Individual traders lost ₹105,603 crore in the equity derivatives market in FY25. For many, these losses stem from a limited understanding of how options actually work. This blog will explain why options strategies matter and how learning the basics can help traders make informed decisions.
Understanding the basics of option trading
An option is a financial agreement where the buyer gets the choice to buy or sell a security at a pre-decided price before or on a certain date. The buyer pays a premium to the seller for this flexibility.
Options are a form of derivatives, deriving their value from an underlying asset. They are used as a hedge as well as a method of generating income.
There are two types of options: call options and put options.
A call option provides the owner with the right but not an obligation to purchase an underlying instrument before or on the expiry date. A call option benefits when the price of the asset rises. The loss in a call option is limited to the premium paid to acquire it, while it has an uncapped profit potential.
A put option grants the holder the right, without the obligation, to sell an underlying asset on or before the date of expiration. A put option is profitable when the price of the underlying asset falls. The risk is limited to the premium paid if prices do not fall, while profits rise as the asset’s price drops below the strike price.
Calls for buying and puts for selling – simple concepts that will come in handy while understanding option strategies.
Best option trading strategies you should know
Below are some popular options trading strategies that you can consider, depending on your risk tolerance and trading objectives:
1. Strangle Option Strategy
The strangle option strategy is commonly used in volatile markets, where big price swings are expected but their direction can’t be determined. In this strategy, both a call option and a put option at different strike prices but the same expiry date are bought.
The goal is to benefit from a sharp movement in the price, whether it moves up or down. If the underlying asset makes a strong move in either direction, one option gains value and helps offset the loss on the other.
This approach works best when the market experiences noticeable price swings within a short period, making it a popular choice during high-volatility conditions.
2. Straddle Option Strategy
The straddle options strategy involves simultaneously purchasing a call and a put option at an equal strike price and the same expiry. If a stock has a significant move, one of these options will appreciate and will compensate for the loss in value of the other option.
This strategy can be very effective in a situation where the markets are highly uncertain, and the direction of movement can’t be determined.
3. Covered Call Strategy
In a covered call strategy, call options of already owned shares are sold. It is great for generating income through the premiums received from selling the call option.
This strategy works best when market conditions are neutral or slightly bullish. If the stock’s market price stays below the market price, you benefit from collecting the premium while retaining your shares.
This strategy can limit the potential gains to the premium if the market price climbs above the strike price.
4. Protective put strategy
The protective put strategy is useful when you want to protect your holdings from downside risk. In this strategy, you buy a put option for shares already owned by you.
If the prices start falling, you can exit at the predetermined rate, and if they stay stable or rise, you only lose the amount of premium paid.
The protective put is a great tool for bullish investors concerned about short-term volatility.
5. Iron Condor Strategy
The iron condor strategy is designed for markets with lower volatility. The word “condor” means a huge-winged vulture. A call option and a put option that are both out of the money are bought, while another call and put at further strike prices with the same expiry date are sold.
This simultaneous buying and selling results in a condor-like structure on the options chain. This strategy yields the maximum benefit when the underlying asset’s price stays within the defined range until the expiration.
6. Butterfly Option Strategy
The butterfly option strategy shines best in neutral markets. It involves four options and three strike prices: lower, middle, and upper. A call (or put) option at the lower strike, two call (or put) options at the middle strike, and one call (or put) option at the higher strike, all with the same expiry, are bought (or sold).
This strategy benefits from low volatility when the underlying asset’s price remains close to the middle strike price.
7. Collar Option Strategy
The collar option strategy is a great method for risk management. The objective is to protect the existing holding while generating income.
This strategy involves selling a call option for your existing share holdings to earn from the premium, while selling a put option, which provides insurance against downside risk.
It essentially puts a financial “collar” around the asset, defining a restricted price range for potential movements.
Factors to consider while choosing an option trading strategy
The following factors are important when deciding on an option trading strategy:
- Market View: The first point you need to understand is your market view. Whether you believe the market is going to move upwards, downwards, or remain in a range has a direct impact on your strategy.
- Volatility: Volatility measures the level of activity in the market . High volatility applies to strategies involving straddles/strangles, while low volatility applies to strategies involving iron condors/ butterflies.
- Risk Comfort Level: Each individual has their own risk appetite. Some strategies are associated with lower risk but certain gains, while others have high risk and more gain potential. Select strategies according to your comfort level with risk.
- Strike Price: The strike price determines whether the option is In-the-Money (ITM), At-the-Money (ATM), or Out-of-the-Money (OTM). It affects how much the trade costs, the level of risk involved, and the chances of making a profit.
- Time Horizon: Your expected holding period matters. Short-term strategies focus on quick market moves, while longer-term strategies allow more time for price action to play out. This influences option expiry selection and overall risk management.
Conclusion
Options are a type of derivative that offer the buyer the right, without obligation, to buy or sell an underlying asset at a predetermined price within or by the end of their expiry date. There are several types of options that are used in different situations. Just keep trying until you can devise a plan according to your risk tolerance and objectives.
FAQs
Options are contracts giving an option buyer the right, but not the obligation, to buy or sell the underlying stocks or indices at a pre-set price within a specified period. The option seller receives a premium in return.
Call options are contracts placed to benefit from the rising trend in underlying assets. Put options are used when expecting a price drop in underlying assets. These options form the basis of many option trading strategies.
Beginners should first understand the basics of call and put options. Start with simple strategies like buying calls or puts based on market predictions, and gradually explore more complex strategies as you gain experience.
Covered calls are ideal for conservative traders. This strategy involves selling call options on underlying stocks you own, providing profit via premiums, and is less risky as you’re dealing with underlying assets you already hold.
In volatile markets, traders can profit from strategies like Strangle or Straddle. These methods involve buying both call and put options to profit from significant market movements, regardless of the direction.
