What are Options & How to Trade Options?
What are Options & How to Trade Options?
Think of your investment portfolio as a recipe that includes various ingredients, each playing a unique role in flavoring your financial journey. These ingredients, or asset classes, typically consist of stocks, mutual funds, exchange-traded funds (ETFs), and bonds. However, there's another ingredient on the shelf called "options." When used wisely, options trading can add a spicy twist to your investment portfolio, offering advantages that stocks and bonds alone cannot provide.
What are Options?
Imagine options as a contract that grants you the freedom (but not the obligation) to buy or sell financial instruments like stocks, ETFs, or index funds at a predetermined price after a specified period. These contracts are traded in a special marketplace known as the options market.
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Types of Option Trading and How They Work
Do you ever hear people talking about "call options" and "put options" in the world of stocks and investments and wonder what they mean? Don't worry; you're not alone! These terms might sound a bit complex at first, but let's break them down in a way that's easy to understand for the everyday Indian.
1). Call Options: Making Money When Stocks Rise
A call option is like a special contract that gives you the power to buy a specific stock at a fixed price, but you don't have to if you don't want to. Imagine you want to invest in the shares of Punjab National Bank (PNB). Right now, the stock is trading at Rs 74 per share, but you believe it's going to shoot up to Rs 100 within a month.
Here's where a call option comes in. You can buy a call option for PNB at a "strike price" of Rs 74. This means that, for a certain amount of money (called the "premium"), you secure the right to buy its shares at Rs 3 each (premium), no matter how high the actual stock price goes.
Now, if, by the time that month is up, PNB's stock does indeed reach Rs 100, you can then sell them at the market price of Rs 100 and you collect the increase in premium. You've just made a profit! But if, for some reason, the stock price doesn't go above Rs 74, you don't have to buy those shares, and the only loss you face is the premium you paid for the call option.
In simple terms, a long call option is when you think a stock's price will go up, and you want to make money from that increase.
2). Put Options: Profiting When Stocks Fall
Now, let's talk about put options. This is another type of contract, but it's all about making money when a stock's price goes down. Suppose you believe that PNB stock, currently at Rs 74, is going to drop to Rs 50 in a month.
With a put option, you can buy a contract strike price of Rs 74 at 2.50 rupees. This gives you the right to sell your shares if their market price falls below that. So, if the stock does indeed drop to Rs 50 or lower by the specified date, you can sell your shares and collect the difference in premium, making a profit. But if the stock price stays above Rs 74, you'll end up with a loss, which is just the premium you paid for the put option.
In simple terms, a long put option is when you expect a stock's price to go down, and you want to profit from that drop.
3). Short Options: The Other Side of the Coin
Now, there's something called a short option, but this involves selling these contracts instead of buying them. When you're short on a call option, you're basically saying, "I'll sell you this stock at the strike price." Conversely, when you're short on a put option, you're saying, "I'll buy this stock from you at the strike price." People do this when they believe the market will move in a way that benefits them.
How to Trade Options in Simple Steps
Options trading offers a unique flexibility to traders and investors in India. When done correctly, using sophisticated strategies like spreads and combinations, it can potentially yield profits in various market scenarios. Here, we'll break down a simple four-step process to help you start options trading:
1. Determine Your Objective
Before venturing into options trading, it's essential to have a clear investment objective. This is true for any type of investment. Your objective will guide your trading decisions. Here are some common reasons for trading options:
- Speculation: Many traders engage in options trading based on their expectations of market movements. They speculate on whether the underlying asset's price will go up (bullish) or down (bearish). Speculation can offer significant profit potential but also comes with higher risk.
- Hedging: Hedging is an advanced strategy used to reduce the risk associated with financial assets. It involves techniques like offsetting derivative positions or diversifying investments to protect against potential losses.
- Arbitrage: Arbitrage involves taking advantage of price differences for the same asset in different markets. While it's common in forex trading and stocks listed on multiple exchanges, such opportunities are often short-lived and can be challenging to find in options trading.
2. Assess Risk-Reward Payoff
Once you've defined your investment objective, you should analyze the risk-reward payoff based on your risk tolerance. Remember that risk refers to the uncertainty and potential loss in an investment decision, not the actual loss itself. To manage risk effectively, consider your risk appetite.
If you are a conservative investor or trader, it may not be advisable to use aggressive strategies such as writing puts or purchasing deep out-of-the-money (OTM) options. It's crucial to understand the risk-reward profiles of different options strategies fully.
3. Develop a Strategy
Creating a well-thought-out strategy is a cornerstone of successful options trading. Begin by researching the volatility of the underlying asset and other factors that can influence its price movement. Understanding these factors will help you design an effective options trading strategy.
For instance, suppose you have a sizable stock portfolio and want to generate additional income before companies release their quarterly earnings reports. In this case, you might opt for a covered call writing strategy, where you hold the underlying stock and sell call options. This strategy generates income from premiums and reduces the risk associated with holding stocks.
You can also combine multiple options to create more complex strategies, such as:
- Bull Call Spread: Buying calls at a specific strike price while simultaneously selling the same number of calls at a higher strike price, all with the same expiration date.
- Bear Put Spread: Buying put options at one strike price and selling an equal number of put options at a lower strike price, all with the same expiration date.
- Protective Collar: Combining the purchase of an out-of-the-money put option with the simultaneous sale of an out-of-the-money call option on an already-owned underlying asset.
- Long Straddle: Simultaneously purchasing a long call and a long put option on the same underlying asset, with the same strike price and expiration date.
- Iron Condor: Combining an out-of-the-money put write with the purchase of an out-of-the-money put (a bull put spread) and selling an out-of-the-money call while buying an out-of-the-money call (a bear call spread).
- Iron Butterfly: Writing an at-the-money put while buying an out-of-the-money put and simultaneously selling an at-the-money call while buying an out-of-the-money call.
4. Establish Parameters
Once you've chosen your specific options strategy, the final step is to set the option parameters. This involves selecting the expiration date, strike price, and option delta to align with your trading goals. For example, if you seek a call option with maximum maturity but minimal cost, you might consider an out-of-the-money call. Conversely, if you want a higher delta call, you can opt for an in-the-money option.