Options trading make a lucrative and versatile trading tool. It has the potential to yield unlimited profit with limited risks taken. You can trade a stock or index using plain vanilla options or complex strategies as per the requirements. Learn here what are Options and how to trade Options.
Options trading make a lucrative trading tool for the speculative traders. The reason for popularity of options among the amateur or inexperienced traders is the low initial investment cost and the potential for unlimited profits with limited risk.
Options buyer can make relatively big gains with options trading. This is because of the cash leverage, the options provide. By paying only a small amount of money, known as Option Premium, one can have a big trading position.
If the trade moves in favorable direction, you make handsome gains which can be infinite. If the trade does not work, your maximum loss will be only the premium you paid to buy the options.
Moreover, options allow traders to play the market both ways, for upside as well as downside. Thus, you can make money in falling markets also. You can do short selling and carry forward our trading positions to the next day in bear markets.
In this way, options are better than stocks. With stock trading, that is not possible.
This property of options makes them useful to the investors also. Options are used as a portfolio hedger to minimize the loss to long term portfolio holdings due to any impending downside risk in the markets.
But options trading can also be very risky for your capital if you do not know how to trade options.
Cash leverage is actually a double edged sword. It is beneficial as well as risky. Although profit potential rises many folds, so is our risk potential.
You can loose your money fast. There are several factors which are acting against an options buyer. It is better to learn option trading well before jumping to the wagon.
Table of Contents
What Are 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/she can either buy stocks or buy options.
Buying stocks requires a big investment capital depending upon the number of stocks one wants to buy. Options can be bought by paying comparatively much less amount. This amount is known as Option Premium.
Options operate in monthly contracts. These contracts expire on the fourth thursday of every month or any day fixed by the exchanges.
So you can keep your position in options trade till the date of expiry at the maximum or you can close your position before the date of expiry.
Thus, there are five things to know about options:
- Current market price of underlying
- Contract expiry date
- Strike price
- Lot size
- Current option price
To make it easy to learn option trading, we will use an example.
We have taken a snap shot from www.icicidirect.com below which shows the options contract details for Reliance Industries (RELIND) stock.
See the following figure below.
Current Market Price of Underlying
The price of option depends upon the current market price of the underlying. As the price of underlying stock or index changes, so does the price of options.
The current market price or the spot price for the Reliance stock is 1497.95 as seen in the below image.
Contract Expiry Date
Options operate in monthly contracts. At the end of the month, a contract expires. At the time of expiry, the prices of all the options become zero.
Depending upon the liquidity or trading volumes in a security, the exchange may provide contracts for 1 month, 2 months or 3 months expiry.
The contract expiry date is Feb 27, 2020 for the February contract (image below).
We can opt to exit the trade with the profits or the losses whenever we wish till the expiry of the contract.
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).
Strike prices are the reference prices for any contract. You can buy or sell any particular strike price option for trading.
Multiple strike prices are available around the current market price of the underlying. You can trade with any strike price, depending upon the trading plan.
For the stock of Reliance, multiple strikes from 1180 to 1700 are available for call options. That is also fixed by the stock exchanges.
The options can be of three types depending upon the strike price. If you do not understand it at this time, you may keep on reading further and come back after finishing the article.
In The Money Options (ITM)
In the money options are the options with strike price less than the current market price of the underlying for a call option and strike price higher than the current market price of the underlying for a put option.
In the above example, the current price for Reliance is 1497. Thus all the call options with strikes below 1497, that is, 1480 and lower are in the money options.
For put options, in the money options are with strikes above 1497, that is, 1500 and higher.
At The Money Options (ATM)
At the money options (ATM) are the strikes which are very near to the current price of the underlying stocks or index.
In the above example, the 1500 strike call option is at the money option. For the put options, the strike lower than 1497, that is, 1480 shall be an at the money option.
Out Of The Money Options (OTM)
Out of the money options (OTM) are the options with strikes far away from the current market price of the underlying.
In the above example, 1520, 1540 and higher are the out of the money call options. For put options, strikes 1480, 1460 and lower are all out of the money put options.
For stock trading, you can trade with any number of stocks ; be it one stock, 10 stocks, 50 stocks or 100 or any number (depending upon money in your account).
However, with options trading, we can trade with fixed number of units only. This fixed number is called as a ‘Lot’. Different stock options have different number of Lot size. In some countries, the Lot size is fixed to 100 for all stocks.
For Reliance stock, in the image above, the Lot size fixed is 500.
Option price is the price determined on the basis of current market price of the underlying. It keeps on changing with the changes in the underlying price.
There are several other important factors which affect the option prices. You must know about them before you go for options trading.
Different option strikes are available at different market price. The strikes which are below or closer to the spot price of the underlying stock have higher prices. The farther strikes have lower prices.
Types Of Options
Till now, we have learnt what are the options and the basic things about an option. Now we move on to types of options.
Options are of two types : call option and put option
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.
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.
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.
As the stock prices fall, the price of a put option increases.
How To Trade Options ?
As we talked above, options trading allow you to trade for upside or downside. Thus you can have either a bullish view (upside) or bearish view (downside) for a stock price or markets for the immediate short term.
If you have bullish view on the markets or a stock, that means you expect the prices to rise in immediate term. In case of bearish view, the prices are expected to decline in the immediate term.
How to Trade Call Option
Lets take an example of stock options trading. 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 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 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). 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.