What is Options Trading?

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, 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.

Understanding Options Trading Meaning

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 maximise potential returns. 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.

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.

Risks Associated with Options Trading

One of the primary risks is the loss of the entire premium amount paid for buying options. If the market does not move in the anticipated direction within the option's lifespan, the option may expire worthless, resulting in a total loss of the initial investment.

For option sellers (writers), the risks can be even greater. Selling uncovered options exposes traders like you to theoretically unlimited losses if the underlying asset moves significantly against their position. For example, a sharp rise in the price of a stock can lead to huge losses for a call option seller.

Another risk is the time decay factor. Options are time-sensitive instruments, and their value diminishes as the expiration date approaches. This makes it challenging for you as a trader to profit unless the market moves quickly in your favour. Additionally, options trading involves market volatility risk, as sudden price swings can impact option premiums unpredictably. Liquidity risk is another factor, where you may face difficulties in buying or selling certain options at favourable prices.

Also, options require a thorough understanding of complex strategies, and lack of knowledge can amplify risks, leading to significant mistakes and financial 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 option 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. Options trading can be used for speculation, hedging, or income generation (through premium collection). And as highlighted previously, it carries significant risk if not managed properly.

Strategies in Option Trading

There are quite a few strategies that traders like you can employ when trading in options. Some of the basic options trading strategies are:

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.

Advanced options trading strategies require a nuanced understanding of volatility and market direction. A few such strategies are:

Iron Condor Options Trading Strategy

This involves selling a lower strike put, buying an even lower strike put, selling a higher strike call, and buying an even higher strike call – all with the same expiry. This strategy profits from low volatility, as you aim for the asset to stay within a defined price range.

Butterfly Spread Options Trading Strategy

Under this, you buy one lower strike call, sell two at-the-money calls, and buy one higher strike call (or the same setup using puts). The goal is to profit from minimal movement in the underlying asset near the middle strike price.

Calendar Spread Options Trading Strategy

As a trader, you sell a short-term option and buy a longer-term option with the same strike price. You aim to benefit from time decay in the near-term option and can be best used when low volatility is expected in the short run.

Participants in Options

The following are the key participants in the options market.

1. Option Buyer: The trader who purchases the right to exercise his option on the seller/writer by paying the premium.

2. Option Writer/Seller: The trader who gets the option premium. So, in case the buyer exercises the option the seller must sell or purchase the asset.

3. Call Option: A call option gives its holder the choice, but not the obligation to purchase an asset before a specific date at a predetermined price.

4. Select Option: A put option gives its holder the choice, but not the obligation to sell the asset at a predetermined price before a specific date.

5. Underlying Asset: This is the financial instrument on which the option contract is based. The value of the option is directly linked to the performance of the underlying asset.

What Is Options Chain in Options Trading?

An options chain, also terms as an options matrix, is an important tool that provides a detailed snapshot of all available contracts for a specific underlying asset to make well-informed trading decisions. It lists both calls and puts, along with their strike prices and expiration dates. The options chain helps gauge market sentiment and allows you to assess the potential risk-reward ratio.

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.

1. Premium: Option premium is the amount that an option buyer must pay the option seller.

2. Date of Expiration: The expiry date is the particular date specified in an option contract. It is also called the exercise date.

3. Strike Price: The strike price is the amount at which the contract is entered. It is often referred to as the exercise price.

4. Stocks Options: The underlying asset of these options is a stock. The holder of the contract is entitled to purchase or sell the underlying shares at the predetermined price. In India the American method of settlement is authorised for these options.

5. Index Options: These are the options when the underlying asset is an index. In India European-style settlement is allowed. Bank Nifty options and Nifty options are a few popular examples.

6. 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, 5 prices 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:

Profitability Scenario in Options

Profitability scenarios in options trading include:

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:

7. 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.

8. The American Option: American options can be exercised at any time up to its expiry date.

9. The European Choice: You can exercise the European options only on its expiry date.

10. 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.

11. 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 4 contracts

How to Analyse Options?

Analysing options requires understanding key factors that influence their price and potential profitability. The first step is to evaluate the “Greeks”, which measure different risks associated with the option.

• Delta indicates how much the option's price is expected to change with a ₹1 move in the underlying asset. A higher delta means the option is more sensitive to price changes.

• Theta measures time decay, showing how much value the option loses as expiration approaches.

• Gamma represents how delta changes with price movements, highlighting the option's acceleration risk.

• Vega shows the option's sensitivity to volatility changes, which directly impacts premiums.

Consider the implied volatility (IV), which reflects market expectations of future price movements. Higher IV means higher option premiums but also greater uncertainty. Compare IV to historical volatility to identify under- or overvalued options.

Examine the option chain, which lists strike prices, premiums, and open interest. Look for high open interest and volume, as these indicate liquidity and ease of entry/exit.

Align your analysis with the underlying asset’s trend and market outlook. Use technical and fundamental analysis to predict price direction and time the trade effectively. Combining these tools helps traders assess profitability and manage risk efficiently.

Understanding Options Taxation

Taxation of options trading in India is governed by the Income Tax Act and primarily treats income from options as non-speculative business income. Here's a concise overview.

• Classification: Profits or losses from options trading fall under non-speculative business income as per Section 43(5) of the Income Tax Act. This applies to both equity and currency options.

• Taxable Income: Income from options trading is reported under business income and taxed as per applicable tax slabs along with your total taxable income (which may include salary, interest, etc). Losses can be adjusted against other non-speculative income, excluding salary, and carried forward for up to eight years.

• Expenses Deduction: You can claim deductions for expenses directly related to trading, such as brokerage fees, internet costs, and professional charges. However, cash expenses exceeding ₹10,000 are not deductible.

• Tax Audit: A tax audit is mandatory if turnover exceeds ₹10 crore (provided 95% or more transactions are digital) or if you opt out of presumptive taxation under Section 44AD and declare income lower than the presumptive rate, while also exceeding the basic exemption limit.

• ITR Filing: Use ITR-3 for regular reporting or ITR-4 under presumptive taxation. Accurate record-keeping is essential to ensure compliance.

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).

Conclusion

Options are flexible financial instruments. So, options trading offers traders like you plenty of opportunities in all kinds of markets. Even though options are risky, you can choose low-risk basic strategies. If you have a low risk appetite, you can still use options to boost overall profits from your investments. However, before making an investment, it is crucial to assess the risk. You should be patient and have a thorough understanding of the share market, and the various securities traded in the market. In addition, always make an appropriate strategy before investing in options.