Investment portfolios often consist of various asset categories, including stocks, mutual funds, exchange-traded funds (ETFs), and bonds. Additionally, options form a unique asset class. When employed effectively, options trading presents numerous benefits not typically found in traditional stock and bond investments. But before delving into these benefits, let’s start with the basics of option trading.
What Are Options?
Options are financial instruments that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. They are versatile tools used in various investment strategies. There are two primary types of options:
Call Options
A call option provides the holder with the right to buy the underlying asset at the strike price before the expiration date. Call options are typically used when an investor anticipates that the price of the underlying asset will rise.
Put Options
A put option, on the other hand, grants the holder the right to sell the underlying asset at the strike price before the expiration date. Put options are commonly employed when an investor expects the price of the underlying asset to fall.
Key Terminologies in Options Trading
Before going any further, it’s essential to understand some key terms relating to options trading:
- Strike Price: The price at which the underlying asset can be bought (in the case of a call option) or sold (in the case of a put option).
- Expiration Date: The date by which the option must be exercised, or it becomes invalid.
- Premium: The price paid for an option, representing the cost of the contract.
- Intrinsic Value: The difference between the option’s strike price and the current market price of the underlying asset.
- Extrinsic Value (Time Value): The portion of the option’s premium not accounted for by its intrinsic value. It reflects factors like time until expiration and implied volatility.
- American Option: This type of option allows exercise at any time until its expiration date.
- European Option: These options can only be exercised on the expiration date.
- Index Options: These options are based on an index as the underlying asset. In India, settlement is typically done in the European style. Examples include Nifty and Bank Nifty options.
- Stock Options: These options are linked to individual stocks. They grant the right to buy or sell underlying shares at a specified price, with the regulator authorising American-style settlement for such options.
Participants in Option Trading
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Buyer of an Option
The one who pays the premium and thus buys the right to exercise his option on the seller/writer.
2. Writer/seller of an Option
The one who receives the option premium and thus is obliged to sell/buy the asset if the buyer of the option exercises their right to buy/sell the underlying asset.
Participants in Option Trading
In options markets, participants are classified based on their position: call buyers, call sellers, put buyers, and put sellers. Buyers are referred to as holders, while sellers are called writers. Buyers take long positions and sellers take short positions.
Importantly, call and put buyers (holders) have the option but not the obligation to execute the trade. On the other hand, call and put sellers (writers) are obligated to fulfill the trade if the buyer exercises their option.
Options come in two main types: calls, which allow the holder to buy an asset, and puts, which allow the holder to sell. Additionally, options are categorised as American or European, determining when the contract can be exercised.
How Does Options Trading Work?
Options trading revolves around buying and selling options contracts. These contracts give individuals the right to purchase or sell a set quantity of an underlying asset at a prearranged price by a specific date.
When engaging in options trading, it’s essential to understand that simply buying or selling an option doesn’t necessitate exercising it upon the contract’s expiration. These are known as “derivative securities” because their value is derived from underlying assets, securities, or other financial instruments.
This means that the price of options is directly affected by changes in the value of the underlying assets or other factors, such as market conditions and implied volatility. Options traders speculate on the future price movements of these underlying assets and aim to profit from these movements.
Difference between Option Trading and Other Instruments
Unlike stocks, which grant ownership, options offer contracts granting the right, not obligation, to buy (call) or sell (put) a stock at a specific price (strike price) by a certain date (expiry). This flexibility allows options traders to:
- Leverage their capital: Options control a larger share position for a smaller upfront cost (premium) compared to buying the stock outright or even a future on the stock. If you are buying an option, you can put up much less money than for a future.
- Hedge existing holdings: Puts can protect against stock price declines, while calls can hedge against missing potential upswings. However, those are not commitments as unlike futures, you can choose to not exercise the option.
- Speculate on price movements: Options offer directional bets (calls for upticks, puts for downturns) with potentially magnified profits (but also the potential for losing the entire premium).
However, options involve greater complexity and risk compared to buying stocks or bonds. They decay in value over time (time decay) and become worthless if not exercised by expiry.
How to Use Call Options?
- A call option allows the purchase of a specific quantity of shares or other assets at a predetermined price before the contract’s expiry.
- Profits are made when the asset’s price increases, as the call option allows buying at a lower predetermined rate, providing a discount.
How To Use Put Options?
- Put options enable the sale of a specified quantity of shares or assets at a predetermined rate before the contract’s expiration.
- Profits can be made if the asset’s price decreases, allowing the sale at a higher predetermined price and minimising losses.
Effective Strategies in Options Trading
Options trading offers a wide array of strategies that investors can employ to meet their financial objectives. These strategies can be tailored to various market conditions and risk appetites. Here are some of the key strategies in options trading:
- Long Call Options Trading Strategy: Involves buying a call option to profit from an expected increase in the underlying asset’s price. It offers the right to buy the asset at a predetermined price.
- Short Call Options Trading Strategy: Includes selling a call option to generate income. This strategy is suitable when you anticipate the underlying asset’s price won’t rise significantly.
- Long Put Options Trading Strategy: Involves buying a put option to benefit from a potential decline in the underlying asset’s price. It grants the right to sell the asset at a specified price.
- Short Put Options Trading Strategy: Entails selling a put option with the expectation that the underlying asset’s price will remain stable or increase. It generates income but carries the obligation to buy the asset if exercised.
- Long Straddle Options Trading Strategy: Requires simultaneously buying both a call and a put option with the same strike price and expiration date. This strategy profits from significant price movement in either direction.
- Short Straddle Options Trading Strategy: Involves selling both a call and a put option with the same strike price and expiration date. It generates income but carries the obligation to buy or sell the asset if exercised, typically used when expecting low price volatility.
Profitability Scenarios in Options Trading
In-the-Money (ITM)
An option is considered in-the-money when it has intrinsic value, meaning it would be profitable if exercised.
Example: You hold a call option with a strike price of ₹50, and the underlying stock is currently trading at ₹55. In this case, the call option is in-the-money because you can buy the stock at ₹50 and sell it in the market for ₹55, resulting in a ₹5 profit per share if exercised.
Out-of-the-Money (OTM)
An option is considered out-of-the-money when it has no intrinsic value and would not be profitable if exercised.
Example: You have a call option with a strike price of ₹60, but the underlying stock is trading at ₹55. This call option is out-of-the-money because there is no profit to be gained by exercising it, as you can buy the stock cheaper in the open market.
At-the-Money (ATM)
An option is considered at-the-money when the option’s strike price is equal to the current market price of the underlying asset.
Example: You hold a call option with a strike price of ₹60, and the underlying stock is currently trading at ₹60. This call option is at-the-money. If exercised, there is no immediate profit, but it holds potential depending on future price movements.
Advantages of Options Trading
- Cost-Efficiency: Buying options involves a lower initial investment compared to purchasing stocks outright, making it a more cost-effective approach for traders.
- Price Lock-in: Options enable investors to lock in a predetermined price (strike price) for the underlying asset, providing a level of price security until the option expires.
- Portfolio Enhancement: Options can enhance an investment portfolio by offering additional income, leverage, and protective strategies against market declines.
- Flexibility: Options trading is inherently flexible, allowing traders to employ various strategies before the contract expires, including adding shares to their portfolio, selling shares for profit, or selling the contract itself.
Risks Associated With Options Trading
While options offer various advantages, it’s crucial to be aware of the risks:
- Limited Lifespan: Options have expiration dates. If the market doesn’t move in the desired direction before the option expires, it can result in a loss.
- Complexity: Options trading involves a learning curve, and strategies can be complex. Novice investors should educate themselves thoroughly before engaging in option trading.
- Potential for Losses: As with any investment, there is the risk of losing the entire premium paid for the option.
- Market Volatility: Options can be highly sensitive to market volatility, which can amplify both gains and losses.
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FAQs
What is options trading, and how does it work?
Options trading is the system of buying or selling options contracts. These contracts are agreements that give the holder the choice to buy or sell a collection of an underlying security at a predetermined price by a specific date.
What are the 4 types of options?
Buying call option (long call), selling call option (short call), buying put option (long put), and selling a put option (short put) are the four types of options. Call buyers and put sellers are bullish. Put buyers and call sellers are bearish.
Is option trading better than stock trading?
There is no investment method that is better or preferable by itself over another. Long-term investors prefer investing in stocks that have steady growth over the course of time, while option traders try to bank on risk and volatility to make good returns.
Is option trading high risk?
Options trading can be riskier if a trader does not do due diligence towards various factors like market conditions, volatility, ongoing trend lines, etc. Options don’t have to be risky if the right way of hedging and protection is adopted.
Which option trading is safe?
Covered calls are one of the safest options trading methods. It enables the trader to sell a call and buy the underlying stock to reduce risks. This way, one can mitigate their risk while trying to maximise the returns.
