Option Trading Basics – Types, Definitions, Strategies, Benefits

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Options trading is catching up fast with investors in India due to its flexibility and promise of high returns. Like equity stocks, options have their own characteristics and it is better to understand the nuts and bolts of this machine before trying to ride it. This article is aimed at getting the basics of trading options right and not getting swayed by profit screenshots floating on Twitter.

What are options?

Options were originally designed to offer buyers the flexibility to purchase a security at the specified price or date. Simply put, the buyer of an option contract has the option to purchase the underlying security or commodity at a predetermined price on an agreed date in exchange for an upfront payment to the seller. This upfront payment is called premium that is payable by option buyer to the option seller (writer).

Options are different from Futures in the sense that the buyer of options contract is under no obligation to purchase the underlying security or commodity.

What are the different types of options?

Broadly speaking, there are two types of options – call (offers the option to buy) and put (offers the option to sell). However, there are variations of both call and put options based on exercisability, contract validity, and underlying security.

For example, European option contracts allow the option buyer to exercise the right to buy or sell only on the date of expiration and not before that. On the other hand, American option contracts can be exercised any time before the expiration date.

Based on contract validity, there are weekly and monthly options and even longer term contracts called LEAPS spanning one to three years.

Similarly, there are stock options where the underlying is the specific stock while index options track a market index.

There are more option types on the basis of other parameters and we plan to cover this topic in a separate post.

Who are the parties involved in options?

An options contract will typically have an option seller (also known as option writer) and option buyer. Option seller or option writer assumes unlimited risk and limited upside. On the other hand, option buyer has limited risk (loss of premium) and unlimited upside.

How do option buyers and sellers make money?

An option buyer purchases a contract in anticipation of price movement in a specific direction. A call option buyer stands to benefit if the market or commodity price goes up and similarly, a put option buyer will make money if the market or commodity price tanks.

If the price movement isn’t significant enough, it wouldn’t make sense for buyer to exercise the option and this way, the option seller gets to keep the premium.

Read Also: 7 common IPO mistakes and how to avoid them

Example of options trading

Let’s assume Ashok Leyland is currently trading at INR91 per share and a trader finds it overvalued. Expecting a price decline, a trader buys a put option at INR3 for the strike price of INR85. In other words, the trader has bought a right to sell Ashok Leyland shares at INR85 even if the stock price declines further. If the stock indeed declines, let’s say to INR75 per share, the trader will pocket a profit of INR7 (difference between 85 and 75, adjusted for cost price of 3). As long as the stock price stays above INR88 (strike price + premium), the trader wouldn’t make money and will eventually lose the premium.

One thing to note here is that option trading is done in lots of varying sizes. The lot size of Ashok Leyland is 9,000 which means that all the cost and profit figures will increase by this multiple. Accordingly, the purchase cost of a single lot will be INR27,000 and the profit, in case the stock price moves to INR75, will be INR63,000.

What are different options trading strategies?

Depending upon the direction and expected moves of the market, traders combine options with futures and stocks. These option trading strategies are aimed at minimizing losses and choosing setups with better risk reward payoffs. Some of these include spreads, covered call, iron condor, and butterfly.

A judicious use of options trading strategies combined with risk management can indeed help in generating smart gains from the stock market. However, there is also a substantial downside in trading options and unfortunately, this is usually sidelined by new traders and investors.

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