Option Trading Tips For Complete Beginners

Key Highlights

• Avoid options with low liquidity; verify volume at specific strike prices.

• Calls grant the right to buy, while puts grant the right to sell an asset before expiration.

• Utilise different strategies based on market conditions; explore various options trading approaches.

Understanding Options Trading

It is important to bear in mind that every option trade involves two parties: a buyer and a seller. Consequently, for each call or put option acquisition, there is always a counterpart involved in selling it. Trading options operates as a zero-sum game – the gain of the option buyer corresponds to the loss of the option seller, and vice versa. The payoff diagram for an option purchase mirrors the seller's payoff diagram.

Now, let's get into the rights of an options buyer and the obligations of an options seller. Suppose stock XYZ is trading at ₹920 in the cash market segment, and the premium for the 940 call option is ₹18 (with a lot size of 500). In a bullish stance on XYZ, A opts to buy the 940 call, while B, adopting a pessimistic outlook, writes the 940 call option. Consequently, A pays ₹9000 (18*500), and B receives the same amount for writing the option.

Types of Options

There are two main types of options used in intraday trading:

Call Option: A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a fixed price before expiry. Traders use call options when they expect the price to go up.

Put Option: A put option gives the buyer the right, but not the obligation, to sell the underlying asset at a fixed price before expiry. Traders use put options when they expect the price to go down.

The Best 6 Option Trading Tips for New Traders

Options should be considered an extension of stocks, providing flexibility in situations where traders are uncertain about holding or selling a security. Unlike stock trading, which is limited to bullish exposure by buying stocks or bearish exposure by shorting stocks, options offer the ability to bet long or short with reduced overall risk and capital expenditure. These advantages are just a fraction of what options trading adds to a trader's toolbox, allowing them to express investment ideas more diversely.

When executed correctly, options strategies can tilt the odds in a trader’s favour, providing a probability of profit exceeding 50%. Unlike stock trades, these strategies can actually reduce overall risk.

1. Unlocking Profitable Opportunities: Options trading thrives on market volatility, providing investors with opportunities amid fear and greed. Skilful use of options allows for capitalising on these situations, making it a valuable strategy for long-term success.

2. Enhancing Portfolios: Options offer a unique avenue to manage risk and add income, going beyond the capabilities of stock trading alone. Success in options trading involves paying attention to the right settings for consistent portfolio benefits, aligning with specific goals such as steady growth, income, or short-term gains.

3. Patience: Patience is crucial for options traders. Acting recklessly without a game plan can lead to mistakes. Recognising the difference between good and bad deals and trading smarter can significantly impact success.

4. Strategic Exit: Planning the exit is a critical aspect of options trading. It goes beyond minimising losses; it involves having a predetermined exit plan and timeframe, considering both upward and downward exits. Timing is crucial, especially as the expiration date approaches, requiring traders to exit if the expected move does not occur within the anticipated time frame.

5. Understanding Time Decay and Expiry: Time decay plays a critical role in options pricing. As expiry nears, the value of an option can erode quickly, mainly if the underlying stock isn't moving in the expected direction. New traders must be aware of how time decay affects profit potential and plan entries and exits accordingly.

6. Start Small and Practise: Options trading involves a learning curve. It is advisable to begin with small trades and build confidence gradually. Testing strategies in real market conditions or even through virtual trading helps in understanding how different setups behave without taking on excessive risk.

Options Trading Strategies for Beginners

New traders can start with strategies that are easy to understand and carry limited risk. Here are some basic strategies suited for beginners:

1. Buying Call Options: This strategy involves purchasing a call option when traders expect the price of the underlying asset to rise. The maximum loss is limited to the premium paid, while the potential profit is unlimited.

2. Buying Put Options: This is used when traders expect the price of the underlying asset to fall. Like call options, the loss is limited to the premium, and the profit increases as the price drops.

3. Covered Call Strategy: In this strategy, traders hold a stock and sell a call option against it. It generates income through the premium received but limits upside if the stock rises above the strike price.

4. Protective Put Strategy: Here, traders buy a put option to protect an existing stock position. It works like an insurance policy, thus limiting losses if the stock price falls sharply.

How to Trade Options Smarter?

Smart options trading is about managing risk, staying informed, and using strategies that suit traders’ trading goals. Here are a few ways to trade more effectively:

1. Focus on Liquid Contracts: Choose options with high trading volumes and open interest. This ensures better price execution and easier entry or exit.

2. Stick to a Defined Strategy: Avoid random trades. Use a clear strategy – whether bullish, bearish, or neutral – and follow it with discipline.

3. Manage Risk with Stop-Loss: Traders should always be clear about their risk appetite before entering a trade. Setting a stop-loss helps protect their capital and avoid large losses.

4. Don’t Ignore the Greeks: Understanding key Greeks like delta, theta, and vega can help traders assess how price, time, and volatility affect their option’s value.

5. Avoid Overtrading: Quality matters more than quantity. Focus on fewer, high-probability setups instead of chasing every market move.

Conclusion

There is a widespread misunderstanding that options are complex and high risk. In reality, options simply provide a means to engage with stocks in different ways. While some may perceive options as difficult to grasp, having a grasp of a few fundamental concepts makes them highly valuable and easily understandable. Anyone can acquire the knowledge to trade options with confidence.