If you are looking to trade options, well, learning how to trade options is the first thing you got to do.
Do not & seriously do not start to trade options with no understanding of this trading segment works in the real-life share market. It will hit you hard, really hard!
We have seen people trading in options with ZERO idea of the segment and losing out that much money, that they could never recover. And we are not trying to demonize options trading or trying to scare you off it.
We are just trying to make you aware that learning the concept is really important.
Now, let’s do that!
How To Trade Options?
How to trade different types of options is a big question in itself. It is not as easy as stock trading. In stock trading, you select a stock and decide the number of shares you want to buy.
After that, your broker will place the order as per your instruction. Of course, you may choose to use any trading platform(s) for placing the order yourself as well.
But, trading in options is a way more complex process, in which only stock and quantity selection is not sufficient. You will have to pay attention to each and every step you take before starting to trade-in options.
Furthermore, each of these steps is going to bring its respective challenges along. Thus, be wary of such challenges and learn the best of the ways to tackle those.
This article is such an attempt where we are trying to dissect the whole process into a much simpler concept.
The very first step out of many important steps is choosing the right options broker.
If you have optimal options stockbroker, you can make your life easy and of course trade smoothly. This is because some brokers charge heavy amount in the name of commission or brokerage and fees which leads to the over-burden on traders or investors.
Options trading has become extremely popular over the last few years. And the educational offerings to traders offered by brokerage firms is one of the keys behind this.
Furthermore, brokerage firms provide different types of tools to their traders which help to select and analyze their trade. The new-age traders want to get almost all ideas, research and knowledge about options trading.
Thus, you need to be aware that few brokers do provide these provisions & you must choose the options broker very carefully.
These are the steps which you should consider before choosing the right options broker.
Firstly, you should check the minimum of the brokerage account. Going with a discount broker makes complete sense.
You should pay attention to the charges of the options broker beyond the brokerage which they charge. The commission and fees of the options broker must be according to your investment capacity. Feel free to use this brokerage calculator for more understanding.
Then, you should consider your technical needs and trading style. Technical needs under the options trade must be full-filled quickly and smoothly. These are majorly solved through the features provided in the trading platforms.
Options broker who provides different tools to select and analyze your trades including technical indicators, specific data points, market scanners etc.
2. Trade options: Opening an Options Trading Account
After choosing the right options broker, you must move forward to open an options trading account.
As you know that an options trading account is the account in which money is transferred from an interest-bearing account to the brokerage account after placing a trade.
After trade completes, money which comes from the selling of an option is transferred back to the traders account after deducting charges of brokerage firms (fees, Taxes, and commission).
Before you get started, you will be asked some questions by your broker and that is because you are going to start a job of relative risk. Queries such as whether you will be able to meet any losses by you or not if incurred will be asked.
With your financial strength, they would also want to know about your experience and understanding of risks associated with options trading. After getting all these information options brokers will give off a permission slip to start the options trading.
Although the variety and specific queries asked may differ from broker to broker, generally there are a pre-defined set of questions a broker executive may ask.
Here is the list of information which is required to give to your options trader before starting trade options.
Your experience in the field of options or stock trading. From how many years you have been trading in options? What is your understanding regarding risks associated with options trade? How many trades you can make per year and what is the size of your trade?
Your purpose of investment through options trading. Whether it is for generating income, for capital preservation, for growth or speculation.
You will have to submit your personal information also along with some documentation. This may include your annual income, cash or liquid investments which can be easily sold, whether employed or businessman, where are you employed or what is the nature of your business, your total net worth.
Which type of options you are looking to trade?
After submission of your answer to the above questions, options broker will decide which level of trading you should be assigned. As you know level 1 to 3 is easy as compared to level 4 and 5.
You should not forget that to trade options, brokers are your important investing partners. So, you should choose options brokers who offer you options education, knowledge, tools, guidance to trade options.
3. Considering Most important Elements of Options Trading
To trade options is not as easy as stock trading.
In options trading, you are buying a right to buy/sell an underlying asset at a fixed price on or before a specific date. So, when to exercise your right and at what time you should wait is the core thing.
Let’s discuss the 3 most important elements of options trading.
a. What is your expectation for the stock movement? what you think that in which direction the stock will move?
If you have decided to trade options, you must have the idea and prediction in which direction the stock will move in which you want to trade.
As you know that a call option is the right to buy an underlying asset at a fixed price on a specified date. So, if you have the idea that the stock price will go high or rise you can buy a call option.
On the other hand, a put option is the right to sell underlying security with a fixed price on a specified date. If you think that the price of the stock will go down in the future, you can buy a put option.
So, if your share market prediction is strong and you get the result accordingly, then you are a person to whom options trading will benefit.
b. Decide how high or low a stock will go
If the options expire ‘In the money’ (ITM) then it remains the value of an option.
The stock price above or below the strike price indicates ITM trade in the call option and put options (stock price above strike price will be ITM for buy option and the stock price below strike price is ITM for the put option).
What strike price you are choosing indicates your prediction where you are seeing the future stock price.
Let’s take an example, suppose you think that the price of a company say XYZ Ltd. will go high from its current price on the basis of some data from ₹50 to ₹70. In this case, you will buy a call option (which will give you the right to buy) with the strike price less than ₹70.
And if your prediction works your trade will be in the money.
Again, suppose if your prediction says that the price of the above company will go down from the current price of the stock from ₹50 to ₹30. Then you will buy a put option (which will give you right to sell) with the strike price above ₹30 and your trade will be in the money.
You must have an idea that you can’t choose any strike price. Strike price chain is pre-decided with a range of different strike prices. For e.g. ₹5, ₹10, ₹15 etc (based on stock price).
The premium which is paid for buying an option is the combination of two components.
One is the Intrinsic value ( Difference between the strike price and the stock price, if the stock price is above the strike price) and another is time value which is determined on the basis of time left before options expiration, interest rates and, volatility etc.
Another example: If you have a call option of ₹50, the strike price is ₹60 and the premium paid is ₹5, then the intrinsic value is (₹60-₹50)= ₹10 and time value is ₹5
c. The time frame within which stock price is expected to go or down:
Yes, after all when the stock price will move for which you want to buy call/put options is an important decision. If you know that the stock price will either go up or down and which option (call or put) you have to buy then the next question comes to the ‘time frame’.
You know that every option has the expiry date which maybe a week, a month, a year also. Long-term investors prefer monthly and yearly expiration options because of less risk, while seasonal traders go for daily and weekly expiration options trade.
Actually, options with longer expiration can move more, and it will lead to fulfilling your investment purpose.
Trade Options Example
Now let’s take a real-life example when you trade options.
Like discussed above, some of the aspects that you need to consider while entering an options trade are:
Current Market Price
We will consider all these aspects of this example.
Let’s say you buy an options contract of a stock with a strike price of ₹100.
You are expecting the stock price to rise to ₹130 by the end of the expiration date. To get into this contract, you pay a premium of ₹1000 (premium per share is ₹10 and each lot has 100 shares).
If the stock price hits the mark of ₹130 on or before the expiration date, you go ahead and exercise the contract. Now, you have bought this stock for ₹100 and can sell it for ₹130 or more (in case the stock goes even higher).
When you do that, your profit would be ₹(130 – 100) X 100 i.e. ₹3000.
From this, you deduct the premium you gave away in order to enter the contract, thus, you would take away a net profit of ₹3000 – ₹1000 i.e. ₹2000 which is a 200% return on your investment of ₹1000.
Trade Options Risk
When it comes to investments, there are some levels of risk involved.
Like it is commonly said – “High Returns Require High Risks!“.
Since options trading can provide you with >100% returns on your investments, the risk can be seen as relatively higher. Here are the kinds of risks involved in this form of trading:
Monetary Losses in Trades
The first and foremost risk while trading options is the monetary loss it can bring to your trades. An obvious aspect related to it is that the beginner level traders lose out more as compared to experienced traders.
This is for the simple reason that experienced traders learn with time. They also, at times, make losses on their options trades but that happens much less as compared to novice traders.
It is highly advised that even if you use exposure in your trades, use it to the extent that goes with your risk appetite.
For example, if you buy an options contract by paying ₹1000 as premium and the market does not go as per your expectations, then you will lose out on the complete ₹1000 premium.
Complex Form of Trading
As you take the next steps to relatively complex forms of trading such as options trading, then you need to equip yourself with the corresponding level of stock market education as well.
In this form, you need to learn options trading strategies that can be used at different instances based on the market condition and trends.
Some options strategies help you when there is a market downtrend, a few when the market is in an indecision state while others can help you during trend reversals too. Knowing and understanding the practical applications of these strategies can take your game to the next level.
The worst you can do is – guessing. Don’t do that!
Yes, this one is a big risk!
What happens is there are MULTIPLE types of options types and there are only a few that are prominent (or let’s say – mainstream). Rest others, with limited prominence, face liquidity challenges as the number of traders using these types are limited too.
If you are trading with a small volume turnover, then it must not be an issue. However, the scope of this problem increases with an increase in capital.
When you trade in the options segment, there is a concept named Spread that comes into play. This is basically the difference between the monetary value a buyer and a seller give and take for the options contract.
Higher the value of the spread, higher is the cost involved for you as an options trader.
Apart from the spread, the other costs involved the brokerage charge levied by the broker along with different kinds of taxes and duties charged by different regulatory bodies.
Impact of Time on Options Value
This factor of time decay although has no direct monetary value attached to it. However, it definitely impacts the contract value in an indirect way.
The longer is the time duration between the options expiry and the current date, larger is the value it adds to the contract. Similarly, as the current date nears the expiration date, it loses its contribution to the value of the contract.
Trade Options Volatility
Implied volatility directly impacts options’ value, which has its internal co-relation with supply & demand.
Simply stated, with an increase in the demand for the option, a corresponding positive movement is seen in the implied volatility of the contract.
Higher implied volatility in options’ contract increases the premium of the contract as well.
It works the other way as well, i.e. with a decrease in demand, the volatility of the contract diminishes which then lowers the value of the contract.
Like discussed above, the time factor also plays its part in the pricing of options. This goes hand in hand with the stock volatility where the contract with nearing expiry date will have a lower impact of volatility as compared to the ones which have a farther expiry date from the current date.
Trade Options Premiums
Whenever you get into an options contract (0r any contract for that matter), Premium is the entity that plays an important role in the decision of whether both the parties will get into the contract or not.
Let’s take a parallel but simpler example.
For instance, you are looking to buy a health insurance plan for yourself and your family. The insurance company is going to provide you with a cover of ₹5 Lakhs on a premium of ₹10,000 a year.
What does this mean?
This implies that the insurance company is internally assuming that nothing will happen to you or your family and they get to keep the premium of ₹10k you are paying.
You, on the other hand, assume that something “may” happen and you get to take the insurance cover of up to ₹5 Lakh by just taking a risk of ₹10k.
Thus, in a simpler sense, the premium is the amount you are paying to a party (options seller in this case) against a specific risk you are taking (which in this case, is the buying of the options contract).
Learn To Trade Options
If you wish to learn how to trade options, here is a reference app for you.
Stock Pathshala – this mobile app provides with stock market education across different levels such as options, commodities, currency, equity trading apart from some of the advanced stock market trading strategies.
Let’s wrap up this detailed piece on how to trade options with a quick summary of the points mentioned above:
How to trade options starts with finding the right options broker.
After finding the right options broker, you are required to open a brokerage account through which you can trade.
To trade options you need to give your personal information related to your income, net worth, liquid money, investments which can be easily sold out, your employment details etc. to the options broker.
There are three main components of options trading i.e. time frame, prediction of high or low from the current price and direction of the stock.
First, If you are a long-term trader you will prefer options with long expiration, while day traders and seasonal traders will prefer options with daily and weekly expiry.
The second one is your prediction about how high and low of the stock price (within your selected expiry period) will go from the current price of the stock.
And the third one is in which direction the stock will move? Whether it will go up or down? On the basis of which you can decide you will buy the call option or put option.
In case you are looking to trade options or stock market investments in general, let us assist you in taking the next steps forward.
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More on Share Market Education:
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