What is Options Trading?

Introduction

Options trading allows investors to speculate on the future direction of the stock market as a whole or individual securities such as stocks or bonds. Options contracts give you the option, but not the obligation, to buy or sell an underlying asset at a predetermined price by a predetermined date.

What is Options Trading?

An option is a financial contract that provides an investor or trader with the right to buy or sell a stock, ETF, commodity, currency, or benchmark at a specified price for a specified period. Options contracts come with a fixed expiry date, usually the last Thursday of a calendar month. When the specified date of expiry arrives, the contract expires, and its value becomes zero. Unlike futures, options do not obligate the buyer or seller to honour the contract.

Options trading in the stock market means you do not own the shares until you exercise the option. This feature makes options trading different from stock trading. When you invest in a stock, you become part-owner of the company. However, when you trade options, you simply express your desire to own the company's shares on a specified date and not own them for real.

Options trading strategies for Beginners

Options trading is one of the most popular investment vehicles for traders. Options confer a right, but not an obligation, on the seller to purchase or sell an underlying asset at a predetermined future price on or before the expiry of a future date. 

There are two types of options – calls and put. Using these options, traders formulate different strategies for trading. These strategies range from being relatively simple to quite complex. Each strategy has a specific payoff and sometimes odd names. 

Whatever the complexity, each strategy has a unique risk-reward trade-off and purpose. If used accurately, these strategies may fetch phenomenal returns for investors. Here is a guide on the basics of call and put options before understanding trading strategies. 

Introduction

Derivatives are financial instruments that derive value from an underlying asset. A call option is a derivative contract that gives the buyer the right to purchase an underlying asset at a predetermined price on or before the contract's expiry. Conversely, a put option confers the right to sell an underlying asset at a predetermined price till the contract's maturity. 

A call or put option does not obligate the buyer. It is merely a right that the buyer may choose to exercise or not. The buyer pays a premium to the seller of the option contract. The buyer will exercise the contract if the market conditions are favourable. If the conditions are unfavourable, then the option expires worthless. 

Below are some of the most commonly used option strategies:

Long Call

Long call refers to purchasing a call option and is a purely directional bet. 

When To Use:

A long call is ideal when you expect the underlying asset's price to increase significantly before expiry. However, if the spot price increases marginally above the strike price, the option may be in the money. But it may not cover the premium paid, and you may end up with a net loss. 

Example:

Suppose you expect the price of ITC Limited to increase and purchase a call option. The option's strike price is Rs. 450 per share, and the premium is Rs. 20 per share. The current market price is Rs. 380 per share. 

Now, the market or spot of ITC Limited on expiry is Rs. 475 per share. However, you may exercise the option and purchase the shares at Rs. 450 per share. In this case, the profit from the trade is the difference between the spot price of the option (Rs. 475) and the strike price of the underlying (Rs. 450), i.e., Rs. 25 per share. Net profit after deducting the premium paid is Rs. 5 per share. 

A long call is a leveraged strategy that enables traders to maximize profit potential with limited capital. In the above example, the capital required to purchase 1000 shares of ITC Limited is Rs. 3. 80 Lakhs (Rs. 380 per share * 1000 shares). The capital required or the premium paid for a long call is Rs. 0.20 Lakhs. (Rs. 20 per share * 1000 shares). The return on capital is significantly higher using the long call strategy.  

Advantages of Long Call:

Traders typically use long calls if there are bullish or confident about a particular stock, an exchange-traded fund, or an index fund. 
A long call is ideal if the trader wants to limit risk and use leverage for maximum profit.

Risk and Reward:

Theoretically, a long call does not limit the profit potential. If the underlying asset's price continues to increase before expiration, the strike price can also keep rising. Therefore, traders extensively use long calls to wager on rising prices. 

The downside to long calls is the upfront investment or premium paid. If the spot price is lower than the strike price, then the option expires worthless. Therefore, a long call is a relatively safe strategy, and traders prefer long calls over outright purchases or futures. 

Covered Call

A covered call is a strategy that involves an existing position in the underlying asset or an asset similar to the underlying asset. Essentially, the trader writes a call option and simultaneously purchases the underlying asset to offset the associated risk. 

When To Use:

A covered call is a good strategy if you own the underlying asset and do not expect a significant price rise in the short term. Experienced traders frequently use covered calls to convert existing holdings into a source of regular income. 

Example:

You hold 1000 shares of RIL at Rs. 1500 per share and decide to write 10 call options with a strike price of Rs. 1600 per share or a premium of Rs. 50. The lot size for each contract is 100 shares. Upon writing the option, you earn a premium of Rs. 0.50 Lakhs (Rs. 50 per share* 10 contracts*100shares). 

On expiry, the price of RIL is Rs. 1550, and the call option expires worthless. In this case, the net profit from the strategy is the premium of Rs. 0.50 Lakhs. Until the underlying asset's spot price exceeds the call option's strike price, the position yields a net profit limited to the premium paid. 

If the price of RIL is Rs. 1650, then the buyer will exercise the call option. The premium paid offsets the loss from the call option. The break-even point for a covered call is the strike price less the premium paid. The above case's break-even point is Rs. 1550 (Rs. 1600 – Rs. 50). 

Advantages of Covered Call:

The primary advantage of a covered call is hedging, which is relatively easy to set up. 
Covered calls generate regular income. Traders may reestablish the position multiple times. 

Risk and Reward:

The upside of a covered call is limited to the premium received, irrespective of the degree of increase in prices. If the share price rises over the strike price on expiry, the trader will have to deliver shares below market price. Covered calls limit the upside potential in exchange for downside protection leading to a lopsided risk-return trade-off. 
 

Long put

Similar to a long call, a long put involves the purchase of a put option and is a purely directional call. Long put is the opposite of a long call. 

When To Use:

A long put is a good option if you expect the underlying asset's price to fall substantially on or before expiry. Bearish traders prefer using long put to benefit from falling prices. 

Example:

Suppose you expect the price of Hindustan Unilever Ltd (HUL) to decrease and purchase a put option. The option's strike price is Rs. 2500 per share, and the premium is Rs. 150 per share. The current market price is Rs. 2600 per share. 

Now, the market or spot of ITC Limited on expiry is Rs. 2300 per share. However, you may exercise the option and sell the shares at Rs. 2500 per share. In this case, the profit from the trade is the difference between the option's strike price (Rs. 2500) and the spot price of underlying (Rs. 2300), i.e., Rs. 200 per share. Net profit after deducting the premium paid is Rs. 50 per share. 

The long call is a leveraged strategy that enables traders to maximize profit potential with limited capital. In the above example, the capital required to purchase 100 shares of ITC Limited is Rs. 2. 50 Lakhs (Rs. 2500 per share * 1000 shares). The capital required or the premium paid for a long call is Rs. 0.15 Lakhs. (Rs. 150 per share * 100 shares). The return on capital is significantly higher using the long call strategy.  

Advantages of Long Put:

Long put allows the trader to use leverage and benefit from falling prices. Capital commitment for significantly low, and ease of transaction is high. 

Risk and Reward:

While the maximum potential for loss from a long put is the premium paid, there is effectively no limit on the future profit from the trade. However, the underlying asset's price cannot drop below zero. 

Short put

Short put or "Going Short" is an options strategy wherein the trader sells or writes a put option. 

When To Use:

A short put is preferable if you expect the spot price to close at or above the strike price on expiry.  

Example:

The market price of HDFC Bank Ltd is Rs. 1200, and you write a put option with a strike price of Rs. 1250 and a premium of Rs.50 per share. 

On expiry, the spot price of HDFC Bank Ltd is Rs. 1300, and the put option expires worthless. You earn a premium of Rs. 50 per share. If the price of HDFC Bank is Rs. 1220, the buyer will exercise the option. The break-even point is the strike price less the premium received, i.e., Rs. 1200. Between Rs. 1200 and Rs. 1250, you will earn some but not all the premium. 

Advantages of Short Put:

Short put allows you to benefit from time decay and profit from a rising or range-bound market scenario. 

Risk and Reward:

Similar to a short or covered call, the maximum from a short put cannot exceed the premium received. The downside of a short put is the underlying stock's total value less the premium received. 

Married put

A married put is a modification of a long put. In addition to purchasing a put, the trader owns the underlying stock. Traders use married puts as insurance for protection against price falls. 

When To Use:

You may use married puts if you expect the underlying asset's price to increase or decrease substantially before expiry. For example, you may await quarterly financial updates that may lead to a price increase or decrease. 

Advantages of Married Put:

Married put not only allows you to hold stock and benefit from price rise but also protects you from substantial loss if the stock falls. 

Risk and Reward:

There is no limit to the maximum profit potential from a married put. The downside of a married put is the premium paid. With a decrease in the underlying asset's price, the value of the put increases. Therefore, the trader only loses the cost of the option rather than any investment value. 

Some Basic Other Options Strategies

The strategies discussed above are straightforward to implement. However, options also entail complex strategies for experienced traders. Below are some examples – 

Protective Collar Strategy – An investor with a long position may use the protective collar strategy. It involves buying a put option and concurrently writing a call option for the same underlying asset. 

Long Straddle – Here, a trader purchases a call and a put option with the same strike price and expiry date. Since it involves purchasing two options, it is slightly more expensive than other strategies. 

Vertical Spreads – Vertical spreads involve buying and selling the same type of option with different strike prices but the same maturity date. Vertical spreads may be bull or bear spreads that will profit when the market rises or falls. 

Long Strangle Strategy – Similar to straddle, the trader purchases a call and put option simultaneously. They will have the same expiration date but different strike prices. The put strike price is lower than the call strike price. 

What Are the Levels of Options Trading

Before initiating option trading, each trader must complete a questionnaire with the brokerage firm. A brokerage firm assigns levels to traders to authorize different categories. 

Level 1: Level 1 allows you to write covered calls and protective puts. 
Level 2: Level 1 AND buy calls or puts; open long straddles and strangles.
Level 3: Level 2 AND long open spreads; long-side ratio spreads.
Level 4: Level 3 AND use uncovered options, short straddles and strangles, and uncovered ratio spreads.

How much money do you need to trade options?

Typically, options trading requires limited capital. Using the above strategies, you may purchase a low-cost option and use leverage for exponential profits. However, it is equally likely to incur losses while putting out all the stops. 

Initially, a meagre investment of a few thousand rupees may be sufficient. Besides capital, patience and in-depth understanding are important for trading successfully.  

Advantages of Trading Options

Leverage - The primary advantage of trading options is leverage. Options require traders to pay the premium amount, not the entire transaction value. Thus, traders can undertake high-value positions with low capital requirements. 

Cost Effectiveness – Traders can use less capital and earn equal profit using options. Naturally, the return on investment is significantly higher than other investment avenues. The cost efficiency of options is high since the premium amount is a modest percentage of the transaction value.
 
Risk Involved - Options are relatively safer than futures or cash markets. The potential for loss from purchasing options is the premium paid. However, writing or selling options may be riskier than purchasing the underlying asset. 
 
Options Strategies – Another benefit of options trading is the possibility of profit in both rise and fall prices. Sometimes, you may not be sure about the direction of the price movement but expect a significant change. Generally, quarterly results, budgets, and top management changes lead to uncertainty. Using a combination of options, a trader can create a strategy that fetches gains irrespective of the underlying asset's price direction.
 
Flexible Tool – Options provide more investment alternatives and are flexible tools. Options allow investors to benefit not only from price movement but also from the passage of time and movement in volatility. 
 
Hedging - Options act as an effective hedging tool and mitigate the risk associated with current holdings. Using a combination of options, traders may virtually eliminate any risk associated with a trade. 

The Bottom Line

Options trading is versatile and provides a trader ample opportunity in each type of market. While options are high-risk investments, traders may opt for basic strategies with limited risk. Even a risk-averse investor can use the option to increase the overall returns. 

However, it is imperative to understand the risk involved and analyze different scenarios before investing. Traders require patience and in-depth knowledge of the markets and instruments for successful returns.