Option Trading

More on Derivatives

Option Trading is a form of contract in which the buyer of the option has the right to exercise his option at a specified price within a specified period of time.

In this detailed tutorial, we will understand with the help of examples and videos on how it works and how to use in it in your trades.

When we think of trading, there are many segments available, each with its own pros and cons. Many forms of trading involve investment and bring long-term gains, whereas many others offer short-term gains due to periodic price movements. One such forms of trading include the Option Trading.

Options Trading

Option Trading – Basics

Options are derivative products the price of which depends upon the price of an underlying security.

As mentioned above, option trading works like a contract but at the same time, this needs to be noted here that in option trading, the buyer does not have the obligation to exercise the option.

He may or not exercise the option to buy or sell a security, depending on the market price of the security. A fee or premium is charged for entering into an options contract, the fee being non-refundable. The predetermined price is called the strike price and the predetermined time is called the expiration date of the option.

Option trading is an excellent way of minimising the risks.

The buyer of the option can enter into the contract anticipating the market to move in a certain direction, and then he may exercise the option if the anticipation turns out correct and make profits and limit losses; whereas, if the anticipation was not correct, he can simply choose to not exercise his option keeping his capital safe and just paying the contract fee.

For example, an options trader holds the shares of IBM with the current market price of ₹160, which he thinks is overpriced and the market will soon go down. In this case, he enters into an option to sell the shares at ₹157 per share and pays a premium of ₹2 per share.

Now, if the market crashes down, as anticipated, and shares trade at ₹153 per share, he can still sell the shares at ₹157, saving him the loss of otherwise being able to sell the shares at ₹153. On the other hand, if the market goes up by any chance, taking the price to ₹162, he can choose to not exercise his option and still sell the shares at ₹162 (current market price) and only end up paying the ₹2 premium.

Option Trading – Types

Option Trading involves two parties – the buyer of the option and the seller or writer of the option.

While the buyer has the right to exercise his option or not, the writer has the obligation to sell the option if the buyer decides to exercise it. Selling or writing an options contract is riskier, but it involves a lot of profit too if the right moves are made at the right time.

Option Trading can be done in two different styles:

European: In European option trading, the option can be exercised only at the expiration date of the option, which is a single predetermined time.

American: In American option trading, the option can be exercised anytime between the purchase and the expiration date of the option.

It is to be noted that in India only the European style of option trading is available.

As discussed, an options trader can either buy an option to buy a security or sell a security. Depending on that, option trading can be of two types:

Options Trading

Call Option:

Call Option is a derivative contract between two parties wherein the buyer of the call option has the right to be able to exercise his option and buy a particular asset during a specified period of time, at a specified price. It is to be noted here that the buyer of the call option has the right and not the obligation.

For example, if the stock of Wipro is trading at ₹273 per share and the trader enters into a call option contract to buy the shares at, say, ₹275, then the buyer of the call option has the right to buy the stock at ₹275 which is considered as the strike price, irrespective of the current stock price, before the contract expires on, say, April 30.

So, in this case, even if the price of the share goes up to ₹280, the trader can still buy the shares at ₹275 as long as the call option has not expired.

Put Option:

Put Option is an options contract wherein the buyer has the right to sell the underlying financial instruments at a specified price during a specified time in the future. The owner of the security insures himself against any heavy downtrends in the market by fixing his sale price at a predetermined position.

If the price of the security falls below the strike price before the expiration date, the buyer exercises his option and sells the security at the strike price thus saving himself from the loss of selling at the lower current market price; however, if the price of the security remains the same or increases, he can choose to not exercise the option and earn profit.

For example, if the shares of IBM are trading at ₹190 and the trader buys a put option on the stock of IBM at an exercise price of ₹185, with a premium of ₹5 per share. Now, when the earnings report is released soon, the share price goes down to ₹170.

The buyer of a put option has the right to still sell the shares of IBM at ₹185 thus giving him a profit of ₹15 per share minus the premium of ₹5, which is ₹10 per share.

Option Trading – Benefits:

Here are some of the top benefits of option trading:

Speculations: Option trading is an effective way for speculating. Using options contracts, the traders can earn huge profits and limit their losses. Options can also be used for hedging.

Income from the existing portfolio: The investors who hold the securities for a long-term can also earn income on their holdings by writing the options contracts. It is risky but if handled well, it can give higher than normal income in the form of premium.

Leverage: Options contract help in significant reduction of costs and is attractive for small budget traders. The cost of investment in option trading is normally about 3-4% of the investment needed in stock trading.

Tax Management: Option trading also helps a lot in managing taxes as the tax paid on the entire capital gain would be way higher than the tax paid on just the premium. a person who holds certain shares and knows that the prices are going to decline, he might as well sell the stock and buy later at the lower prices; but by doing so, he will have to pay huge taxes on the capital gain from the sale of the stock.

Instead, by using the put option, he is only going to end up paying taxes only on that put option trade.

As the bottom line, Option Trading is a smart and efficient way of trading in order to maximise the profits from short-term investments and to limit the risks. If handled well, option trading can make the trader take limitless profits while conserving the capital to a large extent.

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