Options Trading: A Beginner’s Guide On How To Trade Options

photo: www.investopedia.com

Investors can use options trading to speculate on the future direction of the overall stock market or individual securities, such as stocks or bonds. Options contracts provide the option, but not the obligation, to buy or sell an underlying asset at a specified price and by a specified date.

What Are Options?

Options are contracts that can be traded by investors who want to speculate on whether the price of an asset will increase or decrease on a specific future date. With options, there is no obligation to purchase the underlying asset in question.

Nifty 50 options enable traders to speculate on the future direction of the benchmark stock index, which is widely considered to be a proxy for the entire Indian stock market.

Although options may appear to be counterintuitive at first glance, they are not as complex as they may seem. To comprehend options, you only need to be familiar with a few essential terms:

- An option is considered a derivative because its value is derived from another asset. For instance, in stock options, the value of the option contract is influenced by the price of the underlying stock.

- There are two primary types of options: call options and put options. A call option offers the opportunity to buy a security at a predetermined price on a specified date, whereas a put option provides the ability to sell a security at a future date and price.

- The predetermined price mentioned above is called a strike price. Traders can exercise the option at the strike price until the option contract's expiration date.

- The cost of purchasing an option is referred to as the premium, which is calculated based on the underlying security's price and values.

- Intrinsic value and extrinsic value are two factors that contribute to the premium. Intrinsic value is the disparity between the option contract's strike price and the current price of the underlying asset. Extrinsic value is made up of other elements outside of those included in intrinsic value that impact the premium, such as the duration of the option.

- Depending on the remaining time until expiration and the price of the underlying security, an option is classified as either in-the-money (profitable) or out-of-the-money (unprofitable).

Read More: How Many Trading Days In A Year?

How Options Pricing Works

To illustrate these concepts, let's consider an example of a stock that is currently trading for INR 100 per share. Here's how the premiums, or prices, would vary for different options based on the strike price.

Call Option PremiumStrike PricePut Option Premium
HighestINR 90Lowest
INR 95
INR 100 —Current Price
INR 105
LowestINR 110Highest

When trading options, you pay an upfront premium that gives you the choice to purchase a hypothetical stock - call options - or sell the stock - put options - at the designated strike price by the expiration date.

For call options, a lower strike price has greater intrinsic value since the options contract allows you to buy the stock at a lower price than its current trading price. If the stock remains at INR 100, your call options are profitable, and you can acquire the stock at a discount.

On the other hand, a higher strike price has more intrinsic value for put options because the contract permits you to sell the stock at a higher price than its present trading value. Your put options are profitable if the stock remains at INR 100, but you have the right to sell it at a higher strike price, such as INR 110.

How Options Trading Works

photo: media.warriortrading.com

You have the ability to use various options trading strategies, ranging from simple to complex. Generally, when trading call options, you are betting on an increase in prices, while trading put options allows you to bet on a decrease in prices.

Options contracts grant investors the right to purchase or sell a minimum of 100 shares of a particular stock or asset. However, there is no requirement to execute the options contract if the trade is not profitable. If an investor chooses not to execute the options contract, the only money that could potentially be lost is the premium paid for the contracts. As a result, options trading can be a relatively inexpensive way to speculate on a wide range of asset classes.

Option trading provides the opportunity to speculate on several factors, including:

  1. Whether the price of an asset will increase or decrease from its current value.
  2. The extent to which the price of an asset will rise or fall.
  3. The specific date on which these price changes will take place.

To break even with call and put options, the price of the underlying asset must increase or decrease to a certain extent, which is the amount of the premium paid plus the strike price. To make a profit, the following steps are taken:

- Call options

Once the price of the underlying asset surpasses the break-even point, you have the option to sell the call option and earn the difference between the premium paid and the current premium. This is known as "closing your position." Alternatively, you can choose to exercise the option and purchase the underlying asset at the strike price agreed upon.

- Put options

Once the price of the asset falls below the break-even level, you have the option to sell the put option and collect the difference between the premium paid and the current premium. This also involves "closing your position." Alternatively, you can choose to exercise the option and sell the underlying asset at the agreed-upon strike price.

If the price of the asset moves in the opposite direction of what was desired for a call or put option, the contract can be allowed to expire and losses will be limited to the amount paid for the option, which includes the premium and any related trading fees.

As options trading strategies become more advanced, experienced traders may combine two or more calls or puts with varying strike prices or expiration dates, leading to more complex strategies.

Read More: What is Forex Trading

Options Trading Pros

photo: Elets BFSI

Options trading provides traders with a combination of specificity and flexibility. Traders must select a specific strike price and expiration date, which fixes the price they anticipate an asset will reach within a certain timeframe. However, traders also have the flexibility to observe how things develop during that time period, and they are not required to execute a trade if they are incorrect in their prediction.

Options contracts have an expiration date that can range from a few days to several months, which makes options trading an appealing strategy for traders who wish to limit their exposure to a particular asset for a shorter period. Options traders must closely monitor the underlying asset's price to determine whether they are in the money or want to exercise the option.

Options trading is also beneficial as a hedging tool. For instance, if an individual owns shares in a company, they could purchase put options to minimize potential losses if the stock's price falls. This is one reason why options for broad market benchmarks, such as the Nifty 50, are often used as a hedge against potential short-term market declines.

As a result, options trading can be a cost-effective method to make a speculative bet with less risk while providing the potential for significant returns and a more strategic investment approach.

Options Trading Cons

Options trading may not be suitable for everyone, particularly those who prefer a hands-off investment approach. Options trading involves making three decisions - direction, price, and time - which can add more complexity to the investing process than some people are comfortable with.

Unlike trading stocks, there is an additional requirement for options trading in India. The Securities and Exchange Board of India (SEBI) mandates that brokers approve customer accounts for options trading only after they have filled out an options trading agreement. This is to evaluate the customer's understanding of options trading and the associated risks.

To make money from options trading, you need to set price alerts and closely monitor the market to identify profitable trades. Additionally, you must be aware of the risks and trading fees that can accumulate with various options strategies. Although many brokers have eliminated fees for trading stocks or exchange-traded funds (ETFs), fees for options trading still exist.

Commissions for options trading may range from a flat rate to a per-contract fee based on the trading amount, both when buying or selling options. As a result, options traders must consider these fees when evaluating the profitability of an options strategy.

Lastly, since options trades are typically shorter-term in nature, you are likely to incur short-term capital gains tax. In India, any investment held for less than a year is taxed as ordinary income (up to 15%, depending on your income tax bracket) versus a lower long-term capital gains rate for investments held for over a year.

How to Start Trading Options

Before you start trading options, it's important to have a solid understanding of trading. You should also clarify your investment goals, which could be capital preservation, income generation, growth, or speculation. Your broker may have additional requirements, such as disclosing your net worth or the types of options contracts you plan to trade.

Just like any other type of investing, it's crucial to thoroughly educate yourself before you start trading options. You can use online simulators to gain a better understanding of how options trading works before trying the real thing.

When you're ready to start trading options, it's advisable to start small. You can always try more aggressive strategies in the future. At the beginning, focus on an asset that you know well and only wager an amount that you're comfortable losing.

Read More: How Does Trading in A Car Work

Source: https://www.forbes.com

Post a Comment

Lebih baru Lebih lama