What is Options Trading?

Options trading allows you to buy or sell stocks, ETFs, etc. at a specific price within a specific date. This type of trading also gives buyers the flexibility to not buy the security at the specified price or date. While it is a little more complex than stock trading, options can help you make relatively larger profits if the price of the security goes up. That’s because you don’t have to pay the full price for the security in an options contract. In the same way, options trading can restrict your losses if the price of the security goes down, which is known as hedging.

The right to buy a security is known as ‘Call’, while the right to sell is called ‘Put’.

They can be used as:

• Leverage: Options trading helps you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright.

• Hedging: They can also be used to protect you from fluctuations in the price of a share and let you buy or sell the shares at a predetermined price for a specified period of time. One of the integral parts of hedging yourself against market fluctuations is to do financial planning. Here’s what Financial planning is and why it is important.

Though they have their advantages, options trading is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.

How Does Options Trading Work?

Options trading involves buying and selling financial contracts called options. Call options give the holder the right to buy the underlying asset at a predetermined price, while put options give the holder the right to sell the underlying asset at a predetermined price. Traders can profit from options trading based on the movement of the underlying asset, and the profitability depends on factors such as the strike price and market volatility.

Strategies In Option Trading

The following are the strategies in options trading:

Long Call Options Trading Strategy

A long call options strategy involves buying call options on a stock or asset. This gives the right but not an obligation to buy an asset at a predetermined price.

Short Call Options Trading Strategy

In a short call option strategy, an investor sells call options on something they don't own. If the buyer exercises the contract, they are obligated to sell the asset at the strike price.

Long Put Options Trading Strategy

Long put options involve purchasing a put option on a particular asset. The investor uses this strategy when the asset price drops significantly.

Short Put Options Trading Strategy

A short put options strategy involves selling put options on an asset you don't own. The investor uses this strategy when they think the asset's price will stay the same or rise.

Long Straddle Options Trading Strategy

It involves simultaneously buying a call option and a put option with the same strike price and expiration date on the same asset. This strategy is used when an investor expects significant price movement.

Short Straddle Options Trading Strategy

Short straddle options trading strategy involves selling both calls and put options with the same strike price and expiration date on the same asset.

Profitability Scenario in Options

Profitability scenarios in options trading include:

• In-the-Money Option

ITM options lead to positive cash flows for the holder if they are exercised immediately.

In the case of a call option on the index, if the current index value is greater than the strike price (spot price > strike price), the option is said to be in-the-money.

• At-the-Money Option

An ATM option is one that provides zero cash flow (no profit/no loss) if it is exercised immediately.

As an example, if the current index value equals the strike price (spot price = strike price), then the option is ATM.

• Out-of-the-Money Option

When a contract is out of the money (OTM), it would result in a negative cash flow if exercised immediately.

It is called an out-of-the-money option if the index value is lower than the strike price (spot price <strike price).

Advantages Of Options Trading

Options trading offers several advantages, including:

1. Leverage: One of the main advantages of trading options is leverage. Trades in options only require a premium payment, not the entire transaction value. As a result, traders can take on high-value positions with a low capital requirement.

2. Cost Effectiveness: Options allow traders to use less capital and earn a profit. There is a much higher return on investment than in other investment avenues. Due to the modest premium amount, options have a high-cost efficiency.

3. Risk Involved: The risk associated with options is relatively lower than that of futures or cash markets. Options carry a risk of loss equal to the premium paid. However, writing or selling options may carry more risk than purchasing an underlying asset.

4. Options Strategies: Options trading also offers the possibility of profiting in both rising and falling markets. There may be times when you are unsure about the direction in which the price will move, but you expect a significant shift in price. It is common for quarterly results, budgets, and changes in top management to cause uncertainty. By combining options, a trader can create a strategy that generates gains regardless of the direction of the underlying asset's price.

5. Flexible Tool: Options offer more investment options and are flexible tools. Aside from the price movement, investors can also gain from time and volatility movements.

6. Hedging: Using options reduces the risk associated with current holdings and acts as a hedging tool. Traders can virtually eliminate any risk associated with trade by combining options.

Understanding Options Trading

Options trading is a form of investment that involves the buying and selling of financial contracts called options. Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe.

Call options give the holder the right to buy the underlying asset, while put options give the holder the right to sell the underlying asset. Traders can profit from options trading by speculating on the direction of the underlying asset's price movement or by using options as a risk management tool to hedge their existing positions.

Options trading involves various factors such as strike price, expiration date, and option premium, which is the cost of the option contract. It requires an understanding of market dynamics, risk management, and the use of different options trading strategies to maximize potential returns.

About Options

Just as futures contracts minimize risks for buyers by setting a predetermined future price for an underlying asset, options contracts do the same, however, without the obligation to buy that exists in a futures contract.

The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.

There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.

If you’re trading in NSE, you have the option of VIX Futures that can help you quantify the volatility of the market.

Options Related Terms

When you are trading in the derivatives segment, you will come across many terms that may seem alien. Here are some Options-related jargons you should know about.

To know about the jargons related to Futures, click here.

• Premium: The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract.

• Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold.

• Strike Price Intervals: These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded.

There are typically at least 11 strike prices declared for every type of option in a given month - 5 prices above the spot price, 5prices below the spot price and one price equivalent to the spot price.

Following strike parameter is currently applicable for options contracts on all individual securities in NSE Derivative segment:

The option strike price interval would be:

Options Strike Price Intervals For Nifty Index

The number of contracts provided in options on index is based on the range in previous day’s closing value of the underlying index and applicable as per the following table:

Expiration Date:

A future date on or before which the options contract can be executed. Options contracts have three different durations you can pick from:

• Near month (1 month)
• Middle Month (2 months)
• Far Month (3 months)

Please note that long terms options are available for Nifty index. Futures & Options contracts typically expire on the last Thursday of the respective months, post which they are considered void.

American And European Options:

The terms ‘American’ and ‘European’ refer to the type of underlying asset in an options contract and when it can be executed. American options’ are Options that can be executed at any time on or before their expiration date. ‘European options’ are Options that can only be executed on the expiration date.

Please note that in Indian market only European type of options are available for trading.

Lot Size:

Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded.

E.g. options contracts for Reliance Industries have a lot size of 250 shares per contract.

Open Interest:

Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.

Let us understand with an example:

If trader A buys 100 Nifty options from trader B where, both traders A and B are entering the market for the first time, the open interest would be 100 futures or two contract.

The next day, Trader A sells her contract to Trader C. This does not change the open interest, as a reduction in A’s open position is offset by an increase in C’s open position for this particular asset.

Now, if trader A buys 100 more Nifty Futures from another trader D, the open interest in the Nifty Futures contract would become 200 futures or 4contracts.

Types Of Options

As described earlier, options are of two types, the ‘Call Option’ and the ‘Put Option’.

• Call Option

The ‘Call Option’ gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. Call options are abbreviated as ‘C’ in online quotes.

You can learn more about call options here.

• Put Option:

The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls.

Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes. Here’s more about the put option.

Uses Of Call And Put Options

Call Options and Put Options are vastly different in nature. They are not different sides of the same coin. They are two different coins altogether.

Call Option helps you maximize profits. The rule is simple, you buy at lows, and sell at highs. A Call Option helps you fix the buying price.

Put Option is all used to fix the selling price. Put Options are used when market conditions are bearish. They protect you against the decline of the price of a stock below a specified price.

Here’s a simple example explaining the best use of Call and Put Options:

Start trading

How To Trade In Options

This means, under this contract, Rajesh has the rights to buy one lot of 100 Infosys shares at Rs 3000 per share any time between now and the month of May. He paid a premium of Rs 250 per share. He thus pays a total amount of Rs 25,000 to enjoy this right to sell.

Now, suppose the share price of Infosys rises over Rs 3,000 to Rs 3200, Rajesh can consider exercising the option and buying at Rs 3,000 per share. He would be saving Rs 200 per share; this can be considered a tentative profit. However, he still makes a notional net loss of Rs 50 per share once you take the premium amount into consideration. For this reason, Rajesh may choose to actually exercise the option once the share price crosses Rs 3,250 levels. Otherwise, he can choose to let the option expire without being exercised.

Rajesh believes that the shares of Company X are currently overpriced and bets on them falling in the next few months. Since he wants to secure his position, he takes a put option on the shares of Company X.

Here Are The Quotes For Stock X:

Provide your details

Fill in your personal, address, and bank details, and upload identity proof.

E-signature

Fulfill the Aadhaar-based e-Sign process.

Start trading

That's it. You can start your trading journey once we've verified your details and activated your account.

Open Account

Here Are The Quotes For Stock X:

Rajesh buys 1000 shares of Company X Put at a strike price of 1070 and pays Rs 30 per share as premium. His total premium paid is Rs 30,000.

If the spot price for Company X falls below the Put option Rajesh bought, say to Rs 1020; Rajesh can safeguard his money by choosing to sell the put option. He will make Rs 50 per share (Rs 1070 minus Rs 1020) on the trade, making a net profit of Rs 20,000 (Rs 50 x 1000 shares – Rs 30,000 paid as premium).

Alternately, if the spot price for Company X rises higher than the Put option, say Rs 1080; he would be at a loss if he decided to exercise the put option at Rs 1070. So, he will choose, in this case, to not exercise the put option. In the process, he only loses Rs 30,000 – the premium amount; this is much lower than if he had exercised his option.

How Are Options Contracts Priced?

We saw that options can be bought for an underlying asset at a fraction of the actual price of the asset in the spot market by paying an upfront premium. The amount paid as a premium to the seller is the price of entering an options contract.

To understand how this premium amount is arrived at, we first need to understand some basic terms like In-The-Money, Out-Of-The-Money and At-The-Money.

Let’s take a look as you may be faced with any one of these scenarios while trading in options:

• In-the-money: You will profit by exercising the option.

• Out-of-the-money: You will make no money by exercising the option.

• At-the-money: A no-profit, no-loss scenario if you choose to exercise the option.

A Call Option is ‘In-the-money’ when the spot price of the asset is higher than the strike price. Conversely, a Put Option is ‘In-the-money’ when the spot price of the asset is lower than the strike price.

Understand Naked and Covered Options Contracts here.

How Is Premium Pricing Arrived At:

The price of an Option Premium is controlled by two factors – intrinsic value and time value of the option.

• Intrinsic Value is the difference between the cash market spot price and the strike price of an option. It can either be positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). An asset cannot have negative Intrinsic Value.

• Time Value basically puts a premium on the time left to exercise an options contract. This means if the time left between the current date and the expiration date of Contract A is longer than that of Contract B, Contract A has higher Time Value.

This is because contracts with longer expiration periods give the holder more flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a tight spot.

At the beginning of a contract period, the time value of the contract is high. If the option remains in-the-money, the option price for it will be high. If the option goes out-of-money or stays at-the-money this affects its intrinsic value, which becomes zero. In such a case, only the time value of the contract is considered and the option price goes down.

As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.

Key Takeaways

• With options trading, you can buy or sell stocks, ETFs, etc., at a specific price within a specific time frame. Additionally, this type of trading gives buyers the option not to buy the security at a specified price or date.

• Option trading strategies include long call options, short call options, long put options, short put options, long straddle options, and short straddle options.

• The three main options trading scenarios are In-the-Money, At-the-Money, and Out-of-the-Money.

• The advantages of options trading include leverage, cost-effectiveness, flexibility, Options Strategies, and hedging.

• In the stock market, there are two types of options: call and put. The term "call option" refers to an option to buy a stock, and the term "put option" refers to an option to sell a stock.