What is Options Trading?

An Option is a financial instrument, a derivative, and its value is derived from an underlying asset. That could either be a stock, market index, commodity, currency, or any other security. Options are basically contracts between two parties that allow holders to purchase or sell an underlying asset at a specific price on a pre-determined date.

Initially, Options trading may seem a little complex, however, they aren’t. Let us look at some basic terms to understand options.

Important terms in Options

  • Derivative – Options derive their value from other assets, hence they are also referred as derivatives.
  • Call and Put Options – The call option gives you the opportunity to purchase a security at a predetermined price on a specific date whereas a put option permits you to sell a security at a future date as well at a predetermined price.
  • Strike price and expiry date – That predetermined price specified above is known as a strike price. The day on which future transactions will happen at the pre-determined price is the expiry date.
  • Premium – It is the price you pay to buy an option contract.
  • Strike price intervals – The interval between the subsequent strike prices of a stock or index. It is not constant and differs across stocks and indices.
  • Intrinsic value – Option value based on the difference between a stock’s current market price and its option’s strike price.

Is Option a type of derivate instrument?

Yes, an Option is a type of derivative instrument that derives its value from an underlying asset, such as shares , commodities or currency.

Options are a type of derivate instrument where two parties agree to get into a contract to transact an asset at a specific price at a future date. However, the owner doesn’t have the obligation to buy or sell the underlying asset.

What is an Options Contract?

There are essentially two different types of an Options contract: Calls and Puts.

  • Call Options: This gives you the right to buy the underlying asset at the strike price (mentioned in the option contract) on a specific future date. However, there isn’t any obligation for the call owner to buy the security. Investors tend to buy calls when they feel that the price of the underlying asset will increase and likewise sell if they feel the price will decrease.
  • Put Options: A Put Option works exactly opposite to that of the call option. It gives the owner the right, however not the obligation to sell an underlying security at a particular price (strike price) specified in the contract on the expiration date.

Buying a Call Option

Call Option buyer buys the Call Option hoping that the price will rise by the date of expiry. Call buyer will be in profit zone when price of the underlying asset exceeds the strike price. If the price doesn’t go beyond the strike price, the buyer won’t exercise the option. The buyer will bear a loss equal to the premium of the Call Option.

Selling a Call Option

Call sellers anticipate the stock to remain flat or decline so that they can make profits. An option seller pays a margin to the Exchange to enter a position. They collect the margin paid by the call buyer. Call Selling is also called ‘Call Writing’.

Buying a Put Option

Thebuyer of Put Option profits when the stock price goes below the strike price on the expiry date. The option is exercised at the strike price by the put seller within the specified period of expiration. Option by them is used by selling the underlying stock to the put seller at the mentioned strike price.

Selling a Put Option

Put sellers take the position when they expect a bullish market. A Put seller is obliged to buy the underlying stock at the strike price if the option buyer exercises the option on expiry day. The price of a stock should remain the same or go above the strike price so that put sellers can possibly earn a profit.

Difference between Call & Put Option

  • If you buy a Call option, it will help you to buy a stock on a specific date at the strike price.
  • If you buy a Put option, it will help you to sell a stock on a specific date at the strike price.
  • A Call buyer enters the position when the stock market is bullish.
  • A Put buyer enters the position when the stock market is bearish.
    • The cost of premium of a Call option is far less than the equivalent underlying security.
    • When you become a Call seller, you are referred to as an options writer. An option writer provides the margin to the Exchange to take position & collects the premium provided by the option buyer. If you have a stock that’s appreciated since your purchase. You could write a Call Option with a strike price equivalent to the current market price and collect a premium. This is called a “covered call” in options trading.

    Advantages of Put Options

    • One of the main advantages of buying Put Options is that it gives investors the opportunity to speculate on securities that they feel may decline in price.
    • Investors benefit from buying a Put Option as they get to hedge. An investor having many shares in a particular stock may opt to buy a Put Option to secure against the price of that stock falling.

    How Does Options Trading Work?

    Options trading can be done via a Demat & Trading account . The price of options is derived from things like the value of securities and assets, and other underlying instruments. A trader visits the section of Options for index or stocks in the trading platform. A list of strike prices is displayed with corresponding premium rates & open interest on both PUT and CALL sides. The trader can select a particular strike price and enter the position as a buyer or seller. The respective amount has to be paid. The trader can hold the position till expiry or exit the position before the expiry date. If the position is held till the expiry date, the settlement between the 2 parties of the Options contract is executed.

    Benefits of Options Trading

    Options trading can help a trader with higher returns in a short time frame, give the benefit of leverage, and a hedge against uncertainties.

    • A common practice is to use options to limit losses by using it as a hedge.
    • Option traders get the benefit of leverage where, they can take position in a large quantity of stock by just paying a relatively lower premium
    • Several option traders hold position for intraday or a few days is they expect a major price swing is a short time. This can help them earn a high return in a short interval of time

    Options enable in reducing the cost of holding a stock. If suppose you are holding a stock and the price isn’t moving at all. In that case, you can sell higher Call Options, earn the premium and decrease your cost of holding that asset.

    How to Use Call Options

    When you expect the market to rise, you buy a Call option. That’s because a Call Option helps you to buy the underlying asset at the predefined rate. So, you need to select a strike price that is expected to be below the market price of the asset on expiry date. If the situation is such, you will profit from the Call option, otherwise, you only lose the premium paid to buy Call option.

    How to Use Put Options

    Put Option provides investors with an opportunity to make profits if there’s a drop in the asset & security prices in the future. A trader expecting a market fall will buy a Put option. If the asset price stays lower than the strike price on expiry day, trader will profit.

    How are Options Contract Priced?

    Through the options contract, you can take a position in the underlying asset at a fraction of the actual price of the asset by paying an upfront premium. An option premium has two components – intrinsic value and time value. Intrinsic value is the difference between the strike price and the asset’s present price. The time value captures the component of premium owing to the time remaining till expiry.

    The asset price, strike price and the expiration date, all play a role in option pricing. The asset price and strike price affect the inherent value and the expiry date might affect the time value.

    Let’s look at some of the key terms to understand how the strike prices are categorized:

    • In the Money : A strike price on Call side is said to be ‘In-the-money’ when the strike price is near the spot price. Conversely, a strike price on Put side is said to be ‘In-the-money’ when the strike price of the asset is near the spot price.
    • At the Money : When the spot price is same as the strike price, it is said to be in the money
    • Out of the Money : A strike price on Call side is said to be ‘Out-of-the-money’ when it is far higher than the spot price. Conversely, a strike price on Put side is said to be ‘Out-of-the-money’ when it is far lower than the spot price.

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    Option Trading FAQs

    Both stocks and options can be good investment choices, depending on the scenarios. The returns however offered may vary drastically and so are the risks. Therefore, it is advisable that those investing in either of the two should thoroughly understand how they work before getting involved. Stocks also carry risk, but options can be riskier.

    If you follow a disciplined approach and strategy while trading, a good amount of money can be made by trading options.

    Trading options require knowledge and practice. It is better to start trading in stocks at first, trade in small quantities and then gradually proceed to trading options. If done in the right way, options can prove to be a good value addition to your investment.

    You can achieve the same amount of benefit as you would with stocks but with a lesser cost but probably a higher percentage return on the money you invested.

    The premium of options contract closer to the current market price of the underlying asset is generally higher and the premium of options contract far away has lower price.

    If you are new in the trading market, it’s better to start off with a small account size just to get a feel and then gradually proceed to build your account from there. Well, there isn’t any bare minimum amount. You can start trading say with Rs. 15,000.

    Also, commissions and fees need to be taken into consideration as they have a bigger impact on a small amount.

    Options trading can be a complex phenomenon therefore you should be careful with the amount you invest. Position sizing, defining a maximum holding period, and pre-calculation of stops and targets are some of the rules when trading in options.

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