Options trading has recently evolved into one of the most popular financial instruments. However, little is known about its nuances even to those who ventured into it and made profits. Don’t put all your hopes on luck. Trading is not a matter of luck but of preparation. Enough of preaching! We want to say that before you put your hard-earned money in the market, prepare for the battle.
So, let us learn some basics of optional trading today.
What is options trading?
Option is a form of derivative trading instrument, a contract, that gives option holders the right, not obligation, to buy or sell an asset at a predetermined price at a fixed time. Here option is available to the buyer only, not to the seller. Seller on the other hand can redeem a premium amount as a token from the buyer while entering the contract.
Options trading involves two major participants: buyers and sellers of options contracts. (Option buyers (Holders) and options sellers). Holders are investors who purchase options, and options sellers sell options.
Let us understand the process with an example where we take shares of a company’s stock as the contract’s underlying asset.
Suggested Read: Candlestick Patterns- All You Need to Know
Assume Bharat Electronic Ltd(BEL) is currently trading at ₹ 200 per share(spot price)and you are an investor looking for options trading opportunities. Firstly, you will analyze the asset, the BEL, including the company’s performance, trends, and potential future movements.
Based on your analysis, you expect that the price of BEL will increase in the next few months. You decide to buy shares of BEL for ₹220 per share (Strike price) after two months. On the other hand, a seller has shares in BEL and believes the price will go down within a few months. Instead of selling it on the market, he chooses an optional contract as a risk management strategy.
As it is an optional contract, you, the buyer, can buy or not buy the shares on the expiry date. This provides the buyer leverage. To balance it, the seller is provided with an opportunity to receive an option premium amount as a token advance. Even if, the buyer chooses not to buy the shares, the seller at least receives this amount to keep with him. One thing to remember here is that the premium amount is non-refundable. Even if you decide to buy the asset, it will not be adjusted with the strike price you will pay.
Here in the case of BEL suppose, each contract includes 1000 shares the premium price for one share is ₹ 10 and the contract expires after two months. You decide to purchase two contracts, which include a total of 2000 shares.
So you enter into an option contract with a seller to buy 2000 shares of BEL for a total of ₹4,40,000 after two months. You need to pay an option premium amount of ₹20,000. At the end of the contract period, you can exercise your option to buy the share. But if you decide to buy, the seller has no option but to sell.
Now after two months, three possible scenarios can occur. Let us see one of the scenarios, where you can make a profit.
Firstly, the spot price of the BEL at the time of expiry day may go above ₹220 per share. Suppose it is ₹240.
Then you can buy the stock from the seller by paying ₹4,40,000 according to the contract. You already paid the premium amount ₹20,000. So your total expenditure is ₹4,60000 (4,40,000+ 20,000).
If you buy the shares and sell them in the market on the same day you will receive ₹4,80,000 (240×2000). So you made a profit of ₹20000.
We are not bothering you with more calculations here. You can calculate the profit and loss margin as we have done above with different scenarios, like below 220 and exactly 220. And analyze the profit or loss margin considering the spot price and premium amount into account.
In this case, you are a buyer and the analysis is from a buyer’s perspective. You can do the same from the perspective of a seller.
As you have seen a particular scenario of option trading in detail. Let us see different kinds of options and the possible positions.
Call and Put Options
A Call option gives you the right, but not the obligation, to buy the underlying asset.
A put option gives you the right, but not the obligation, to sell the underlying asset.
If you are expecting that the underlying asset’s price will increase, you can buy a call option or sell a put option. If there is a possibility of a decrease in the price of the underlying asset, you can either buy a put option or sell a call option.
Long Call and Short Call
When an investor buys a call option, a long call position is created. Here the investor, suppose it is you, pays a premium to the option seller which gives the investor the right to buy the underlying asset at a predetermined price at the expiration date or before. If the price of the underlying asset goes above the predetermined price plus the premium amount paid, you will gain a profit.
A short call option involves the selling of a call option by an investor. When you sell the call option, you receive a premium amount from the buyer. The buyer in exchange receives a right to sell the underlying asset at the predetermined price. Buyer’s choice is not mandatory, he can exercise his will to either buy or not.
Here your maximum profit is the premium amount you received. If the price of the underlying asset increases significantly, losses can go higher.
Long Put and Short Put
A long put position happens when an investor buys a put option and a Short put position occurs when you sell a put option. In the long put, if the price of the underlying asset falls below the strike price minus the premium, there is a possible profit. In the case of the short put, maximum profit is limited to premium and losses can go higher as the price of the asset falls.
Benefits of Options Trading
- They have the potential to increase the cost-effectiveness.
- As a dependable form of hedge, it is less risky if used with caution.
- Potential for higher returns
Risks of Options Trading
- Options trading has a limited timespan. If the price does not move as expected, there may be losses.
- Lacks ownership benefits.
- Optional trading involves various terms and strategies. This complexity may confuse people with less trading experience in trading
FREQUENTLY ASKED QUESTIONS ON OPTIONAL TRADING
Can option trading be profitable?
With proper understanding, strategy, and planning, you can make a reasonable amount of profit through optional trading.
What are Greeks in Options?
Option Greeks are financial metrics that an investor can use to measure factors that affect the price of an option contract. The main Greeks include variables represented by the Greek letters teta, gama, delta, vega, and rho.
Which options trading is best in India?
Straddle is considered one of the best optional trading strategies used in the Indian financial market.
What is straddle in options trading?
It is buying or selling both the put option and call option at the same strike price and expiration date on the same underlying asset.
