Five key parameters to look for before buying an option

Options trading has emerged as a significant segment of the Indian stock market in the last decade. If you see the daily volumes data, it accounts for more than 85% of the total trade volumes on the National Stock Exchange (NSE).

Options trading has a potential to offer attractive returns to investors while protecting downside risks. It may appear complex at first, but it is not difficult to learn a few essential points and apply them to your options trading strategy. So, let’s delve into knowing the key parameters that one needs to consider before buying an option.

Factors to consider while buying an option

• Check the volatility

  Volatility is one of the crucial determinants of the value of an option. When the volatility in the market is high, more significant price swings increase the possibilities of substantial moves in option price in either direction. Now, because the alternative is non-linear, you end up making a profit when the movement is in your favour, but at the same time, you incur a loss when the action is against you.

• Understand the behaviour of time value

  The price you pay for an option, i.e. the premium, consists of two components - intrinsic value and time value. Let us say the call option strike price of a stock is Rs. 1560; the spot price is Rs. 1570, and the premium is Rs. 46. Now, out of the premium of Rs. 46, Rs. 10 is the intrinsic value of the option (Rs. 1570 - Rs. 1560) and the balance of Rs. 36 is the time value of the option. It is crucial to understand this difference as the option's time value keeps reducing as the expiry approaches and becomes zero at the time of expiry. Therefore, it is important to know how much you are paying for time value when buying an option.

• Frame an effective strategy

  Beginners often tend to adopt a single trading strategy. They either only buy options or only sell options. However, it would help if you considered it wise to adopt different trading strategies as per the market situation. For example, if you expect volatility in the market, you may buy an option combination Straddle or a Strangle. On the other hand, if you expect the market to be range-bound, you may sell a Straddle or Strangle. You can also explore specific strategies such as Butterflies and Covered Calls if market expectation is mildly bullish or bearish.

• Hedge your risks

  Options are highly flexible and dynamic, and hence you can use them to hedge your portfolio risks. As an example, let’s say that you hold a stock in your portfolio where you fear that stock prices may crash in the near term. In this scenario you can hedge on the stock price by purchasing a put option of that particular stock. This way, hedging can protect your capital in the case of unexpected market moves. Hedging is a preferred strategy used by large or institutional investors to protect downside risk on their portfolio. It can also be used by retail investors after a careful understanding of the hedging process and its costs.

• Selection of strike prices

  Often investors tend to buy cheap options hoping that the stock will rise and earn them good returns. Therefore, they consider buying deep out-of-the-money strikes, which are available at a low premium. The chances of getting that strike price in the money are meagre unless stock price witnesses a huge swing in price. When you have a limited period to exercise your rights in options trading, it is good to prefer at-the-money or slightly out of-the-money strike prices because there is a high probability of it getting exercised even with a slight movement in the stock price. Deep out of the money strikes carry a much higher risk of time decay of the premium making the option worthless.

Conclusion

If you consider all the parameters mentioned above, you are likely to trade better in options trading. Like any investment, there is an inherent risk in options trading. But once you understand the basics of how it works and are willing to take the associated risks, there is significant investment potential in options trading.