A basic guide to Options Trading

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Speculations in stock markets are not new. Many speculate where markets will go in the future and base their investment decisions on it. If you can speculate correctly, options trading can turn out to be quite rewarding. So, what is it and its various aspects? Let’s find out.

Understanding Options

Options trading involves options. Options are tradable contracts that allow you to trade in instruments at a pre-decided rate in the future. However, it doesn’t necessitate you actually to buy the instrument in question. To put it otherwise, in an option, the seller gives you the right to buy or sell an asset at a specific price in the future in lieu of a payment called premium.

Key terms related to Options Trading

Before going ahead, let us understand a few key terms related to Options Trading.

  • Strike Price: Strike price is the predetermined price mentioned in the option contract. It is also known as the exercise price.
  • Expiry Date: Expiry date is the date specified in the contract until which it is valid.
  • Call Option: Call option gives you the right but not obligation to buy an asset at the strike price.
  • Put Option: Put option gives you the right but not obligation to sell an asset at the strike price.

Understanding Options Trading with an example

Suppose the share of a company is trading at Rs. 600 per share, and you feel that its price will go up in the future. You can monetise your prediction through options trading. You enter into an options contract with the seller specifying the strike price say Rs. 650, and the expiry date.

The options contract gives you the right to buy the stock from the seller anytime at the strike price before the expiry date. Now suppose the price of the stock has gone up to Rs. 750, you can immediately exercise your options contract, buy the share from the seller at Rs. 650 and sell it in the market at Rs. 750.

You will make a profit of Rs. 100 per share. However, if the stock price remains constant or falls, your loss will be equal to the upfront premium paid. Thus, with options, your loss has an upper limit which is the premium paid upfront. However, your profits have no upper limit. In other words, the potential is unlimited.

Options Trading: How to do it?

Now that you have an idea of options trading, let us understand how you can do it. To involve in it:

  • Open a trading account

If you don’t have a trading account, open one with a broker. However, if you have an existing equity trading account, you don’t need to open a separate account. To trade in Futures & Options, you might need to submit some additional documents such as income proof, tax returns, etc.

You can get information about the additional documents from your broker. Once submitted, the broker will activate the Futures & Options (F&O) trading facility.

  • Pick Options to buy or sell

Once the F&O option is enabled, you need to pick the options to buy or sell. As said, the call option gives you the right to buy a stock at the strike price, while the put option gives you the right to sell stocks.

  • Predict the strike price

The next step involves predicting the strike price. For example, if you feel that a company’s share trading at Rs. 150 will go up to Rs. 200 in the future, buy a call option with a strike price of less than Rs. 200. However, if you feel that the price will dip to Rs. 100, buy a put option of the strike price of above Rs. 100.

  • Determine the expiry date

Monthly options contract expires on the last Thursday of the month. On the other hand, weekly options contract expires on the last Thursday of the week.

If Thursday is a trading holiday, then Wednesday is considered to be the expiry date. A long expiry date gives a stock more time to move up, and hence you must determine the expiry date correctly.

Advantages of Options Trading

  • No obligation to execute a trade

Options trading requires you to set a strike price and an expiry date based on your speculation of where a stock price is heading. You get the desired flexibility to see how things are working during that period and if things don’t go as you have thought, there is no obligation to execute a trade.

  • Higher return potential

If chosen at the right strike price, options trading has the potential to offer higher returns. However, for this, you need to speculate correctly and choose the optimum strike price.

  • Acts as a hedging tool

Options trading can act as a good hedging tool. If you own a company’s stocks, by exercising the put option, you can hedge against losses in case the stock’s price goes tumbles.

  • Easy liquidity

Transactions in options trading are swift. Hence, your money is not locked up for a long period of time, unlike trading in shares. At the same time, options allow you to trade in various instruments, including stocks, currencies and index products, thus widening your choice.

The Bottomline

However, like others, you need to adopt due diligence while doing options trading. Have a clear understanding of the mechanism and analyse your risk appetite before going ahead. Do through research and go ahead only when you have covered all the bases.

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Disclaimer

Views expressed above are the author’s own.

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