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 about how it works and how to use 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 Option Trading.

Option Trading in India

As far as the Indian stock market trading is concerned, Options are derivative products the price of which depends upon the price of the 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 Basics

If you are a beginner-level trader, then you need to understand some of the intrinsic aspects of this form of trading for avoiding Option Trading mistakes.

The main question that arises is- Is Option Trading Safe?. Option trading is an excellent way of minimizing 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.

Types of Options

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 options expiration date, 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:

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 security remains the same or increases, he can choose to not exercise the option and earn a 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 Strategies

This has been observed multiple times that a lot of traders, especially beginners, jump into option trading without any understanding and know-how of the concept.

This needs to be understood that options trading if done with correct strategies, can help to limit your losses and uplift your profits.

Won’t that be wonderful?

To get to that level, you just need to understand some of the basic and advanced level option trading strategies and you will be good to go.

We are listing some of the top strategies for your reference:

There are tons of other option strategies too that have their own set of provisions, actions and related risks and profits.

Best Indicator for Option Trading

Indicators help the trader in defining the right price point to enter and exit the trade. Here the option trading indicators are meant to offer signals to trade according to the market trend, volatility, momentum, and other parameters.

Using the right kind of indicators helps in identifying the trend which further helps a trader in deciding what kind of position they want to take in the market.

For example, as discussed, a bullish market brings in the opportunity to buy a call option or sell a put option. Similarly, in a bearish market, one should buy a put option or sell a call option.

Also, with the right understanding of technicalities, support and resistance you can set stop loss and target and pick the right strategies discussed above.

Now for all the above information, technical indicators for options trading play a vital role. Here are some of them:

Relative Strength Index

The momentum indicator oscillates between 30 and 70 to provide information on momentum in the market. These values give an idea of the oversold and overbought condition that further help in analyzing the trend reversal.

RSI 70 indicates that the buyer’s activity has increased the price and now there is a chance of potential reversal. Similarly, RSI 30 gives you the detail of sellers’ activity and upcoming bullish signals.

Bollinger Bands

Apart from implied volatility, historical volatility is also important in understanding the market and in taking the right position in the options market. For example, sellers always look for the range market to take a position and this is where Bollinger Bands help in identifying the market condition.

It is a volatility indicator that helps in determining the range in which a stock or index is most likely to move in the given time frame. This then help in setting a stop loss and target price that eventually reduces the options trading risk.

Money Flow Index

This is similar to the RSI indicator that gives an indication of overbought and oversold conditions in the share market. The only difference is, it uses volume data along with price thus providing better signals and reversals.

It oscillates between 20 and 80 where one get information of oversold and overbought condition respectively.

Option Trading Tips

If you are completely new to the world of option trading, then here are a few quick tips for you. Remember, following one or two tips won’t really help the cause. You will have to consider all of these while making your trading decisions.

Here are the tips:

  • Be wary of the time period otherwise, you will be lost in the pressure.
  • Looking for stocks with high volume and liquidity
  • Option buyer should ideally go for volatile stocks
  • It makes sense to trade options through a stockbroker with low option trading charges as the premium and other costs in this form of trading are already high.
  • Pay attention to risks as per your appetite
  • If you don’t understand a trading product, don’t go for it.

Following these tips will not even assist you to increase your profits but also put a cap on your potential losses.

Options Trading Example

Although, we took a quick example above to understand this concept, let’s have a detailed illustration of how it works in different situations.

This will help you to relate your option trading investment with different market permutations.

Let’s say on December 1, Infosys stock is trading at ₹850. The premium is placed at ₹10 for a Feb 880 Call.

This implies a couple of things:

  • The expiration date is of February
  • The strike price is ₹880.

If you do a simple calculation, then you will be paying for ₹10 X 100 i.e. ₹1000 to get into the contract (this is because one contract implies a lot of 100 shares).

Thus, you are ₹1000 down at the onset itself.

Furthermore, you would want the stock to go as high as it can since you are sitting at a price of ₹850 + 10 i.e. ₹860 to breakeven.

Now, there are 3 situations:

1. The stock goes down the barrel to a price of ₹820: In such a case, you won’t be exercising the option and this will be a loss-making trade for you with a loss of ₹1000 (the premium you paid).

2. The stock stays at the same price: Even, in this case, it won’t make any sense for you since you have paid a premium amount and it the breakeven point stands at ₹860.

3. The stock jumps to 890: Well, this is was the case you were expecting to be and that is the reason you went into the contract anyway.

Here, with a simple calculation, you can see that the overall rise in the stock price for your contract is ₹(890 – 850) * 100 i.e. ₹4000.

Now, if you deduct ₹1000 premium amount, then your overall profit is ₹(4000-1000) i.e. ₹3000.

This is a return of 300% on your initial investment of ₹1000.

And this is why option trading is one of the most exciting forms of trading.

Option Trading Intraday

Although performing options trading within an intraday setup will bring its own pressure and requirement of analysis expertise, you can definitely perform this form of trading within a single trading session.

However, you will be required to make use of multiple option trading strategies depending on the market situation, trend, and expectations.

Again, you’d ideally be looking for stocks with volatility and high turnover in volume so that you get your opportunity to make a sizable profit out of it.

Furthermore, it makes sense to look for multiple opportunities since your profit takeaway will be limited on a per-trade basis and thus, with multiple option contracts, you get a larger number of situations to make a profit and minimize losses.

App for Option Trading 

If you are looking to choose an app specifically for option trading, well honestly, there is no such specialized app for this form of trading.

You may choose any of the top mobile trading apps and there is a high chance that that mobile app will provide an optimal trading experience for call and put options investments.

However, for your reference, here are some of the well-designed and highly user-friendly mobile trading apps in India:

It is highly recommended that you go through a demo version/guest login of the mobile trading app before making your final call as different traders have their own set of preferences.

Option Trading Profit

You might have heard this popular phrase a lot – “Higher Profits Require Higher Risks”.

Well, that is pretty much applicable here. A lot of traders will tell you that option trading is risky but what they won’t tell you is that it is highly profitable too.

Of course, you will need to take care of some of the specific aspects while following the option trading strategies, and you will more or less be making out profit on an overall basis.

The extent of profit depends on your risk appetite.

As discussed in the options trading example section above, if the market goes as per the trader’s expectations, he/she is churning out a profit of 300% which was certainly not possible if that trader had gone for the cliched form of stock market trading.

Option Trading Risk

Similarly, when we talk about the risks associated with this form of trading, that is definitely there too.

A majority of the traders scared off of option trading are doing it for the reason that they don’t really understand how it works.

Obviously, it is not rocket science but you are required to consider all forms of permutations that are likely to happen with the stock.

And of course, you will be vouching for the most probable scenario that you think will happen as per your stock market analysis.

Depending on the strategy you are using, most of the time, the monetary amount which is at risk is basically the premium you pay to get into the contract.

It can be more than that, however, that will basically imply you had no idea about what you are getting into.

Thus, understanding the market/stock situation at both the fundamental and technical level is crucial before you get into the contract.

Option Trading Tricks

Humans have this tendency to look out for tricks or insider secrets to master any skill.

Well, when it comes to stock market investments or option trading specifically, there are no quick guides. You will have to learn and understand (and experience) different trading strategies while keeping a lot of patience.

This is the only trick that we can suggest to you.

There might be some advisory firms or investment “guides” that will tell you that there are tricks to master option trading. The only thing we can tell you that they are just fooling around.

Option Trading Benefits:

Here are some of the top benefits of option trading:

Speculations: Option trading is an effective way of 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 the 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 a premium.

Leverage: Options contract help in a significant reduction in 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 maximize 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.

Apart from this, you can review our detailed article on Pros and Cons of Option Trading to reap its benefits.

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