Option Trading Basics

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Those who are curious to expand upon their investment holdings such that they encompass more than stocks, bonds, exchange-traded funds, or mutual funds ought to consider options. But before beginning, one must be aware of option trading basics.

This allows investors to diversify their investments. While the risks associated with options can be vast, so too can the potential returns generated on the same.

Although you as a reader might feel that options trading is best suited to those who are fluent in this arena, that isn’t true provided you are given appropriate resources. Angel One for instance serves as a full-service brokerage that provides its clients with not just the tools to trade options but also the opportunity to understand how they operate.

Let’s dive in to understand the option trading basics and enhance our knowledge for the better execution of the trade.

What is Option Trading?

Options trading involves engagement with trading instruments that permit traders to purchase and sell certain securities keeping in mind a certain date and certain time for the same.

An option, therefore, refers to a contract that is bound to an underlying asset which could be in the form of a stock or any other security. This contract is valid for a specified time frame which may be brief or extended over a period of several years.

Worth noting here is the fact that while those who have options in their name are permitted to trade the underlying asset mentioned in the contract, they aren’t obliged to do so. Should they actively make a decision to trade this option they are understood to be exercising their option.

Option Trading Terms

Although options have been traded domestically for over a period of 15 years, they have only experienced major liquidity as of 2006.

An option is solely given to one party in a transaction and this is the buyer of the underlying asset under consideration. Let’s now have a look at the terms to understand the option trading basics.

Option Writers: Option sellers may also be called option writers. He/She is the one who writes option contracts and receives premiums to trade-in options.

Premium Amount: The amount that an option buyer pays to an option seller at the time of their agreement is referred to as the premium amount.

Strike Price: The price at which the option contract is being traded.

Spot Price: The current price of the underlying asset is called the spot price.

Intrinsic Value: This is the profit that the buyer can earn while trading in the option.

In the case of a call option, Intrinsic Value is Strike Price-Spot Price while for put option it is Spot Price-Strike Price.

Buyers of call options serve to benefit provided the price of their asset surges past the strike price. Should the price of the asset hover at or fall below the strike price the buyer of the option isn’t in a position to benefit from the trade. Owing to this very fact it is imperative to purchase options at a time during which their prices are expected to rise & vice versa for put option buyers.

Therefore, it is important to keep in mind the directional view of the underlying security before diving into options trading.

Call Option and Put Option

The next concept to understand in the option trading basics is to know its different types. Depending upon the trends, options trading is of two different types call options and put options.

Call options permit you to purchase underlying security for an agreed-upon price within an allocated time frame. Strike price refers to the price you pay for this underlying security. The expiration date here refers to the final date by which you have the right to exercise your call option.
On the flip side, put options permit you to sell your underlying security for an agreed-upon price within the allocated time frame.

Moneyness in Option Trading

Based on the intrinsic value of an options contract, which is the difference between the strike price and the spot price, we can calculate something called the moneyness of that option. The option moneyness essentially denotes whether you will gain or lose from that option if you exercise it right away.

There are three kinds of moneyness for any options contract.

In the Money (ITM)
At the Money (ATM)
Out of the Money (OTM)

If the intrinsic value of an options contract is a positive number, then the option is considered to be ‘in the money. And if the intrinsic value of an option is zero, it is considered to be ‘out of the money.

In a list of options contracts, the one with a strike price that is equal to the spot price is termed as being ‘at the money.’ Practically speaking, however, it’s only rarely that the spot and the strike price coincide exactly.

So, the options contract whose strike price is the closest to the spot price is often considered ‘at the money.’ Sometimes, it’s also referred to as ‘near the money’ instead.

Best Indicator for Option Trading

Options trading is complex but using the right indicator helps you in defining the right strategy that ultimately increases your profit percentage in the market. This technical options trading indicator helps a trader in determining the trend, volatility, momentum, and other aspects.

All these factors eventually help you in taking the right position in the market.

Here is the list of some of the important indicators that you can use for analyzing indexes and stocks for options trade:

1. Relative Strength Index

This indicator helps you in identifying the momentum of the market. This indicator oscillates in the range of 30 and 70 and gives you an idea of oversold and overbought market conditions respectively.

Here RSI value above 70 indicates that the buyer’s activity has increased the value of the index or stock and now there could be a potential reversal soon. This makes it easier for traders to determine when to enter and exit the trade in the share market.

Similarly, RSI 30 indicates an oversold condition

2. Bollinger Bands

Volatility plays an important role in share market trading this makes the use of Bollinger Bands even more important. It is a volatility indicator consisting of 3 bands (upper, middle, and lower).

The middle band is 20-period SMA and the upper and lower are 2-standard deviations of the moving average.

More is the difference between the upper and lower band, more is the volatility, and vice versa. In simple terms, Bollinger Bands help in determining the range of stock or index movement at a given point in time.

3. Money Flow Index

It is the indicator that helps in determining volume along with price data and is also known as volume-weighted RSI. It gives information on the inflow and outflow of money in a particular trading asset.

By default, it gives you the data of 14-period but oscillates between 80 and 20 which helps in determining the overbought and oversold conditions respectively.

Since it considers volume data in the calculation, hence it is best suited for trading stocks in options that you want to hold for a longer time frame.

Conclusion

To know option trading basics such that you can trade them with efficiency and stand to potentially accrue profits on the same, visit Angel One’s Smart Money portal such that you can learn appropriate option strategies for trading.

Once you feel comfortable with the knowledge you have acquired, feel free to use the Angel One application to trade options with ease.

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