - Rs 4 (premium paid) = Rs 1

Participants in Options

The participants in options trading are:

1. Option Buyer: Option buyer is a trader who pays a premium to purchase the rights to exercise his/her option while option trading
2. Option Writer/Seller: Option buyer pays the premium to the option writer/seller. When the option buyer exercises his/her right, the writer/seller of the option must buy or sell the asset.
3. Call Option: When the holder gets a choice to purchase an asset before a specific date and at a predetermined price, it is called a call option. Here the holder has a choice of making an action of purchase but not an obligation.
4. Put Option: When the holder gets a choice to sell an asset before a specific date and at a predetermined price, it is called a put option. Here the holder has a choice of making an action of selling his/her asset but not an obligation.

Uses of Call and Put Options

Call and Put are used for different purposes by investors. The below table shows different objectives and how Call and Put makes use of them.

How to Trade in Options?

Many brokers, including ICICI Direct, allow you to trade options. To start options trading, you can follow the below steps

• Get your trading account: If you don't have one, then you must get one to begin trading options. ICICIdirect offers trading accounts with zero opening charges and a margin trading facility.

• Add funds to your account: Once you have your trading account and F&O is enabled, you log in and add funds to your account. You can deposit the margin amount as per the Option contract you chose to trade.

• Choose What you want to do: You can pick Buy calls, Sell calls, Buy puts, and Sell puts. We will look at these terms in a while.

• Pick the Option you want to buy or sell: Determine the options contract you want to buy or sell.

• Place the Order: The final step would be to execute the contract by clicking on the Place Order. Check all the details before submitting the order.

Options Trading Terminologies

Buying Calls (Long Calls)

Buying Calls is like purchasing a coupon that allows you to buy a specific item at a fixed price later. As we have said a few times now, it gives you the right (but not the obligation) to buy a stock at a predetermined price (strike price) before or at the option's expiration date. So, if you believe a stock's price will go up, you buy a call option to lock in the right to purchase it at a lower price, potentially profiting if the stock rises.

Writing Covered Calls

Imagine you own a stock and decide to sell someone else the right to buy that stock from you at a certain price. This is known as writing a covered call. What does covered mean here? It means you already own the stock, so you are covered in case the buyer exercises their right. Let us explain with an example. If you own 100 shares of a stock at Rs 50 each, you can sell a call option with a strike price of Rs 55. If the stock rises above Rs 55, the buyer may choose to buy it from you at that price.

Long Puts

This is like buying insurance for your stock investments. Buying a put option gives you the right (but not the obligation) to sell a stock at a predetermined price, protecting you from potential price drops. If you fear a stock might decrease in value, you buy a put option. If the stock price drops, you can sell it at the higher strike price, minimizing your losses.

Short Puts

This is like selling insurance. When you sell a put option, you give someone else the right to sell a stock to you at a specified price. If they exercise this right, you are obligated to buy the stock. You sell a put option with a strike price of Rs 40. If the stock stays above Rs 40, you keep the premium you earned. If it falls below Rs 40, you may be required to buy the stock at that price.

Combinations

This strategy involves combining different options (calls and/or puts) to create a more complex strategy. Think of it like mixing and matching ingredients to create a recipe tailored to match your goals and risk tolerance. One of the most popular combinations is a straddle. Here, you buy a call and a put with the same strike price. It is used when you expect a significant price movement but are unsure of the direction.

Spreads

Spreads involve simultaneously buying and selling options on the same underlying asset but with different strike prices or expiration dates. Through this, you aim to reduce your investment risk. A bull call spread involves buying a call option and selling another with a higher strike price. This way, you profit from a price increase, but the sold option helps offset some of the costs.

Common Terms in Options Trading

Below are some of the commonly used terms used in options trading:

• American Option: These are option contracts that can be exercised at any time before expiry or on the expiry date itself.
• European Options: These are most commonly used in Indian markets and can only be exercised on the expiration date.
• Strike Price: This is the price at which both the parties enter the contract.
• Premium: It is the amount a seller gets from the buyer. It also acts as a reward for the risk the seller takes for selling the contract in the market.
• Expiry Date: This is the date at which the option expires and becomes invalid

Difference Between Options Trading and Other Instruments

• A right but not an obligation: Unlike other financial instruments, options trading gives the buyer/seller the right but not the obligation to execute the contract. This means, if circumstances are unfavourable, the buyer can choose not to execute the options contract. 
• Highly flexible: Options contracts allow traders to customize their investment strategies by selecting certain variables like strike price, expiration date and more. 
• Leverage: Since options are derivatives, they have a certain amount of leverage. Thus, allowing traders to earn potentially higher returns with relatively lower capital. 
• Limited risk: As mentioned before, traders can choose between exercising the contract or not, at a future date and price. Therefore, making options a relatively safer in comparison to futures or margin trading. 
• Complex nature: Compared to other instruments, options can be rather tricky and complex. It requires traders to have proper understanding of the market, the underlying asset and timing. When trading in options, traders must accurately predict the direction of the market and the magnitude of price movements in order to make a profit.

Short-Term vs. Long-Term Options Trading

You can refer to the below table to understand the difference between short-term and long-term options trading.

How to Read Option Tables?

Here are a few things you need to know to read option tables:

• Each option contract has a unique symbol. It typically includes the stock symbol, expiration month code, expiration year, and strike price. For example, NIFTY24JAN5000CE represents a NIFTY call option expiring in January 2024 with a strike price of 5000.
• Calls and puts are usually listed together. Calls give the right to buy and puts give the right to sell.
• Options have expiration dates. Identify the expiration date in the options symbol to understand when the contract expires.
• Strike prices represent the predetermined price at which the option can be exercised. The strike prices are listed in the table, and you'll typically find them in ascending order.
• The premium is the price of the option contract. It reflects the cost of buying the option. For call options, the premium is for the right to buy, and for put options, it's for the right to sell.
• Open interest indicates the total number of outstanding option contracts. Higher open interest often implies greater liquidity and trader interest in that option.
• Volume shows the number of contracts traded during a specific time period. High volume suggests active trading and liquidity.
• The bid price is what buyers are willing to pay, while the ask price is what sellers are asking for. The difference between the two is the bid-ask spread. Narrow spreads are preferable for liquidity.
• Implied volatility represents the market's expectation of future price volatility. Higher IV generally leads to higher option premiums.
• Understand In-the-Money (ITM), At-the-Money (ATM), and Out-of-the-Money (OTM) based on the relationship between the stock price and the option's strike price. In-the-money options have intrinsic value, at-the-money options have a strike price close to the stock price, and out-of-the-money options have no intrinsic value.
• Theta measures the time decay of an option, while delta represents the sensitivity of the option's price to changes in the underlying stock price. These Greeks provide insights into how the option value may change with time and price movements.

How Is Risk Measured With Options?

The risk of options is measured using four different dimensions listed below (collectively called Greeks):

• Delta
• Theta
• Gamma
• Vega

Important Characteristics of Options:

• Flexibility: Options provide investors with a high degree of flexibility in designing strategies to suit various market conditions and investment objectives.

• Leverage: Options offer leverage, allowing investors to control a large position with a relatively small amount of capital. It means that the percentage returns (both gains and losses) on the investment can be significantly higher than if you directly traded the underlying asset.

• Limited Risk, Unlimited Profit Potential: One notable feature of options is the ability to define and limit risk. When you buy an option, the most you can lose is the premium paid for that option. On the other hand, options offer unlimited profit potential, particularly for call options, as the underlying asset price can theoretically rise without bounds.

Options Trading FAQs

1. Where Do Options Trade?

You can start trading options on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).

2. Can You Trade Options for Free?

Options trading involves fees and commissions. The fees and commissions vary from broker to broker, so check the numbers before you start options trading.

3. Is option trading for beginners?

Options trading might be complex for beginners in India. But with the right option strategies and a good understanding of options trading, they can also start it. 

4. Is Trading Options Better Than Stocks?

Both these instruments serve a different purpose. While options offer leverage and act as a hedging instrument, stocks represent ownership and can be less complex in comparison. However, this depends on the investors risk appetite, financial goals and time horizon. Conservative investors might invest in stocks while a much more aggressive investor might trade in derivatives like options.

5. How are Options Taxed?

Under the Income Tax Act of 1961, any profit or loss from Futures and Options must be considered under “Non-speculative” business income. Traders are required to disclose any profits or losses made on their income tax returns (ITR). 

6. What are the Types of Options Trading?

There are mainly two types of options:

Calls: This gives the trader the right, but not the obligation to buy an underlying asset at a predetermined price at a future date. Long call options can be used to speculate the price of the asset in the market might rise.

Put: This gives the trader the right, but not the obligation to sell the underlying asset at a certain strike price or on the day of expiry. Unlike a long call, a long put is used if there is speculation that the underlying assets’ price might fall.