options trading

What is Options Trading & How Does it Work?

Investors may speculatively predict the future course of the whole stock market or specific instruments, such as stocks or bonds, via the use of options trading. The opportunity to purchase or sell an underlying asset at a specific price by a certain date is provided by options contracts, but it’s not a legal requirement.
What do Options mean?

Without having to purchase the speculative asset in issue, investors may use options as tradable contracts to make predictions about whether its price will be more excellent or lower at a certain point in the future.

For instance, Nifty 50 options allow investors to opine on the potential course of this benchmark stock index, which is sometimes seen as a proxy for the Indian stock market. Options first look a bit paradoxical, but they aren’t as tricky as they seem. Several essential phrases are all you need to comprehend options:

Derivative- Options are a derivative, meaning that an option’s value is derived from another asset. Consider stock options, where the price of a particular stock determines the option contract’s value.

Call option and put option– In contrast to a put option, which enables you to sell a security at a future date and price, a call option allows you to purchase a security at a fixed price by a specific date.

Strike price and the date of expiry- A special price is a preset price that was discussed before. Until the expiry date of an option contract, traders may exercise the option at the strike price.

Premium- A premium is a cost associated with buying an option, which is determined by considering the value and price of the underlying asset.

Intrinsic and Extrinsic value- The difference between the strike price and the current value of the underlying asset in an option contract is known as intrinsic value. Extrinsic value refers to other elements that influence the premium that is not included in intrinsic value, such as the option’s expiration date.

In-the-money and out-of-the-money– An option is considered to be in-the-money (profitable) or out-of-the-money (unprofitable) depending on the price of the underlying securities and the time to expiry (unprofitable).

Understanding Options Pricing

Let’s use an example to explain this language. Think about a stock that is now selling for INR 100 per share. Here is how, according to the strike price, the premiums—or prices—affect various options.

When you trade options, you pay a premium up front in exchange for the option to buy or sell the fictitious stock at the predetermined strike price before the expiry date. Call options and put options are both available to you.

Since the options contract enables you to purchase the stock at a lower price than it is currently trading for, call options with a lower strike price have more intrinsic value. Your call options are in-the-money if the stock price stays at INR 100, allowing you to purchase the shares at a reduced price.

For put options, however, a higher strike price has a more excellent intrinsic value since you may sell the stock at a higher price than it is presently selling for, thanks to the contract. If the stock continues at INR 100, your options are still worth something, but you have the option to sell them for more money by setting the strike price to INR 110.

options trading
What is Options Trading?

You may use a variety of options trading tactics, from a simple approach to complex, convoluted deals. However, in general, trading call options is how you bet on increasing prices, while trading put options is how you bet on decreasing prices.

A minimum of 100 shares of stock or other assets may be purchased or sold under an options contract. If a transaction is unsuccessful, there is no need to exercise options. The only money investors stand to lose if they decide not to exercise their options is the premium they paid to buy the contracts. As a consequence, speculating on a variety of asset classes through options trading may be pretty inexpensive.

Options trading enables you to speculate on:
  • Whether the price of an asset will change from its present state.
  • How much a price change will there be for an asset.
  • The day these pricing increases will take effect.

With call and put options, you must see a change in the underlying asset’s price to break even, which equates to an amount in rupees equal to the premium paid plus the strike price. How to make money is as follows:

  • Call options: You may sell a call option and profit from the difference between the premium you originally paid and the current premium after the underlying asset’s price has exceeded the break-even point. As an alternative, you may use the option to purchase the underlying asset at the agreed-upon strike price.
  • Put options: If the asset’s price falls below the break-even point, you may sell the underlying option contract to close the position and get the premium spread. You may also use the option to sell the underlying asset at the agreed-upon strike price.

Let the contract expire to avoid losing more money than you invested in the option if the asset’s price goes against you and you choose a put or call option (e.g., the premium plus associated trading fees).

Advanced traders may pair two or more calls or put with various strike prices or expiry dates, making options trading strategies highly complex.

Pros of Options Trading

Specificity and flexibility are combined in options trading. The price the trader believes an asset will reach over a specified period must be locked in by selecting a precise strike price and expiry date. They are not required to execute a deal, but they do have the freedom to wait and see how things pan out if they are incorrect.

Options trading techniques are attractive to traders who wish to restrict their exposure to a particular asset for a shorter length of time since options contracts have an expiry date, which may be a few days to many months. Options traders must closely watch the underlying asset’s price to assess if they are in the money or wish to execute their option.

Trading options are appealing as a hedging strategy. You may purchase put options, for instance, if you hold stock in a firm to limit your potential losses if the stock price declines. One reason this is why options on extensive market benchmarks, such as the Nifty 50, are often utilized as a hedge against potential short-term market falls.

Options trading may thus be a cost-effective method to place a speculative wager with reduced risk while still providing the possibility of huge rewards and a more planned approach to investing.

Cons of Option Trading

Not everyone should engage in options trading, particularly those who choose a passive investment strategy. Options trading effectively requires you to make three choices (direction, price, and time), which some investors may find too complicated.

In contrast to stock trading, there is a further barrier in options trading: Brokers are required by the Securities and Exchange Board of India (SEBI) only to allow client accounts for options trading once you have completed an options trading agreement. Your comprehension of options trading and the risks involved will be evaluated using this.

Set price alerts and carefully check the market to observe when your deal becomes lucrative if you want to succeed at options trading. You also need to know the costs associated with trading, which may mount up when using different options techniques. While many brokers no longer charge commissions for trading stocks or exchange-traded funds (ETFs), they still apply to options trading.

When you purchase or sell options, commissions might be a set cost or a charge dependent on the number of contracts you trade. Therefore, while assessing the profitability of an options strategy, options traders must consider these costs.

Last but not least, as options transactions are by their very nature shorter term, you may result in short-term financial gains. Any investment you’ve held for less than a year will be taxed in India as ordinary income at a rate of up to 15%, depending on your RBI income tax category, as opposed to assets you’ve owned for more than a year, which would be taxed at a lower long-term capital gains rate.

Steps for Beginning Options Trading

Before you get started with options, it’s essential to have a good foundation in trading. Your investing goals, such as capital preservation, income generation, growth, or speculation, should then be described. You may also need to disclose your net worth or the options contracts you want to trade, according to your broker’s additional requirements.

Like any other kind of investment, it is advisable to do your homework before you start and utilize online simulators to get a sense of how options trading operates before you try it out for real.

Start modestly when trading options when you’re ready to do so; you may always attempt more aggressive options tactics later. It’s preferable to start with a stake that you can afford to lose and concentrate on an asset you are familiar with.