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What is Options Trading?

10 Mins 22 Jun 2023 0 COMMENT
Options Trading

In recent years, options trading has become super popular among traders. At the same time, SEBI issued a circular last year saying that most traders lose money in options trading. What do you think is the reason behind it? One of the main reasons for this is that traders start with it without understanding the derivates or the required knowledge. Therefore, let us help you with the basics. So, before you place your first order, you have adequate knowledge. So, what is options trading?

Options trading is a strategy where traders buy or sell contracts that give them the right, but not the obligation, to buy or sell an asset at a predetermined price before or at expiration. Calls provide the right to buy, while puts provide the right to sell.

Example of Options Trading

Let us take an example of options trading to introduce the different terms associated with it. Later, we will take up those terms and explain them in detail. You can come back to the example again and see if you have understood it better.

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.

How Does Options Trading Work

Like in any other form of trading, the underlying principle of options trading is determining the chances of the stock price in the future. The higher the likelihood of something occurring, the more expensive an option that profits from that event would be. The closer you get to the expiration date, the option value will be reduced. Can you guess the reason? As you get closer to the expiry, the likelihood of making the right guess increases. So, the reward is reduced. For this reason, you would have heard of the phrase - option is a wasting asset.

What role does time play in options? Time is a component of the option price. Understand this: a three-month option will be more valuable than a one-month option. The reason is that when you have more time in hand, the chances of the price moving in your favor increase. For this reason, you will find a strike for the same option, that expires in a year, will cost you more than the same at a strike for a month.

The last parameter to know to understand how options work is volatility. It increases the option price as uncertainty pushes the odds of an outcome higher. You will see a larger price swing if there is volatility in the underlying asset price, as it increases the possibility of a substantial move both down and up.

What Happened 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.

 

Scenario 1

Scenario 2

Stock Prices

Rs 120

Rs 110

Premium

Rs 5

Rs 5

Profit/Loss

Rs 5 per share

Invested Amount

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.

Objective

Call Options

Put Options

Speculation on Price

Anticipating an increase in the underlying asset's price.

Expecting a decrease in the underlying asset's price.

Hedging

Hedging against potential losses in a long stock position.

Hedging against potential losses in a short stock position.

Generating Income

Writing (selling) covered calls to earn premium income.

Writing (selling) cash-secured puts to earn premium income.

Risk Management

Protecting a portfolio by buying call options as a form of insurance.

Protecting a portfolio by buying put options as a form of insurance.

Stock Entry Strategy

Using call options to control a stock entry at a lower price.

Using put options to establish a stock entry at a specified price.

Stock Exit Strategy

Selling call options against owned stock for additional profit.

Selling put options against cash reserves to potentially acquire stock at a lower price.

Market Volatility

Benefiting from increased volatility with strategies like long straddles.

Benefiting from increased volatility with strategies like long straddles.

How to Trade in Options?

Many brokers, including ICICIDirect, 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

Next, we look at some terms we have covered in this section.

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.

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.

Parameters

Short-Term Options Trading

Long-Term Options Trading

Time Horizon

Typically days to weeks

Months to years

Objective

Capitalizing on short-term price movements

Hedging against long-term market risks

Strategy Focus

Emphasizes quick price changes and volatility

Takes a broader view, considering fundamental factors

Types of Options Used

Often uses weekly or monthly options

Utilizes options with longer expiration dates

Risk Tolerance

Requires active monitoring due to shorter timeframes

Tends to be more patient, with less frequent adjustments

Market Analysis

Technical analysis is crucial for short-term trends

Fundamental analysis plays a significant role

Profit Potential

Offers the potential for quick, substantial gains

Potential for compounding returns over an extended period

Risk Management

Requires tight risk management due to short holding periods

Emphasizes long-term portfolio diversification

Tax Implications

Short-term capital gains tax rates apply

Long-term capital gains tax rates may be more favorable

Example Strategy

Day trading options or swing trading

Buying LEAPS (Long-Term Equity Anticipation Securities)

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.
Future and Option

 

Is Trading Options Better Than Stocks?

Whether trading options is better than stocks depends on your preferences, risk tolerance, and investment goals. Both options and stocks have advantages and disadvantages, and the suitability of each depends on your financial situation and trading objectives. There is no one-size-fits-all answer. Some investors prefer the potential for higher returns and flexibility offered by options, while others appreciate the simplicity and ownership aspect of stocks.

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

Here are the three 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.