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.
Options trading involves simple trading strategies and complex options trading strategies which involve combination of different strategies which we will talk about in this article.
What Is Options Trading
Options trading is a trading strategy which involves buying and selling of options in financial markets. Our purpose is to buy options at low prices and later on sell these options at higher prices to make the profits. We can also do short selling in options. While short selling, we sell options at higher prices in anticipation of buying these options at low prices to make money and close our position. Options trading is different from stock trading.
Stock trading involves buying and selling of stocks or shares. A stock or a share is a small entity of a company and have its monetary value. When we buy shares of a company, we become a shareholder in the profits made through business of that company. We get profits in the form of rise in share prices, dividends announced by the company or the bonus shares issued by that company. We can sell shares on higher prices than the buying prices and pocket the profits. Selling shares ends our ownerships in the company’s future profits.
We can buy only the number of shares depending upon how much cash we have to buy the shares. We can buy even one share or hundreds or thousands of shares as per the permissible limit by the market regulators and our cash availiblity.
However, options are derivatives. That means they are derived from some underlying asset ; like stocks, market indices, commodities, currencies etc.
Buying options does not give you the ownership of the underlying asset.
Options operate in contracts which give the option buyer the right but not the obligation to buy or sell and underlying asset at a predetermined price at or before a predetermined time or date. The option may exercise or sell his/her option position on or before the contract expiry date or may simply let it to expire by doing nothing. The maximum loss in the later scenario is the option premium paid to buy the options.
Depending upon the way the options are exercised, they can be either American options or European options. However, depending upon the direction in which we want to play the stocks, options are of two types – call options and put options.
A call option is the right but not the obligation to buy an underlying asset at a predetermined price on or before a predetermined time. Similarly, a put option is the right but not the obligation to sell an underlying asset at a predetermined price on or before a predetermined time.
When we expect a share price to increase in near future, we can buy call options instead of buying that share. Options operate in various lot (number of share) sizes. A lot can have 100 shares, 500 shares or any number as fixed by the stock exchanges. So, we can buy one lot or multiple lots and not like one share of any random number of shares as in cash trading.
When the stock price increase, the value of call option also increases. As the number of shares in a lot size is more, our profits in options trading are also multiplied as compared to share trading. What is more is that buying an options lot requires much less money, the option premium, to buy as compared to money required in share trading in cash segment. Thus, with small amount invested, we can make big profits in short time periods. The maximum loss in a losing trade is only the premium paid to buy an option.
Let us take an example! A stock xyz is trading at ₹100 per share. You expect it to move to ₹110 in a week. You have ₹5000 in your trading account. Normally, you can buy 5000/100 = 50 shares (excluding brokerages). If the stock moves to ₹110, you end up making profits 10×50 = ₹500. However, you also have the option to buy a call option of strike 110 which is trading at say, ₹10. The lot size for the call option is, say, 500. You can buy that call option at option premium of 10×500 = ₹5000. When the stock price moves to 110, the price of call option also moves higher, say, to ₹20. Here, you close your position and get back 20×500 = ₹10000. So, you doubled your money with same investment through options trading.
Options trading make a very good trading idea. But you should be well prepared and have in depth knowledge about how options work. There are lots of advantages of options trading :
- Options trading has the potential to deliver high returns with small investments
- The risk of losing is limited to the premium paid to buy an option. You know your maximum loss before you enter a trade.
- Options add versatility to trading. We can do short selling and hold our short positions to carry forward to next trading session.
- Options trading can be done through various combination strategies to earn almost risk free returns.
- Professional traders and institutional investors use options as a portfolio hedging tools to protect their long term portfolios from sharp market falls.
Just as the cash leverage in options trading is an advantage in a profit trade, it becomes too risky in a losing trade. We can lose money fast. Let us know how to trade options and how to avoid the undue losses.
How To Trade Options ?
Options trading requires a lot of homework and knowledge to succeed. Your homeworks includes the research of the stocks in the form of chart reading, knowing the important things to keep in mind before jumping to the trade. We will take them one by one :
- Making a strategy
- Choosing right time frame for the trade
- Choosing the right option to trade
- Buying options
- Selling options
Making A strategy
Making a strategy or a trading plan is a very important part of trading. Studying the technical charts or technical analysis makes the backbone of your homework. Read the daily technical charts and look for the current trend in the general market and the stocks following that trend. In options trading, we can not stay in a trade for many days, so we need to study the charts keeping our time frame very short. Daily candlestick charts are the best to find stocks for options trading.
- Look for stocks with fresh breakouts or breakdowns from important moving averages like 10 day EMA (exponential moving average), 30 day EMA, 50 day SMA (simple moving average) or 200 day SMA.
- Stocks breaking above or down of trendlines, support or resistance lines.
- Stocks making important short term candlestick patterns.
- Use technical indicators like relative strength index (RSI), MACD (moving average convergence divergence) indicators or stochastics to support the expected future price movements along with the above breakouts or breakdowns.
The stocks showing above behaviors are perfect stocks for options trading. Trade only after the confirmation of above signals at the end of day close. Never make your own opinion or anticipate without adequate signals. Trade along the larger trend in the markets. Picking stocks for short selling in bullish markets is not worthy even though the stock is in bearish mode.
At the end of your research, you should be ready with your entry price levels, target price levels and your stop loss price levels for the stock. If you are not sure of anything of these, do not trade.
Choosing The Right Time Frame
Right time frame for trading in options is very crucial. You have to remember that there are so many factors which affect the option pricing. Time decay is one of them. For option buyers, it is the race against time.
Make sure to make your trading strategy such that targets are not too big and not taking too much time to achieve them. The time decay is the biggest enemy of option buyers. If you want to buy options, keep your time frame for trade very short, not more than 4-5 days. If the trade does not work in these days, it is better to exit the trade rather than keep waiting for the targets and loosing money to time decay. If you are option seller, you can, of course, keep the trade running.
Whenever, your target is achieved or you believe you have made enough profits, exit the trade quickly.
Choosing The Right Option To Trade
After you have prepared your strategy, you should be knowing about the general trend of the market (bullish or bearish) , current trend in the stock you chose (bullish or bearish) and which type of option (call option or put option) you would be trading in.
You need to remember 4 simple things before we further learn how to trade options :
- Buy call options – bullish view
- Sell put options – bullish view
- Buy put options – bearish view
- Sell call options – bearish view
So, you can either buy call and put options or sell call and put options. You can buy or sell options as single or multiple options in combinations.
Now which option is the right option to trade? There are three types of options – in the money (ITM) options, at the money (ATM) options and out of the money (OTM) options. Most of the beginners in options trading has the tendency to buy OTM options because they are available for low premium and look cheap options to buy. Actually, they are never but actually costly because they have no intrinsic value.
Always buy in the money or at the money options. The premium decay is not very fast in these options as compared to the out of the money options.
ITM or ATM options are the options which are as near as possible to your entry level you found in the research above.
Time decay in option premium is an important thing to remember before you buy options. It is the decrease in option premium with each passing day, even if the stock price remains same. Premium decay is the biggest enemy of an option buyer and best friend of an option seller. Premium decay is fast in the OTM options and when the time left to expiry is short.
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.
Buying Call And Put Options
Buying options is quite a simple strategy to trade options. You can buy options by paying option premium. To buy a call option or put option depends upon our speculation or prediction which should be based on technical chart reading.
If you expect the underlying asset price to move higher, you can simply buy call options. With increase in the underlying asset price, the option price will also increase. These options can be exercised or sold at higher price on or before the contract expiry date. The difference between selling and buying price is your profit.
If you expect the underlying asset price to fall in near future, you can simply buy put options. The value of put options increase with fall in underlying asset price. The put options can be exercised or sold on or before the contract expiry date with difference between selling and buying being your profit.
Selling Call And Put Options
Above, we talked about buying options only. We can add more versatility by short selling the options also. This is also called as writing options.
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.
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 –
Bull spreads is the strategy of buying an at the money or in the money call option and selling an out of the money call option of the same expiry. This strategy is applied when the stock is expected to move higher but with limited upside. The option trader in bull spreads makes money from increase in low strike call option premium and fall in higher strike call option premium.
Bear spreads are similar to bull spreads except that here we trade in put options. Higher strike put options are bought and low strike put options are short sold. The limited downside in stock price results in profits earned.
Calendar spreads involve options trading in options from different expiry option contracts.
Straddles in options trading are applied when strong moves are expected in markets or stock prices but the direction of move is uncertain. It can move up or down and in short time. Call and put options of the same strike and same contract expiry are bought. A sharp move causes one option to increase in value and decrease in the other option price. Difference between the option premium received at the time of exiting the trade is your profit.
Strangles in options trading are similar to straddles except that the options traded in strangels or of different strikes. So, here a very large move in the underlying asset price is needed to turn this strategy into profits.
Important Things To Know 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.
- Trade options in stock with high liquidity. It makes easy to enter and exit the trade quickly from liquid trades.
- Avoid buying options when implied volatility is very high as compared to historical volatility levels. Higher volatility leads to higher premium. Sometimes, this volatility cools off quickly after the passage of an event and the option premium falls very fast leading losses even though the stock is moving in desirable direction.
- 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.