A basic guide to options trading

Stock market speculation is nothing new. Many speculate on the direction the markets will take in the future and base their investment decisions on that. If you can speculate correctly, options trading can be very rewarding. So what is it and its different aspects? Let’s find out.

Understanding Options

Options trading involves options. Options are negotiable contracts that allow you to trade instruments at a predetermined rate in the future. However, this does not oblige you to buy the instrument in question. Simply put, in an option, the seller gives you the right to buy or sell an asset at a specified price in the future instead of a payment called a premium.

Key Options Trading Terms

Before moving forward, let us understand some key terms related to options trading.

  • Strike price: The strike price is the predetermined price mentioned in the option contract. It is also called strike price.
  • Expiration date: The expiry date is the date specified in the contract until which it is valid.
  • Call Option: The call option gives you the right but not the obligation to buy an asset at the strike price.
  • Put option: The put option gives you the right but not the obligation to sell an asset at the strike price.

Understanding options trading with an example

Suppose a company’s share is trading at Rs. 600 per share, and you feel that its price will rise in the future. You can monetize your prediction through options trading. You enter into an options contract with the seller specifying the strike price, say Rs. 650, and the expiry date.

The options contract gives you the right to buy the shares from the seller at any time at the strike price before the expiration date. Now suppose the stock price has risen to Rs. 750, you can immediately exercise your options contract, buy the stock from the seller at Rs. 650 and sell it in the market at Rs. 750.

You will make a profit of Rs. 100 per share. However, if the stock price remains constant or declines, your loss will be equal to the initial premium paid. So with options your loss has an upper limit which is the premium paid upfront. However, your profits have no upper limit. In other words, the potential is limitless.

Options trading: how to do it?

Now that you have an idea of ​​options trading, let us understand how you can do it. To participate:

If you don’t have a trading account, open one with a broker. However, if you already have a stock trading account, you do not need to open a separate account. To trade futures and options, you may need to submit additional documents such as proof of income, tax returns, etc.

You can obtain information about additional documents from your broker. Once submitted, the broker will activate the Futures & Options (F&O) trading feature.

  • Choose options to buy or sell

Once the F&O option is activated, you must choose the buy or sell options. As we said, the call option gives you the right to buy a stock at the strike price, while the put option gives you the right to sell stock.

The next step is to predict the strike price. For example, if you believe that a company’s shares are trading at Rs. 150 will go up to Rs. 200 in the future, buy a call option with a strike price below Rs. 200. However , if you think the price will fall to Rs. 100, buy a put option of the strike price above Rs. 100.

  • Determine the expiry date

The monthly options contract expires on the last Thursday of the month. On the other hand, the weekly options contract expires on the last Thursday of the week.

If Thursday is a public holiday, Wednesday is considered the expiration date. A long expiration date gives a stock more time to go up, so you need to determine the expiration date correctly.

Benefits of options trading

  • No obligation to execute a transaction

Options trading requires you to set a strike price and an expiration date based on your speculations about the direction of a stock’s price. You get the flexibility you want to see how things work out during this time and if things don’t go your way, there’s no obligation to execute a trade.

If picked at the right strike price, options trading has the potential to deliver higher returns. However, for this you need to speculate correctly and choose the optimal strike price.

Options trading can be a good hedging tool. If you own stock in a company, by exercising the put option, you can protect yourself against losses if the stock price drops.

Transactions in options trading are fast. Therefore, your money is not tied up for a long time, unlike stock trading. At the same time, options allow you to trade various instruments including stocks, currencies, and index products, expanding your choice.

The bottom line

However, like others, you must exercise due diligence when trading options. Have a clear understanding of the mechanism and analyze your risk appetite before jumping in. Do some research and only move forward when you’ve covered all the bases.



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Disclaimer

The opinions expressed above are those of the author.



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