In the last couple of years, there has been a significant increase in stock market activity. This was witnessed as the trading volume has increased multifold in India. Most of the trading volume is generated from the derivatives market which comprises buying and selling of futures and options. These derivative contracts derive their value from the underlying asset.
As they do not have a value of their own, their prices change as the value of the underlying asset changes. The traders make the most out of these price fluctuations to gain from it. Options trading has been a fascinating instrument as the prices are very volatile. But at the same time, one cannot ignore the fact that extreme volatility comes with a high risk of loss.
Be it the profitability or risk, in this article, we will look at all the aspects of options trading. Let’s get started with the basics first.
Options are the derivative contracts that derive their value from the underlying asset. An options contract gives the buyer a right to buy or sell the underlying asset to the seller of the options who are obligated to sell or buy the same asset at a predetermined price and date.
This predetermined future date is called the exercise/expiration date and the predetermined price is called the strike price. The options are of two types, (i) Call option and (ii) Put option. Let us understand each of them below.
A call option is a contract that gives the buyer a right to buy and the seller an obligation to sell. An option buyer pays a premium to the seller. This premium goes up as the price of the underlying asset rises.
A put option contract, on the other hand, gives the buyer a right to sell and the seller an obligation to buy. The value of the premium paid buyer rises as the price of the underlying asset falls.
Buying and selling the above-mentioned options contracts is what options trading is all about. You can trade options either by buying a call or put option or by selling a call or put option. Many traders also use the combination of all four and trade options based on various strategies.
Let us look at how you can trade in the options one by one for each type.
Call options are typically used to initiate a bullish position in the underlying stock or index. To buy the call option, a buyer pays a premium. As the price of the underlying stock or index goes up, the option premium rises and a trader makes a profit. For instance, you are bullish about Stock A, therefore, you buy a call option for Rs. 10 with a strike price of 1200. Let’s assume that the current market price of Stock A is Rs. 1100. So, as the stock price goes up, the premium of Rs. 10 will increase, giving you profit. If the stock price falls, your maximum loss will be Rs. 10 per share.
Put options are considered for initiating a bearish position in the underlying index or stock. The premium paid for buying a put option increases as the price of the underlying stock or index falls. The buyer of the put option can benefit from the falling prices as the put option premium and price of underlying stock are inversely related to one another. For example, if you are bearish on Nifty, you can buy a put option. Suppose, Nifty is currently trading at 18000 and you buy a put option with a strike price of 17900 for Rs. 50. As the index spot value goes down, your option premium will increase, giving you the profit. However, if Nifty goes up, the maximum amount of loss will be Rs. 50.
So far, we have discussed buying options. But somebody has to sell the option for us to buy, right? The action of selling options is called option writing and the sellers of options, call or put, are called option writers. An option writer sees options from an opposite perspective. A seller collects the premium paid by the buyer of the option and their maximum profit is limited only to the premium collected.
The risk of potential loss in option selling is practically unlimited. Therefore, option writers always have their positions hedged in the stock market to avoid huge losses. Unhedged option selling is highly discouraged due to its potential of unlimited loss.
However, if options are traded in the right way, it has many advantages. Let us look at them below.
We have listed some of the benefits of options trading for you.
Apart from the above, there are certain considerations, which are discussed below, that the options trader must understand.
The Bottom Line
Trading options can be very rewarding if they are used in the right way. The added advantage comes from the ability of options to provide unlimited profit potential and limited risk of loss. But due to high volatility in options premium, it is an extremely risky asset class as well. Therefore, options trading requires keeping stop-loss orders in place and demands proper trade management.
Apart from just trading in one option, you can trade multiple options to hedge your position to avoid big losses. However, you might end up paying high brokerage if you have a higher number of transactions. You can choose a plan offered by TradeSmart to save on your brokerage. TradeSmart has the lowest F&O brokerage in India starting from 0.007% or Rs. 15 per order, as per the plan of your choice. Find out more here.
You can buy a call option if you have a bullish view as you can benefit from the increased premium as the price of the underlying asset goes up.
No, the margin required for selling an option is higher compared to buying the option. This is because the loss exposure in selling options is unlimited whereas the maximum loss in the case of option buying is the premium paid.
MTM stands for mark to market or mark to margin. It is a technique that calculates the present value of your trade that is still active. Its purpose is to bring the fair value of trading positions based on the daily price fluctuations.
There are numerous strategies that include a combination of buying and selling call and put options to build hedged positions in the stock market. Iron condor, butterfly, strangle, straddle, etc. are some of the commonly used option trading strategies.
Options are considered one of the riskiest trading assets. Options premium prices are highly sensitive and often the prices make wide swings. You must always keep a tight stop loss in place while trading in options.
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Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.