Options can be a complex and intimidating world for beginners, but it can also offer significant opportunities for investors. They make a versatile trading tool. Buying and selling of options on stock exchanges is called as options trading.
They offer a lot of advantages to the traders. They allow trading stocks in big quantities by paying very small amount of money. The profits potential is much higher for options buyers with small risk involved. That is the reason for their popularity among the retail traders and the beginners in trading.
Although they have the potential to yield big profits with small amount invested, the risk is also equally big. If not done diligently and with proper plan, you may lose your money fast.
This guide will provide an overview of what options are, how they work, and some basic strategies for trading them. Whether you’re a seasoned investor or just starting out, understanding options can help you make more informed investment decisions.
What Are Options
Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and time. The underlying asset can be a stock, commodity, currency, or index. So, they are derivatives which means that their value is derived from the underlying asset.
Options can be used for hedging, speculation, or income generation. The price of an option is determined by various factors, including the price of the underlying asset, the time until expiration, and the volatility of the underlying asset.
They work in the form of contracts. These contracts can be weekly or monthly (fixed by the stock exchanges) having weekly or monthly expiry. After the expiry date, the value of the contract becomes zero.
If a trader has bought an option and it increases in value after some time, the trader may choose to sell it and pocket the profits. Otherwise, the trade can be carried along till expiry date in expectation of more profits and either closed before the expiry date or let it expire on the expiry day at the last traded price.
However, the trader can also opt to exercise the option contract. Exercising option contract means to apply for the delivery of the underlying stocks before the contract expiry date.
Depending upon the time to exercise and expiry of the contract, options can be American or European.
American options can be exercised any time before the contract expiry date. They are very popular among the traders. The reason is that the traders can buy underlying stocks though options contract by paying small option premium and keep it as long as before the expiry date. Near the dividend announcement date by the company, they can exercise them and take the delivery of the underlying stocks and become eligible for dividend payout.
European options do not have such luxury for the traders. They can be exercised only on the day of contract expiry. So, the traders cannot take the delivery of the stocks if the dividend payout date is earlier than the contract expiry date.
Options are ‘long only’ type of trading tool. That means, if you expect the stock price to rise in short term, you can buy an option and make profits from the stock price rise. But if you expect the stock price to fall in short term, you can again buy an option and make profits from the stock price fall.
Types Of Options
Options are of two types: call option and put option.
What is a Call Option
By definition, a call option gives the buyer of the option the right to buy the underlying asset at a predetermined price on or before the contract expiry date.
A trader expecting stock prices to go up can simply buy a call option. This is equivalent to buying stocks which the trader will want to sell when the stock prices increase. As the stock price rises, the value of call option also increases.
The trader may sell (exercise) the call at higher price and close the trade. The difference between selling and buying the call option is his/her profit.
Thus, when we have bullish view on any underlying, we can buy a call option.
What is a Put Option
By definition, a put option gives the buyer of the option the right to sell the underlying asset at a predetermined price on or before the contract expiry date.
As the stock prices fall, the price of a put option increases. Buying a put option is like short selling a stock in margin trading. However, with put option, you can carry forward your short position to next day unlike margin trading which is only available for intraday trading.
Components Of Options
An option has some important components which you must know. These are five components:
- Current market price of underlying
- Contract expiry date
- Strike price
- Lot size
- Current option price
To make it easy to learn, 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)
Some of these components are direct determinants of option prices. They are current market price of the underlying, the expiry date and the strike price. Understanding about them is very important for options trading.
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 increase in stock price leads to increase in call option prices while fall in put option prices. on the other hand, fall in stock price leads to increase in put option prices while decrease in call option prices.
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 weekly or monthly contracts. At the end of the week or 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 stock exchange may provide contracts for 1 month, 2 months or 3 months expiry.
The contract expiry date in case of our example stock 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 we don’t close our 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 becomes zero. In the money options expire at a value of difference of stock price and strike price (keep reading).
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. Stock exchanges also keep on enabling or disabling the new strikes as the stock keeps on making quick moves in any direction. For example, if the stock moves from spot price of 1497 to, say, 1700 due to any sudden move, the strikes around 1700 will get enabled.
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.
What Is In The Money Option (ITM)
An option 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 is what is in the money 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.
What Is At The Money Option (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 and the strike lower than 1497, that is, 1480 shall be an at the money put option.
What Is Out Of The Money Option (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 and 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.
Options trade on the stock exchanges at a certain price. This price determined on the basis of current market price of the underlying and several other important factors affecting the option prices. This is what is option premium of that stock option.
The two most important constituents of option premium are the time value and the intrinsic value of an option.
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. But that does not make the farther strike options as cheap options to buy.
Strategies for using Options in Your Investment Portfolio
Options can be a valuable addition to your investment portfolio, but it’s important to have a strategy in place before getting started.
One common strategy is using options to hedge against other investments, such as buying put options to protect against a potential drop in the stock market.
Another strategy is using options to generate income, such as selling covered call options on stocks you already own.
It’s important to do your research and understand the risks and rewards of each strategy before implementing them in your portfolio.
Options make a very good trading tool if used diligently, with proper research and discipline. You can make money fast with options trading with small risk taken.