Future & Options
| July 27, 2023
Introduction to Options Trading: A Beginners Guide
Everyone like to have options so that they can choose as per their wish. This is what options trading gives you, the option to choose. In the stock market, or to be specific derivatives market, options are like the ruler, with all the power and no obligations.
However, for beginners, option trading may seem a bit complex, as there are a lot of things to keep in mind while trading options. That said, options are also one of the best ways to trade in the market without putting in a lot of money, however, that doesn’t restrict your profit potential. Let us find out how and to do that, we need to dig deeper.
What are the options? What is option trading?
Options are derivative contracts, which are used to speculate the price of the underlying asset and trade accordingly. These derivative contracts offer the buyer the right to buy or sell the underlying asset at a specified date for a pre-determined price. While you get the right to buy or sell the underlying asset, there is no obligation to do it. This is the feature that makes options most sought after.
So, Options trading can be defined as the trading process of buying and selling these option contracts.
Types of Options
Call option: Call option offers the ‘right to buy’ the underlying asset at a predetermined price on a specified date, without any obligation. Traders purchase the call option when they think the price of the underlying asset may go up in the future. So, in order to make a profit, they buy call options by paying a premium, which gives them the right to buy the underlying asset at a future date for a pre-determined price.
Suppose, you think the price of stock A will go up next month as the company is coming up with new products, which have huge demand in the market. Let's say, the current price of stock A is Rs. 1000. You are anticipating the price of the stock to go up to Rs. 1200 next month. Therefore, you buy the call option at a strike price of Rs. 1050. You bought five lots, and each lot has 100 stocks, and the premium you paid is Rs. 2000 each, which means a total of Rs. 10000, paid as a premium.
Now there can be two scenario:
Scenario 1: Price of stock A goes up to Rs. 1250 next month
If this happens, then you can execute your call options, and buy 500 units of stock A at a price of Rs. 1050.
Buying price = Rs. 1050*500 = Rs. 525000
Premium paid earlier = Rs. 10000
Total investment = Rs. 535000
You can sell the shares at a price of Rs. 1250 each.
Selling price = Rs. 1250*500 = Rs. 625000
Net profit = Total Investment – selling price
= Rs. 625000 -535000
= Rs. 90000
Scenario 2: Price of stock A decreases to Rs. 950 next month
Now, since, the price drops against the expectation, you choose not to execute the contract. As there is no obligation to execute the contract on the contract buyer.
Thus, your total loss would be the amount of premium paid in this case which is Rs. 10000.
However, if you had invested in the stock instead of buying the call option, then
- First, you had to invest Rs. 525000 at one go for buying 500 shares at Rs. 1050 each.
- Secondly, if the price drops to Rs. 950 each, then your loss would have been Rs. 100 per share. Therefore the total loss would have been Rs. 100*500 = Rs. 50000.
So, instead of losing Rs. 50000, you lost Rs. 10000, which is much better, isn’t it?
Put Option: When you believe or anticipate the price of an asset to go down, you can buy a put option as this derivative contract gives you the right to sell an underlying asset at a predetermined price on a specified date, without any obligations of executing the contract.
Again let’s understand this with an example;
Suppose, you think the price of stock B will decrease in September 2023, as the company is not performing well in this quarter. So, purchase five Put options, by paying a premium of Rs. 2000 each, which makes it Rs. 10000 in total. The lot size of each put option is 100 shares. Thus, you can sell 500 shares at the end of the contract. Now, the current market price of stock B is Rs. 1000, and you think it will come down below Rs. 900 each by September. Therefore, the put options you bought have a strike price of Rs. 1000 for each share.
Here, like above, can be two scenarios;
Scenario 1: The price of stock B goes down to Rs. 850
Since the price of the stock has come down as per your anticipation, you will execute your contract.
To buy 500 shares, your investments would be Rs. 850*500 = Rs. 425000
Selling price = Rs. 1000*500 = Rs. 500000
Gross profit = Rs. 500000 -425000 = Rs. 75000
Premium paid = Rs. 10000
Net profit = Rs. 65000
Scenario 2: Price of stock B goes up to Rs. 1100
In this case, you can choose not to execute the contract and your loss would be limited to Rs. 10000 which is the premium amount paid by you.
Suppose, you had short-sell 500 units of stock B at Rs. 1000, you had made Rs. 500000 then. However, if the price went up to Rs. 1100, for squaring off your position, you had to buy stock B at Rs. 1100 each, which means, an outlay of Rs. 550000. Therefore, in this case, your loss would have been Rs. 50000.
The extent of Profit and loss
- In the case of a call option, the maximum profit can be infinite for the call option buyer. This is because the price of the underlying asset can go up to any extent, and thus, there is no upper limit on the profit.
- In the case of a put option, the maximum profit for the option buyer is the difference between the strike price of the contract and Rs. 0 as the price of the underlying asset cannot go below that.
- The losses in both cases can be up to the amount of premium paid.
Important concepts of option trading
In option trading, there are certain terminologies and concepts which you need to keep in mind. These include –
Strike price: This is the price, which is determined at the time of drawing the option contract at which the buyer of the option contract will be able to buy or sell the underlying asset. As per the example for a put option, the strike price is Rs. 1000 which means the put option buyer, can sell the underlying asset which is stock B in that example at a price of Rs. 1000 when the market price has dropped to Rs. 850.
Expiration date: The contract will become executable on this date. It is also the expiration date and this is specified at the time of making the contract. Suppose, in the above example, the expiration date is 9th September, then on 9th September, if the price is below the strike price, and the option buyer is willing to execute the contract, he or she can. However, if not, then it will expire.
Premium: The premium is the amount you pay in order to purchase the option. In the above example, Rs. 5000 is the total premium paid for buying the five lots of put option. The premium is determined on the basis of the price of the underlying asset and values.
Intrinsic Value: in options trading, intrinsic value means the gap between the strike price of the option contract and the present market price of the underlying security. So, in the above example of a call option, the gap between the strike price and the current market price is Rs. 50 which is the intrinsic value.
Extrinsic value: This value is a qualitative measure of representing factors like is the premium amount for the contract is justifiable or not, how long the option will be good, and other such factors, which are not considered by the intrinsic value.
In-the-money option: If an option contract is profitable depending on the price of the underlying security and the time until expiration, then it is known as an in-the-money option. In the above, example, the time of expiration is in September. The strike price is Rs. 1000 and the underlying security’s price was Rs. 1000 at the beginning of the contract. So, the option will be in-the-money until the market price of the underlying security doesn’t go above the Rs. 1000 mark. Since, it is a put option, where you will make a profit when and if the price of the underlying security goes down. Therefore, it will be in-the-money until the price of the underlying security doesn’t go above the strike price.
Out-of-the-money Option: This is when the option contract becomes unprofitable. Going by the above put option example again, if the price of the underlying security goes above the strike price of Rs. 1000, then it will become an out-of-the-money option, as the price went up against your anticipation of price going down.
How to start options trading?
If you are starting with options trading, then here are the steps you need to follow.
- Firstly, you need to have an online trading account, which you can easily open with our quick and easy, paperless account opening process.
- Now the next step is crucial, where you start finding those securities, which have the potential upside and downside. Once you find the same, you need to anticipate whether the price will go up or down in the future. If you think it will go up, you have to buy the call option and if you think it will go down you will have to purchase put options.
- Then you need to determine the strike price of the option contract and also analyse if the premium that you have to pay is reasonable or not.
- Next, you need to determine the period for the potential rise or decrease in the price. This is required for deciding the expiration date of the contract.
- Once all these are sorted, you pay the premium and buy the options.
- Now, upon expiration, if the options are in-the-money, then you can execute them and make a profit, while if they become out-of-the-money, then you can choose not to execute them.
So, this is how you start options trading in the beginning and once you grow, you can learn new option trading strategies to generate better results.
Option trading strategies for beginners
As a beginner in the option-trading arena, you can use the following three option-trading strategies to your benefit.
Long call: This is one of the basic options trading strategies that beginners can use while trading options. Here you have to buy call options when you think the price of the underlying security will increase in the near term. Since you have to buy the call option, it is known as the ‘going long’ on-call option and thus, long call. In this strategy, there is no cap on the profit, while the loss is limited to the amount of premium paid.
Long Put: When you expect the price of the underlying security to do down in the near future, you can buy put options, which is known as long put as you are ‘going long’ on the put option.
Covered call: This options trading strategy is a little advanced where you have to sell a call option which means you are ‘going short’ as you expect the price of the underlying security to reduce but to protect yourself from the losses, you also buy underlying security equivalent to the number of units in the call option sold by you. You receive the call option premium as you sell the option in this strategy. Now if the price of the underlying security decreases below the strike price, as expected by you, then the call option buyer will not execute the contract, so, you do not have to sell the underlying securities and your profit is the premium you have received. On the contrary, if the price of the underlying security goes up against your expectation, then you sell the securities you have bought to the call option buyer at the strike price and the premium is retained by you, which is your profit.
Why you should consider options trading?
Infinite returns: The maximum profit that one can make with options, especially the call option has no upper limit. It can go up to any extent as the price of the underlying security can increase in that way. Even in the put option, one can make a profit to the extent of the price of the underlying touching the floor.
Low-cost – high return: While the return potential is superb with options trading, the cost of trading these instruments is limited to the premium amount. This helps traders to generate higher returns without investing a lot of money.
Lower Risk Potential: The risk potential of the options is limited to the amount of premium paid.
Multiple strategies: There is a wide range of option trading strategies, which the traders can pick to enhance their trading and generate positive returns.
While buying or selling securities directly can help you make good returns, the downside is too risky as well and thus, trading options become more sensible to mitigate the risk to quite an extent while increasing the profit potential. However, you need to be cautious and evaluate everything before you start trading options.