Options trading make a lucrative and versatile trading tool. Buying options has the potential to yield unlimited profit with limited risks taken. Learn here what are options and how to trade in options.
Options trading is an attractive and popular trading tool for the traders. Earlier, only institutional investors and mutual fund houses used to trade options as a portfolio hedging tool. But now more and more retail traders and beginners in stock trading also want to trade options.
The reason for popularity of options trading is the potential of options to make a large sum of money in a short span of time . In addition to that, the risk of loss in options trading is limited due to the inbuilt mechanism of risk management in options.
Options enable you to make big profit in quick time because of the cash leverage. You do not require much money to trade options in contrast to cash trading which requires big money to earn big profits. By paying very small amount of money, known as ‘option premium’, traders can create a long position in options. You may head over here to know what are options and the types of options such as call options and put options.
Options trading involves simple trading strategies and complex options trading strategies which involves combination of different strategies which we will talk about in this article.
How To Trade Options ?
You would need a trading account to start trading options. These days, you can easily get an online trading account from any broking house of your choice. Most of the trading accounts have futures and options trading enabled for retail traders. See below how it looks like :
As we talked above, options trading allow you to trade stocks or any underlying for upside or downside in prices. Thus you can have either a bullish view (upside) or bearish view (downside) for a stock price for the immediate short term.
How to Trade Call Option
Lets take a stock options trading example. In the above example, the stock Reliance is trading at a price of ₹1497.
You expect price to move towards 1520 before the expiry day. You would simply buy any strike call option.
To learn options trading in a better way, suppose you bought 1520 strike call option at a price of ₹10.
To buy the call option, you need to pay a premium = strike price x lot size : 10 x 500 = ₹5000.
Now as the stock appreciates in price, you shall see that the price of the call option starts increasing.
Lets assume that stock price touches 1520 after a week and the option price is at 20. You have achieved your target and you can sell it at this price. You get 20 x 500 = ₹10000 back.
Your profit is 10000 – 5000 = 5000 or selling price – buying price or 20 – 10 = 10 x 500 = 5000.
How to Trade Put Option
Consider the above example again.
Suppose you expect stock to fall towards 1470 from its current market price of ₹1497 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 1470 strike put option at price of ₹25 by investing 25 x 500 = ₹12500. (not seen in the above image as it was for call options only :))
As the stock moved towards 1470, the option prices rises to ₹45 and you sell it. Here you get profit of ₹ 10000 when actually the stock price was falling.
Now, we learnt how to trade options by simply going long on an option – either buying a call option or a put options. This is long only options trading.
Selling The Options
Above, 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.
This is simply the vice versa of buying options.
We saw above that when the price of underlying increases, the price of call option increases and at the same time the price of put option decreases. When the stock price decreases, the price of put option increases while that of call option decreases.
We can use this property to our advantage through selling options. If we expect the stock price rise, simply sell the put option. When the stock price rises, the price of put option will fall and we can buy back at lower price and close our trade, pocketing the profits.
Similarly, we can sell the call option when we anticipate the decline in stock price. We close the trade at low call option price after the stock decline, again pocketing the profits.
The most important thing to remember in option selling is that here your risk potential is unlimited and the profits are limited. This is opposite to what we saw in options buying.
This is similar to short selling in stocks where we gain from fall in stock prices.
You might like to read whether writing Options is profitable indeed.
Options Trading Strategies
You may use various options trading strategies as per your requirement or circumstances. Some are simple buying or selling options and some are as combinations of both. These combinations are categorized as below –
1. Bull Spreads
2. Bear Spreads
3. Calendar Spreads
Important Things About Options Trading
There are some very important things to keep in mind while trading options. Otherwise, the losses are significant. You would not even realize when you emptied your trading account. These are :
- Trade options only when you are very much sure of price moves in the stock.
- Trade options for very short term only unless you are selling options. Time decay is against the option buyers while works in advantage to the option sellers.
- Do not buy far away strike options (out of the money options). They have low premium. A far out of the money looks like a cheap option to buy but actually it is not so.
- Always buy at the money or in the money options. Option premium to buy these options is higher than the far strikes but the time decay is very slow in them.
- Selling naked options carries substantial risk. Use strict stop losses or covered options to limit the risk.
- Buying naked options although carries limited risk, it is also not a good strategy unless you do it very diligently. Premium erosion is very fast if the stock does not move as expected and you are forced to hold on to your position for few more days.
Options trading can make you quick money if done with wisely and with due diligence. The capital required is much less for buying options but many factors are working against an option buyer. The buyer needs to be very accurate and disciplined to make money in options trading.
Smart traders in the market always sell options. With selling options, although your profits are limited but the time decay works in your favor. Even if the stock remains stagnant at a price for days, option seller makes money while option buyer looses.
Thus, always take your options trade after adequate homework and research. Never get caught in the allure of trading big with small money in a hope to make a fortune in short span of time with options trading.