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What is Option Trading?

Mahesh Sawale
3 Mar, 2022

What is Options Trading? | Options Trading and Its Types

When we think about options trading, there are many options available to us.

Every option has some positive and negative aspects.

Many trading methods offer benefits when invested for the long term, while many provide investment gains over the short term due to periodic price movements.

The methods of doing such trading include option trading. Options are like derivative products whose price of securities depends on their underlying asset.

In this detailed post, we will understand with the help of examples how it works and how to use it in your trading.

What is Option Trading?

Let us now discuss in detail Option Trading.

Options trading is a form of contract in which the buyer of an option has the right to exercise his options at a specified price in a specified period of time.

At the same time, we should also note that in options trading, the buyer has only the right to exercise the options but he cannot exercise this option. Whether the trader can exercise the option to buy or sell the securities depends on the market value of the security.

A fixed fee or premium is charged for placing an option contract and this fee is non-refundable. In this options trading, the predetermined price is called the strike price, and the predetermined time is called the expiry date.

How to do Option Trading?

If you are a beginner-level investor, you need to understand some aspects of this form of trading.

Option trading is a great way to reduce the risks in the market.

The buyer of an option can enter a contract to move the market in a certain direction, and then if his guess turns out to be correct. If he makes a profit then he can use this option to limit his loss. But if his guess is not correct, he can choose not to exercise the option to secure his capital and pay the contract fee.

For example, an options trader holds shares of IBM at their current price but thinks they are a bit expensive, and they are going to drop in value soon. In this case, he can choose to sell the option for ₹157 per share and also pays a premium of ₹2 per share.

As expected, even if the market falls down to ₹ 153 now, the trader can sell his shares for ₹ 157 only, due to which he has to suffer less loss because if he does not do this then he can sell his shares for ₹ 153. I could sell it.

On the other hand, if the market rises in any way and the price of the share becomes ₹ 162 then he still cannot use the option for his option trading and sell his shares for ₹ 162 (current market). price) for which he has to pay only ₹ 2 premium.

Option Types

After knowing the basic information of options trading, let us now talk about the types of options.

There are two parties involved in options trading - the buyer of the option and the seller of the option. In this, the buyer has the full right to exercise or not to exercise his option, but if the buyer decides to sell it, then the seller is obliged to sell it. Writing and selling an options contract is very difficult, but it can also be very profitable if the right steps are taken at the right time.

Options trading can be done in two different ways:

European: In European options trading, options can be exercised only on the option's expiry date, which is a predetermined time.
American: In American options trading, options can be exercised anytime between the purchase of the option and its expiry date.

But we must note that the only European way is available for options trading in India. As discussed, an options trader can only buy the option to buy or sell his securities.
Now it depends on him because option trading can be done in two ways:

Call Option: 

A call option is a derivative contract between two parties, in which the buyer of a call option has the right to exercise his option to buy a particular asset for a specified period of time and at a fixed price. It should also be noted that the buyer of a call option has only the right to buy the asset and not the obligation to exercise the same.

For example, if Wipro stock is trading at ₹273 per share and the trader enters into a call option contract to buy ₹275 per share, the call option buyer has the right to buy the stock at ₹275 per share This price is called the strike price.

The trader can buy this contract at the strike price irrespective of the current stock price on the expiry date which is April 30.
So, in this case, even if the share price becomes ₹280, the trader can still buy the share at ₹275 until the call option has expired.

Put Option: 

A put option is an option trading contract in which the buyer has the right to sell his underlying financials at a specified price during a specified time in the future.

This way the owner of securities can protect himself against market downturns by pre-determining the sale value of his securities.
If the price of the securities falls below the strike price before the expiry date, the trader avoids the loss by selling these securities at their strike price instead of their current market value.

However, if the price of the securities remains the same or rises, he can opt for forwarding profit by not exercising the option.
For example, if IBM shares are trading at ₹190 per share and a trader buys his stock in a put option at ₹185 per share, he also has to pay a premium of ₹5 per share.

But when the earnings report is released, soon the value of the shares goes up to ₹170 per share.

Even then, the buyer of the put option has the right to sell his IBM shares for ₹ 185 per share.
In this way, he gets a profit of ₹ 15 per share, out of which even if the premium of ₹ 5 per share is reduced, he is still in profit with ₹ 10 per share.

Option Trading Strategies

It has been seen many times that a lot of traders, especially new ones, start doing options trading without any understanding and knowing the concepts. It needs to be understood that options trading if done with the right strategies can help limit your losses and maximize your profits.
To get to that level, you just need to understand some basic and advanced level options trading strategies. 

We are listing some of the top strategies for your reference:
  • short put
  • short call butterfly
  • bull call spread
  • long call
There are lots of other options strategies that have their own set of provisions, actions and risks, and profits.

Options Trading Tips

If you are completely new to the world of options trading, here are some tips for you.

Remember, following one or two options trading tips doesn't really help. You need to consider all of these when making your trading decisions.

Here are some Option Trading Tips:
  • Keep the time period in mind and be careful, otherwise, you will be at a loss due to time pressure.
  • Look for stocks with high volume and liquidity.
  • Option buyers should ideally go for volatile stocks.
  • It makes sense to trade options through a stockbroker with low brokerage charges Because the premium and other costs are already high in this form of trading.
  • Pay attention to the risks according to your risk appetite.
  • If you don't know about a trading product, don't choose it.
Following these options trading tips will not only help you maximize your profits but also help you control your potential losses.

Option Trading Rules:

From the above example, you must have understood what is option trading, with this if you want to trade-in options now then it is important to follow some rules so that you can get success in options:
  • Consider position sizing
  • don't overtrade
  • Take into account the duration of the position
  • assess the risks
  • maintain discipline in trade
By following all these rules, you can reduce your losses in options trading or you can increase your profits.

Options Trading Intraday:

The performance of options trading in intraday setups shows the need for your own pressure and analysis expertise. You can certainly perform this form of trading in a single trading session. However, you will need to use multiple options trading strategies depending on the market conditions, trends, and expectations.
You are looking for stocks with high turnover in volatility and volume so that you have the opportunity to make a huge profit out of them. Furthermore, it is worth looking for as many opportunities as your profit takeaway will be limited on a per-trade basis, and thus, with multiple options contracts, you will need a large number of options to make profits and minimize losses.

Options Trading Risks

Similarly, when we talk about the risks associated with this form of trading, it is definitely here as well.

Most of the traders in options trading don't really understand how it works. Obviously, it's not rocket science, but you need to consider all kinds of changes that are likely to happen with stocks as well.

Certainly, you will vouch for the most likely scenario that you think will happen according to your stock market analysis.

Most of the time, the monetary amount that is at risk is basically what you pay for the contract, depending on the strategy you use.

It could be more than that, though, so it would basically be that you had no idea what you were doing.

Conclusion:

Options trading is a smart and efficient way of trading to maximize profits and limit risk from short-term investments.

If handled well, this options trading can help the trader with unlimited profits as well as save his capital.
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