Options Trading For Beginners And How Does It Work?

Options knowledge is a success factor for any option trader.  In this article, let us understand Options Trading For Beginners And How Does it Work?

What are Options?

Options are tradable contracts that investors use to speculate about whether an asset’s price will be higher or lower at a certain date in the future, without any requirement to actually buy the asset in question.  Options are also called as derivative as they derive their value from its underlaying asset.

What is option trading?

Options trading is nothing but buying or selling of an option contract of a stock, Index, currency, commodities or bonds. Buying or selling of options contract depends on investors research on market direction.  One can buy/sell call or put based on his research and strategies.   Option trader has multiple options to trade in options contracts. Options contracts give you the choice but not the obligation to buy or sell an underlying asset at a specified price by a specified date.  There is no physical exchange of documents at the time of entering into an options contract. The transactions are recorded in the stock exchange. Option trading volume is high in Nifty, Banknifty, and stock options followed by Finnifty and currencies.

Types Of Options

There are 2 types of options the ‘Call Option’ and the ‘Put Option’.

Call Option Example:

Let’s say the current Bank Nifty index is trading at 40,000. You believe that the index will increase in the near future. To capitalize on this, you decide to buy a call option.

Call Option: Bank Nifty Call Option with a strike price of 40,500 expiring in one month.

Premium: Rs.200 (the cost of the option contract).

Scenario 1: If the Bank Nifty index increases to 41,000 at expiration, you can exercise your call option. By exercising the option, you have the right to buy Bank Nifty at the strike price of 40,500, even though the current market price is 41,000. You make a profit of 41,000 – 40,500 – 300 = Rs. 200.

Scenario 2: If the Bank Nifty index remains below the strike price of 40,500, it is not profitable to exercise the call option. In this case, you would let the option expire and your loss would be limited to the premium paid, which is Rs. 300.

Put Option Example:

Now let’s consider a put option example where you anticipate a decrease in the Bank Nifty index:

Put Option: Bank Nifty Put Option with a strike price of 40,500 expiring in one month.

Premium: Rs. 250 (the cost of the option contract).

Scenario 1: If the Bank Nifty index drops to 40,000 at expiration, you can exercise your put option. By exercising the option, you have the right to sell Bank Nifty at the strike price of 40,500, even though the current market price is 40,000. You make a profit of 40,500 – 40,000 – 250 = Rs. 250.

Scenario 2: If the Bank Nifty index remains above the strike price of 40,500, it is not profitable to exercise the put option. In this case, you would let the option expire and your loss would be limited to the premium paid, which is Rs. 250.

These are simple examples to explain the concept of call and put options.

Option Trading Key Terminologies

Option trading looks complex but if you understand it thoroughly it is easy to understand and manage. Let us understand few key terms used in option trading:

Option Chain: An option chain is a list of all available options for a particular underlying asset. It displays various strike prices, expiration dates, premiums, and other relevant information.

Call Option: An option contract that gives the holder the right to buy the underlying asset at a predetermined price (strike price) within a specific timeframe.

Put Option: An option contract that gives the holder the right to sell the underlying asset at a predetermined price (strike price) within a specific timeframe.

Strike Price: The price at which the underlying asset can be bought or sold when exercising an option contract.

Premium: The price paid by the buyer to the seller for the option contract. It represents the cost of buying or selling the option.

At-the-Money (ATM): A call or put option is at-the-money when the market price is approximately equal to the strike price.

Out-of-the-Money (OTM): A call option is out-of-the-money when the market price is lower than the strike price. A put option is out-of-the-money when the market price is higher than the strike price.

In-the-Money (ITM): A call option is in-the-money when the market price of the underlying asset is higher than the strike price. A put option is in-the-money when the market price is lower than the strike price.

Option Buyer: The buyer of an options contract is called the ‘options buyer’.

Options Writer: The seller of an options contract is called the ‘options writer’.

Bid Price: The bid price is the highest price that a buyer is willing to pay for an option contract at a given moment.

Ask Price: The ask price is the lowest price at which a seller is willing to sell an option contract at a given moment.

Bid-Ask Spread: The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for an option contract. It represents the transaction cost of trading options.

Market Order: A market order is an instruction to buy or sell an option contract at the current market price. The order gets executed immediately at the best available price.

Limit Order: A limit order is an instruction to buy or sell an option contract at a specific price or better. The order will only be executed if the market reaches the specified price.

Stop Order: A stop order is an instruction to buy or sell an option contract once the market price reaches a specified level. It is used to limit losses or capture profits.

Expiration Date: The last day on which the option can be exercised. After this date, the option contract becomes invalid.

Contract Size: The number of units of the underlying asset that each option contract represents.

Open Interest: The total number of outstanding option contracts in the market.

Long Position: When an investor holds or buys options, they are said to have a long position. They profit if the market moves in their favor.

Short Position: When an investor sells options without owning them, they are said to have a short position. They profit if the market moves against the buyer of the options.

Exercise: The act of using the right to buy or sell the underlying asset at the strike price before the option expires.

Implied Volatility (IV): Implied volatility represents the market’s expectation of the future volatility of the underlying asset. It is a crucial factor in determining the price of options.

Delta: Delta measures the sensitivity of the option’s price to changes in the price of the underlying asset. It indicates the degree to which the option price will move in relation to the underlying asset’s price movement.

Gamma: Gamma measures the rate at which the delta of an option changes in response to changes in the price of the underlying asset. It helps gauge how sensitive the delta is to price movements.

Theta: Theta measures the rate of time decay of an option’s value as the expiration date approaches. It quantifies the amount by which the option’s value decreases with the passage of time.

Vega: Vega measures the sensitivity of an option’s price to changes in implied volatility. It indicates the impact of changes in volatility on the option’s value.

Spread: A spread involves simultaneously buying and selling two or more options of the same type (either calls or puts) but with different strike prices or expiration dates. Spreads are used to limit risk, control costs, and potentially profit from price movements.

Covered Call: A covered call strategy involves owning the underlying asset (such as stocks) and simultaneously selling call options on that asset. It can be used to generate additional income while holding the asset.

Protective Put: A protective put strategy involves buying put options on the underlying asset to protect against potential downside risk. It acts as insurance, allowing the investor to sell the asset at a predetermined price if its value declines.

Breakeven Point: The breakeven point is the price level at which the option trader neither makes a profit nor incurs a loss. For a call option, it is the strike price plus the premium paid. For a put option, it is the strike price minus the premium paid.

Liquidity: Liquidity refers to the ease of buying or selling options contracts in the market without significantly affecting their prices. Options with high liquidity have tighter bid-ask spreads and allow for efficient trading.

Intrinsic Value: Intrinsic value is the portion of an option’s price that is determined by the underlying asset’s actual value relative to the strike price. For call options, it is the difference between the asset’s market price and the strike price (if positive). For put options, it is the difference between the strike price and the asset’s market price (if positive).

Time Decay: Time decay, also known as theta decay, refers to the gradual erosion of an option’s value as it approaches its expiration date. Options lose value over time, assuming other factors remain constant.

Extrinsic value: Also known as time value, is the component of an option’s price that is not attributable to the intrinsic value. It represents the premium paid for the potential future movement of the underlying asset’s price, time remaining until expiration, and other factors that influence the option’s likelihood of being profitable

Hedge: Hedging involves using options to offset potential losses in an investment position. By taking opposite positions in options contracts, investors can mitigate risks and protect their portfolios against adverse price movements.

Options Trading Pros/Advantages

1. Flexibility: Option trading provides flexibility for traders to profit in various market conditions. With options, traders can potentially make money from both upward and downward price movements of the underlying asset, depending on the type of option they hold. This flexibility allows traders to adapt to changing market conditions and implement strategies that align with their outlook.
2. Limited Risk: When buying options, the maximum risk is limited to the premium paid for the option. This defined risk allows traders to know their potential losses upfront, providing a level of risk management and helping to protect against unexpected market events. This feature can be particularly beneficial for risk-conscious traders.
3. Leverage: Options trading allows traders to control a larger position of an underlying asset with a smaller investment compared to directly owning the asset. This leverage amplifies potential returns, enabling traders to achieve higher percentage gains compared to the initial investment. However, it’s important to note that leverage also increases the potential for losses, so it should be used judiciously.
4. Hedging and Risk Management: Options can be used as effective hedging instruments to manage risk. By holding options contracts, traders can protect their existing positions in the underlying asset from adverse price movements. This hedging capability allows traders to mitigate potential losses and limit downside risk, providing a valuable tool for risk management.
5. Variety of Strategies: Options trading offers a wide range of strategies that can be tailored to individual trading objectives and market conditions. Traders can employ strategies like covered calls, protective puts, straddles, and spreads, among others. These strategies allow for the customization of risk-reward profiles, the generation of income, and the potential for profits in different market scenarios.

Options Trading Cons/Disadvantages

1. Limited Time Horizon: Options have expiration dates, after which they become worthless. This limited time horizon means that traders need to be mindful of time decay. Options can lose value as time passes, which can erode their profitability if the underlying asset doesn’t move in the desired direction within the expected timeframe.
2. Complex Nature: Options trading can be complex and requires a good understanding of options contracts, strategies, and various factors influencing their value. It can involve analyzing variables such as strike prices, premiums, volatility, and time decay. The complexity of options trading may present a learning curve for novice traders and may require ongoing education and practice.
3. Risk of Loss: While options trading provides limited risk when buying options, it’s important to note that the premium paid for the option can be lost if the trade doesn’t move in the expected direction. Options can expire worthless, leading to a complete loss of the premium paid. Additionally, options trading involves leverage, which amplifies both gains and losses, potentially exposing traders to significant losses if the trade goes against their expectations.
4. Liquidity Concerns: Options markets may have varying levels of liquidity, depending on the specific options contracts being traded. Illiquid options can lead to wider bid-ask spreads and make it challenging to enter or exit positions at desired prices. Lack of liquidity may impact execution and potentially increase trading costs.
5. Complexity of Strategies: While the variety of options strategies can be an advantage, it also introduces complexity. Advanced options strategies, such as multi-leg spreads or combinations, can involve multiple moving parts and require careful monitoring. Poor understanding or execution of complex strategies can lead to unintended consequences and potential losses.

How Option Trading is different from other Instruments Trading

• Rights vs. Ownership: Option trading involves the right, but not the obligation, to buy or sell an underlying asset. Traders do not own the asset itself. In contrast, trading other instruments such as stocks or bonds involves ownership of the actual asset.
• Limited Risk vs. Unlimited Risk: When buying options, the maximum loss is limited to the premium paid for the option. This provides a known risk. In other instruments, such as stocks, the potential loss can be unlimited if the price of the asset declines significantly.
• Leverage and Potential Returns: Options trading allows traders to control a larger position of an underlying asset with a smaller investment, known as leverage. This amplifies potential gains, but also increases the potential for losses. Other instruments may also offer leverage, but the leverage ratio can vary.
• Time Sensitivity: Options have an expiration date, after which they become worthless. The value of options is affected by time decay, meaning they lose value as time passes. This time sensitivity is unique to options trading and requires traders to consider the impact of time when making trading decisions.
• Diverse Strategies and Complexity: Options trading offers a wide range of strategies beyond simple buying and selling, such as spreads, straddles, and hedging techniques. These strategies allow traders to take advantage of different market conditions and manage risk. Other instruments may have fewer complex strategies available.

FAQ:

What are options?

Options are financial derivatives that give traders the right, but not the obligation, to buy or sell an underlying asset (such as stocks, commodities, or currencies) at a specific price (strike price) within a predetermined period (expiration date).

What is the difference between a call option and a put option?

A call option gives the holder the right to buy the underlying asset at the strike price, while a put option gives the holder the right to sell the underlying asset at the strike price. Call options are typically used in bullish strategies, while put options are used in bearish strategies or for hedging purposes.

How does options trading differ from stock trading?

Options trading provides more flexibility than stock trading. With options, traders can profit from both rising and falling markets, while stock trading only allows for potential gains from rising prices. Options also offer leverage, meaning traders can control a larger position with a smaller investment compared to stock trading.

What is time decay?

Time decay, also known as theta decay, refers to the reduction in an option’s value as it gets closer to its expiration date. Options lose value over time due to diminishing time remaining for the underlying asset’s price to move in the desired direction. It is a critical factor to consider when trading options.

How can I manage risk in options trading?

Risk management is crucial in options trading. Set clear risk parameters, such as stop-loss orders, to limit potential losses. Diversify your options positions to spread risk across different assets or strategies. It’s also important to educate yourself about options and continuously monitor your trades to adjust or exit positions as needed.

What are some common options trading strategies?

Common options trading strategies include buying and selling calls or puts, covered calls, protective puts, straddles, and spreads (such as vertical spreads or iron condors). Each strategy has its own risk-reward profile and is suited for different market conditions and trader objectives.

How can I get started with options trading?

To get started with options trading, educate yourself about options, open a brokerage account that offers options trading services, and practice with paper trading or virtual accounts. Develop a trading plan, start with simple strategies, and gradually expand your knowledge and experience as you gain confidence.

What are the risks involved in options trading?

Options trading involves risks, including the potential loss of the entire premium paid for the option. Options are time-sensitive, and if the underlying asset doesn’t move as expected, the option can expire worthless. Leverage in options trading can amplify losses. It’s important to understand these risks and only trade with risk capital.

Can I lose more than my initial investment in options trading?

When buying options, your maximum loss is limited to the premium paid. However, if you sell options or engage in complex strategies, losses can exceed the initial investment. It’s crucial to understand the risks associated with different options positions and implement proper risk management techniques.

Are options suitable for all traders?

Options trading may not be suitable for all traders. It requires a good understanding of options and the associated risks. Consider your risk tolerance, investment goals, and trading experience before engaging in options trading. It’s advisable to consult with a financial advisor or experienced options trader if you have specific concerns or questions.

Important Note: Option trading involves risks, and traders should educate themselves, understand the complexities of options, and practice sound risk management. While these pros highlight the advantages of option trading, individuals should carefully assess their own investment goals, risk tolerance, and market knowledge before engaging in options trading activities.