What Is Options Trading and How Does It Work?

The Indian financial market comprises many assets, including equities, bonds, commodities, etc. However, derivatives are one of the most common asset types used by investors. 

One kind of derivative is the options that grants the buyer the right but does not impose any obligation to sell an underlying asset at a later date and fixed price.

Financial instruments known as options allow you to purchase a valuable underlying asset at a relatively lower cost, which could result in significant gains. In this article, we’ll go into the basics of options, their features, and how they work.

Understanding derivatives and their types

Derivatives are financial contracts whose value relies on an underlying asset or a collection of underlying assets. The main idea behind derivative contracts is to make money by speculating how much the underlying asset will be worth. Derivative contracts come in four major types: swaps, forwards, options, and futures. 

What are options?

As a derivative, the value of an option is based on the value of the underlying instrument. A stock, currency, index, commodity, or other kind of asset might be this specific underlying instrument. 

Options give the buyer the right to trade an underlying asset at a fixed price at a later date. However, there is no obligation. Call and put options are the two categories of option contracts.

On the National Stock Exchange (NSE), the option stock list comprises 185 stocks, including some big names like Reliance Industries, Infosys, Tata Consultancy Services, HDFC Bank, etc.

Features of an options contract

Derivatives: Since the value of an option contract is based on how well the underlying asset performs in the market, option contracts are considered derivatives.

Expiration: Options are time-limited contracts. It will expire useless if the bearer doesn’t exercise the option by a specific date.

Strike price: A predetermined fee, known as the strike price, is attached to options; it is the amount at which the contract will be exchanged.

Speculation: Speculation is a strategy-based options trading. Instead of directly purchasing stocks, speculators use an options contract to establish a leveraged position at a lower cost.

Hedging: Investors use options to hedge their holdings by taking a contrary position in the market and lowering the risk associated with other open bets.

Zero obligation: The buyer of an options contract is free to execute the contract, but they have no obligation to do so. This implies that the option buyer may keep the contract and wait for the desired price movement rather than be forced to pay for or purchase the underlying asset.

Settlement: The option contract is considered settled when the option buyer chooses to exercise the right to purchase or sell the underlying assets on the expiration date.

Contract Size: Every option contract has a contract size, also known as a lot size, representing the amount of the underlying asset associated with the contract.

How do options work?

If you want to buy or sell an underlying asset at a specific future date, you may do so via an options contract on the stock market. Every options contract has an underlying asset that affects the contract’s pricing. 

The underlying assets may be any securities, such as stocks, bonds, or commodities, where the investor has the right to purchase or sell them for a certain quantity at a predetermined price. However, investors are not obliged to execute the options contract and are free to exit if they believe the underlying asset’s price direction would result in a loss. 

The following are some fundamental concepts related to stock market options: 

Strike price: Alternatively referred to as the exercise price, this is the sum at which the sellers and purchasers decide to carry out the options contract at a later date. 

Expiration date: The future date on which buyers of options contracts may exercise their right to purchase or sell the underlying asset is known as the options contract’s expiry date. 

Premium: The amount that purchasers of an options contract have to pay sellers to have the right to execute the contract on or before its expiration date is known as the premium. It is the price paid to the seller for the risk he undertakes if, in any case, the asset price continues to shift adversely. 

Spot price: In the stock market, this is the underlying asset’s market price at present. Buyers will examine this pricing to determine how much they may benefit or lose, based on which they decide whether to exercise or cancel options contracts. 

Steps to trade options effectively

Trading options can be a highly profitable strategy, but it requires understanding the nuances of the market and proper planning. Here’s a step-by-step guide to trading options effectively:

1. Understand the Basics: Before diving into options trading, it’s crucial to understand the basics, including what options are, the difference between call and put options, and the terminologies like strike price, expiration date, and premium.
2. Choose a Trading Strategy: There are different strategies in options trading such as covered calls, protective puts, and straddle. Choose a strategy that suits your risk appetite and market outlook.
3. Select the Right Option: Based on your strategy, choose the right call or put options. Consider factors like the strike price, expiration date, and current market conditions before making your selection.
4. Monitor the Market: Stay updated with the market’s trends and volatility. This will help you decide the best time to enter or exit your option positions.
5. Use Proper Position Sizing: It’s important to not overcommit your capital. Trading options can be risky, so always ensure you’re using a position size that aligns with your risk management strategy.
6. Exit Strategy: Know when to exit a position. Setting clear profit-taking and loss-cutting points can help you avoid emotional decision-making.

Option chain explained: how to read it and use it in trading

The Option Chain is a powerful tool for options traders. It lists all the available strike prices, expiry dates, and the corresponding call and put option prices for an underlying asset.

How to read an Option Chain:

1. Strike Price: This is the price at which the underlying asset can be bought or sold. It’s listed in the middle of the option chain, and you can choose based on your market outlook.
2. Calls and Puts: On the left, you’ll see call options, and on the right, put options. Calls give you the right to buy the asset, and puts give you the right to sell the asset.
3. Bid and Ask Prices: The bid price represents what buyers are willing to pay for the option, while the ask price shows what sellers are asking. The difference is the spread.
4. Open Interest (OI): This shows the total number of outstanding contracts. High open interest may indicate high liquidity, making it easier to enter or exit trades.
5. Volume: This represents the number of contracts traded during the day. Higher volume suggests active trading and better liquidity.
6. Implied Volatility (IV): This is a measure of how volatile the market expects the asset to be in the future. Higher IV often indicates higher option premiums.

How to use the option chain in trading:

• Evaluate Liquidity: High open interest and volume can indicate good liquidity, making it easier to trade.
• Analyze Sentiment: By comparing the calls and puts, you can gauge market sentiment. More calls might indicate a bullish sentiment, while more puts may suggest bearish sentiment.
• Identify Support and Resistance: Strike prices with high open interest often represent important support or resistance levels.

Top advantages of options trading

Options trading offers several benefits to traders, making it an attractive choice for many. Here are the top advantages:

1. Leverage: Options provide leverage, meaning you can control a large amount of the underlying asset for a relatively small investment (the premium). This means your potential returns are amplified.
2. Flexibility: Options can be used in various strategies, from hedging to speculation, allowing traders to profit from both rising and falling markets.
3. Risk Management: With options, you can set up trades that allow you to define your risk upfront. For example, buying a put option allows you to protect your long stock position in case of a downturn.
4. Income Generation: Traders can generate income by selling options, particularly covered calls. This strategy allows investors to earn premiums while holding onto their stocks.
5. Limited Risk for Buyers: When you buy options, the maximum loss is limited to the premium paid for the option. This makes options an attractive way to take a position in the market with defined risk.
6. Diversification: Options give you the flexibility to diversify your portfolio with strategies that go beyond just buying and holding stocks. They can be used in conjunction with other financial instruments for better risk-adjusted returns.

Risk management in options trading

While options can offer significant rewards, they also come with risks. Managing these risks is essential for long-term success. Here are key strategies for managing risk in options trading:

1. Define Your Risk: Always know your maximum potential loss. For buyers of options, this is limited to the premium paid, but sellers of options can face unlimited losses if the market moves against them.
2. Use Stop-Loss Orders: A stop-loss order can help you limit losses on a trade by automatically closing your position if the asset price reaches a certain level. This is especially important when trading options that can change value quickly.
3. Position Sizing: Don’t risk too much of your capital on a single trade. Use proper position sizing to ensure that one loss won’t drastically impact your portfolio.
4. Hedge with Options: Use options to hedge your positions. For example, protective puts can be used to protect long positions in stocks, while covered calls can be used to generate income while holding stocks.
5. Monitor Implied Volatility (IV): Keep an eye on the implied volatility (IV) of options. Higher IV generally means higher premiums and increased risk. Trading options during times of lower IV can reduce the cost of your options.
6. Avoid Overleveraging: While options offer leverage, it’s important not to overextend. Using excessive leverage can amplify your losses if the market moves against you.
7. Diversify Strategies: Don’t rely on just one options strategy. Use a mix of different strategies like straddles, strangles, or iron condors to protect yourself from market fluctuations.

Conclusion

One of the most profitable trading instruments is options, which may provide some of the highest returns on your original investment in the stock market. Today, the trading volume in the futures and options market exceeds 400 times that of the underlying cash-market turnover.

But before you start trading these securities, don’t forget to familiarise yourself with the risks involved. 

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