Options trading make a lucrative trading tool. It has the potential to yield unlimited profit with limited risks taken. Learn here what are Options and how to trade Options.
Options make a lucrative trading tool for the speculative traders. The reason is unlimited profit potential and limited risk in Option Trading. But it can also be very risky if you do not know how to trade Options.
Being a Derivative, Options allow traders to play the market both ways, for upside as well as downside. This property of Options makes them useful to the investors also, as a portfolio hedger to minimize the loss to long term portfolio holdings due to any impending downside risk in the markets. Cash leverage is the additional advantage with Options.
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How to Trade Options
Before we learn how to trade options, let us have some basic understanding if what are Options.
Options are derivatives similar to Futures. That means they are derived from underlying security (stocks, currencies, commodities, market indices etc. Here we shall go with examples of stock options trading for understanding purposes). As the price of the stock increases or decreases, the prices of Options also increase and decrease.
If a trader predicts that a stock is going to rise in very short period of time (few days), he can either buy stocks or buy Options. Buying stocks stock requires a big investment capital depending upon the number of stock one wants to buy. Options can be bought by paying comparatively much less amount. This amount is known as Premium.
Options operate in monthly Contracts. These contracts expire on the fourth Thursday of every month. So you can keep your position in Options trade till the date of expiry at the maximum or you can close your position as per your wish before the date of expiry.
If you don’t close your position till the date of expiry, it shall get expire at the last traded price of the last trading day. On expiry, the value of all Out of Money Options become zero. In the Money Options expire at a value of difference of Stock Price and Strike Price (Stock price – Strike Price).
Depending upon the liquidity or trading volumes in a security, the exchange may provide contracts for 1 month, 2 months or 3 months. To make it easy to learn option trading, we have taken a snap shot from www.icicidirect.com below which shows Contract details for Reliance (RELIND) stock.
See the following figure below. For a 900 Strike Price Contract of February 2015, the underlying security is Reliance Industries (RELIND), Stock Price is 928, Contract Expiry Date is February 26, 2015 (fourth Thursday), Strike Price is 900, Lot size is 250, LTP or Last Traded Price of Call Option is ₹ 45.
You shouldn’t make the mistake of assuming an Option a Cheap one which has low LTP. Head over to article on finding a cheap Option to know more about how to trade Options wisely.
Depending upon the liquidity, a number of contracts are made available by the stock exchanges for trading in an underlying security. These Contracts are available in the form of what we call a ‘Strike’.
Each Contract represents a group of a particular number of stocks called as ‘Lot’ size. For different company stocks, there is same or different Lot size. Lot size is fixed by the stock exchanges depending upon the market price of the stock.
Types of Options
As we talked above, Options allow you to trade for upside or downside. Thus you can have either a bullish view (upside) or bearish view (downside) on a stock or markets for the immediate short term.
You can trade your views by via stock Options trading. Options have been divided into two types depending upon these two views.
By definition, a Call Option gives the buyer of the Option the right to buy the underlying security at a specific price on or before the specific time period.
This specific price is fixed in the form of ‘Strikes’ and the specific time is the time of expiry. If a trader is expecting prices to go up for a stock, he/she can simply buy a Call Option. As the stock price rises, the Call Option price also increases.
How to Trade Call Option
Lets take an example of stock options trading. Suppose the stock Reliance is trading at a price of ₹1000. The stock exchange may define the Strikes for the Options as 940 960 980 1000 1020 1040 1060 and the Lot size is 250.
You expect price to move towards 1050-1060 before the expiry day. You would simply buy any strike call option.
The amount you pay to buy the Option is called as the ‘Premium’.
To learn Options trading in a better way, suppose you bought 1020 strike Call at a price of ₹25. You pay Premium of 25 x 250 = ₹6250. Now as the stock appreciates in price, you shall find that the price of the Call Option starts increasing.
Lets assume that stock price touches 1040 after a week and the Option price is at 45 and you sell it at this price. You get 45 x 250 = ₹11250 back. Your profit is 11250 – 6250 = 5000 or 45 – 25 = 20 x 250 = 5000.
By definition, a Put Option gives the buyer of the Option the right to sell the underlying security at a specific price on or before the specific time. Buying a Put Option is similar to Call Option.
The difference here is that you have a bearish view on the stock and you anticipate fall in stock price in the coming days. As the stock prices fall, the price of a Put Option increases.
How to Trade Put Option
Consider the above example. Suppose you expect stock to fall towards 950 from its current market price of ₹1000 in near future. Now you shall buy the Put Option of a lower strike to reap the benefit of price decline of stock.
Suppose you bought 980 strike Put Option at price of ₹25 by investing ₹6250. As the stock moved towards 950, the Option prices rises to ₹45 and you sell it. Here you get reward of ₹ 5000 when actually the stock price was falling.
Here we talked about buying Options only. We can add more versatility by selling (writing) the Options also. With buying Options, you have limited risk and unlimited reward potential. On the other hand, by selling an Option, you are getting a limited profit and unlimited risk on your position.
You might like to read whether writing Options is profitable indeed.
Options Trading Strategies
You may use various trading strategies with Options as per your requirement or circumstances. Some are simple buying or selling Options and some are as combinations of both. These are categorized as below –
1. Bull Spreads
2. Bear Spreads
3. Calendar Spreads