Options are derivative contracts that grant the buyer the right (and not obligation) to either buy or sell the underlying assets at a fixed price on the date of or before the contract expires. They are important since they help investors hedge their risks or increase leverage for smaller initial investments.
Understanding Option Trading
An option, as mentioned earlier, is a financial contract that provides an investor/ trader with the right to buy or sell a stock, ETF, commodity, currency or benchmark at a specified price for a specified period. They come with a fixed expiration date, which is usually the last Thursday of the calendar month. It is important to note here that, unlike futures, options do not hold the buyer/seller under any obligation.
Options trading means that you do not own the shares until you exercise the option,, unlike stock trading, where you buy/sell the stock and become a part-owner of the firm. Options trading, in simpler words, is a simple expression of interest in owning the company’s shares.
To learn more about option trading, there are a few terms you should be aware of:
Trading Premium
The trading premium is the price to pay to the seller of the option upon entering the contract. The broker receives this as a fee, which is subsequently transferred to the writer on the exchange. It is expressed as a percentage of the underlying, which is based on several factors, including the intrinsic value of the contract options. The premium value fluctuates based on whether the option is in-the-money or out-of-the-money.
American and European Options
American options are options that can be exercised on or before their expiry date at any time. European options are the ones that can be exercised only on the expiry date.
Open Interest
Open interest applies to the cumulative number of available positions on an options contract at any given point in time. It becomes zero for a given contract after the expiration date.
Strike Price
The predetermined price at which an option can be purchased or sold upon exercise is known as the strike price.
Call and Put Option
The owner of a call option has the option to buy the asset at a fixed price. The owner of a put option is entitled to sell it.
Advantages of Option Trading
- Leverage: Trading options stand out primarily for their use of leverage. This means that instead of paying the full price for a trade, you only need to cover a small upfront cost, known as a premium. This setup allows traders to engage in trades of significant value while only requiring minimal capital.
- Cost Efficiency: Options trading is notably cost-effective. By investing a smaller amount of capital, traders have the potential to achieve substantial profits, offering a higher return on investment compared to many other investment methods. The reason behind this efficiency is the relatively low premium required to enter an options trade.
- Mitigated Risk: Compared to futures or direct stock market investments, options trading involves lower risk. The maximum loss a trader faces is limited to the premium paid for the option. However, it's important to note that selling options. The practice known as writing introduces a higher level of risk compared to simply buying options or stocks.
- Strategic Advantages: Options trading allows traders to profit from both upward and downward movements in the market. This is particularly useful in situations where the market's direction is uncertain, such as during earnings announcements, budget releases, or leadership changes.
- Flexibility: Options offer a wide range of investment opportunities beyond simple price movements. Investors can also benefit from the effects of time decay and market volatility on option prices.
- Hedging: Options serve as an effective hedging tool, significantly reducing the risk associated with an investor's portfolio. Through the strategic use of options, traders can essentially neutralize the risk associated with their positions, providing a safeguard against unfavourable market movements.
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Option trading strategies for beginners:
Now that we have a basic understanding of option trading and the allied terms, let us have a look at the different option trading strategies.
Long call
Buying a call option, known as a long call, represents a straightforward bet on the market moving upwards.
Optimal conditions
This strategy is best applied when one anticipates a substantial rise in the price of the underlying asset before the option expires. It's worth noting, though, that a slight increase above the strike price might not offset the cost of the premium paid, potentially leading to a loss.
Benefits and drawbacks of a long call
Traders who are bullish on an index fund, stock, or ETF and want to leverage their position for maximum gain while minimizing risk tend to favour this strategy.
The potential for profit with a long call is theoretically unlimited, as the price of the underlying asset could continue to rise indefinitely before the option expires. This makes long calls a popular choice for speculating on upward price movements.
The main disadvantage is the initial premium outlay. If the market price doesn't surpass the strike price, the option becomes worthless. Hence, a long call is considered a safer strategy compared to direct stock purchases or futures contracts, preferred by traders looking to manage risk effectively.
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Covered call
The covered call strategy is a popular method among investors who already hold stocks or similar assets. It involves selling a call option while owning the corresponding number of shares of the stock, aiming to balance out the risks involved.
Suitable conditions
This strategy is ideal for investors holding shares who anticipate the stock price will not surge significantly in the near term. Experienced investors use it frequently to turn their stock holdings into a reliable source of income.
Benefits and drawbacks of a covered Call:
The major benefit of employing a covered call strategy is its ability to hedge against potential losses, making it a relatively straightforward approach to management. Moreover, it can serve as a regular income source, with the option to reapply the strategy multiple times over.
The drawback of a covered call is that it limits the profit potential to the premium received, regardless of how much the stock price increases. Conversely, if the stock price escalates above the strike price at expiry, you may have to sell your shares at a lower price than the current market value. This strategy trades off the opportunity for higher profits in favour of more predictable, but limited, returns and some level of downside protection.
Long put
Purchasing a put option, known as a long put, is essentially making a directional bet that the price of an asset will decline. It's the converse strategy for a long call.
Appropriate usage:
Opt for a long put when you anticipate a significant drop in the price of the underlying asset by or before the option's expiration date. Traders with a bearish outlook who want to profit from a drop in prices tend to favour this strategy.
Benefits and drawbacks of a long put:
The long-put strategy offers traders the advantage of leveraging to capitalise on declining market prices with a relatively small capital outlay and straightforward execution.
The most you can lose with a long put is the premium paid, capping your downside risk. Conversely, the profit potential is substantial, albeit with the natural limitation that the asset's price cannot fall below zero, setting a theoretical cap on earnings.
Short put
Selling a put option, often referred to as a short put strategy, involves the trader taking on the obligation to buy the underlying asset if the option is exercised.
Ideal situations for a short put:
This strategy is well-suited when you believe that the asset's price will remain at or above the option's strike price at expiration.
Benefits and drawbacks of a short put:
Engaging in a short-put strategy enables you to capitalize on time decay, making it a profitable approach in rising or stable market conditions.
The profit from a short put is capped at the premium collected upfront. Conversely, the risk involves potentially having to purchase the stock at the strike price, which could be higher than the market value, minus the premium received, exposing you to significant downside risk.
Married put
A married put strategy is essentially an enhanced version of a long put, where the investor not only buys a put option but also owns shares of the underlying stock. This approach serves as a safeguard, offering protection against potential declines in stock value.
Appropriate application
Married puts are particularly useful when you anticipate significant movements in the stock's price, either upwards or downwards, possibly due to impending financial announcements or quarterly earnings reports.
Benefits and drawbacks of married Put:
This strategy enables investors to retain ownership of a stock, enjoying the potential for price appreciation, while simultaneously guarding against significant losses should the stock price plummet.
The profit potential with a married put is theoretically unlimited, as any increase in the stock price could lead to gains. The main drawback is the cost of purchasing the put option, which represents the maximum financial loss. Should the stock's price fall, the increase in the put option's value can offset losses, limiting the investor's risk to the initial premium spent on the option, rather than a substantial decrease in the stock's value.
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Other options and strategies for beginners
Protective Collar Strategy
A long-position investor may employ the protective collar tactic. It entails writing a call option for the same underlying asset while simultaneously purchasing a put option. Assume you own shares of Infosys, which are trading for Rs 1600 at the moment. To implement a protective collar strategy, you decide to buy a put option to protect against a potential decrease in stock price, while also selling a call option to offset the cost of the put. For instance, you buy a put option with a strike price of Rs 1550, costing Rs 30 per share, and sell a call option with a strike price of Rs 1650, earning Rs 30 per share. This strategy limits your potential loss if Infosys's stock price falls below Rs 1550, while the premium received from selling the call option covers the cost of buying the put. However, if Infosys's stock price rises above Rs 1650, you may have to sell your shares at Rs 1650, capping your upside.
Long Straddle
In this case, a trader buys both a put and a call option with the same expiration date and strike price. Since it involves purchasing two options, it is slightly more expensive than other strategies. For a long straddle, let's use HCL Technologies, with its stock at Rs 1600. You purchase both a call and a put option at this strike price with the same expiry date. This strategy is beneficial if you anticipate significant price volatility but are uncertain about the direction. For example, if HCL announces a major project win or loss, the stock could move significantly. If HCL's stock jumps to Rs 1700 or drops to Rs 1500, either your call or put option will become profitable, potentially covering the cost of both options and then some.
Vertical Spreads
Purchasing and selling the same kind of option with a different strike price but the same maturity date is known as vertical spreading. Bull or bear vertical spreads can profit from rises or falls in the market.
Long Strangle Strategy
The trader simultaneously buys a call and a put option, much like in a straddle. They will differ in strike prices but have the same expiration date. The strike price of the put is less than the strike price of the call. A long strangle for an X company trading at Rs 450 entails purchasing a put option with a lower strike price and a call option with a higher strike price, both with the same expiration date. For instance, you might buy a call option with a strike price of Rs 460 and a put option with a strike price of Rs 440. This strategy is a bet on volatility, expecting the company's stock to move sharply in either direction. If there's a significant price movement due to, say, quarterly earnings reports, one of your options could significantly increase in value, leading to a profit.
How much money do you need to trade options?
Options trading often demands a modest initial investment. By employing the strategies mentioned, one can buy an affordable option and utilise leverage to potentially achieve significant returns. Nonetheless, there's also a considerable risk of loss when employing these tactics.
A small sum of just a few thousand rupees can be enough to get started. Along with financial capital, patience and a comprehensive knowledge of trading are crucial for success.
The Final Words
Options trading offers flexibility and numerous opportunities across various market conditions. Although options carry a significant level of risk, there are basic strategies available that limit exposure. This means that even investors who prefer to avoid risk can leverage options to enhance their portfolio's returns.
Understanding the risks and carefully evaluating different investment scenarios is crucial. Successful trading in options necessitates patience and a thorough understanding of both the markets and the financial instruments involved.
Also Read: Expiration Date in an Options Contract: Importance, Factors to Consider
