What is Options Trading?
Options are contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price on a specific date. They are called derivatives because they derive their value from underlying assets. Options trading is a strategy traders use options to speculate, earn income, and hedge risk.
Options trading can look intimidating, but when used correctly, it offers high profits, which cannot be earned alone from trading shares and ETFs. In options trading, traders speculate on the future direction of the share price or market. Before understanding how options trading works, let’s understand the commonly used terms in options trading.
Commonly Used Option Trading Terminologies
- Call option: An option that gives the buyer the right to buy shares at a fixed price on a specific date.
- Put option: An option that gives the buyer the right to sell shares at a fixed price on a specific date.
- Strike price: The price at which the buyer of a call option agrees to buy the underlying shares, and the buyer of the put option agrees to sell the underlying shares.
- Expiry date: The date at which the option contract expires is the expiry date.
- Premium: The price of the option contract is the premium. The buyer of the option pays a premium and earns the right to buy or sell shares on the expiry date.
- Intrinsic and extrinsic value: Intrinsic value is the difference between the strike price and the asset’s current price. On the other hand, extrinsic value is the difference between the premium and intrinsic price.
- Bullish and bearish: If traders expect the market or share price to go up in the future, then they are bullish about the market. In contrast, if they expect the market to go down, then they are bearish about the market.
- In-the-money: The option is in the money when the asset price and strike price are leaning in the buyer’s favour. In such a case, the buyer will benefit from exercising the contract.
- Out-of-the-money: The option is out-of-the-money when the asset price and strike price are leaning against the buyer, and the buyer will be better off without exercising the contract.
- At-the-money: An option is at the money when the strike price equals the spot price. The buyer can choose or not exercise the contract as both will give similar benefits.
How Does Options Trading Work?
In options trading, if traders are bullish about the market, they can buy a call option, and if they want to bet on falling prices they buy a put option. As a buyer of a call option, traders will fix a price at which they will buy the shares on a future date. In contrast, as a buyer of the put option, traders will fix a price at which they will sell the shares on a future date.
Options trading is a low-cost way to speculate about an asset’s market or share price. This is because, as a buyer of a call or a put option, traders will have the right but not the obligation to fulfil the contract. If the contract is not profitable on the date of expiry, then traders can choose not to exercise their right. In such a case, they will only lose out on the premium.
Traders can also sell the call or put option if they want to speculate about the markets falling or rising and pocket the premium amount immediately. But when they sell, they have to fulfil their side of the contract.
Traders can simultaneously buy call and put options to make money in the short term. They can buy and sell options in different combinations, and each combination is called a strategy.
Types of Options Trading Strategies
The following are the types of option trading strategies that every trader must know.
Bull call spread: It is a bullish strategy where the trader will buy a call option and sell another one with a strike price higher than the former one. He is bullish about the market and will benefit when the underlying security price rises.
Bull put spread: Here, the trader will buy a put option and sell another put option with a strike price higher than the former one. The trader will benefit when the price of the underlying security increases.
Synthetic call or Protective put: In a synthetic call the trader buys the underlying asset and also a put option of that asset. If the asset prices rise, there are unlimited profits; if the price falls, the loss will be limited to the premium paid for the put option.
Bear call spread: It is a bearish strategy where the trader buys a call option and sells another call option with a strike price lower than the former. The profits are earned only when the price of the asset falls. In this strategy, both the profits and losses are limited.
Bear put spread: When the traders expect the markets to go down moderately, they buy a put option and sell a put option with a strike price lower than the former. The losses and profits are limited. Profits occur when the asset price falls.
Synthetic put or protective call: The trader earns profits when the markets go down. Here, this strategy combines a future short position with buying a call option. The profit is unlimited when the price falls, and the loss is limited to the premium paid.
Long and short straddle: It is a market-neutral trading strategy where the trader combines the call and puts options at the same strike price. A long straddle gives unlimited profits with limited loss. In contrast, a short straddle gives unlimited loss, and profits are limited to the premium earned.
Long and short strangle: The trader will buy a call option with a higher strike price than a put option in a long strangle. The profits are unlimited, and loss is limited to the premium paid. Short strangle involves selling a call with a higher strike price than the put. The profit is limited to the premium, and the loss is unlimited.
Long and short butterfly: Butterfly combines the bull and bear spreads and limits the profits and losses to a particular amount. It is a neutral strategy with fixed risk and capped profits.
Advantages and Disadvantages of Option Trading
Advantages of options trading
- Excellent hedging tools: Options are good hedging tools, however, one must use them correctly. Traders can reduce their downside risk in equities by using options. For example, if a trader has shares in a company and they have a concern about the price going down, they can buy a put option to limit the downside risk.
- Cost-efficient: Options are cheaper than equities because they are contracts of underlying assets and do not represent ownership. For example, if a trader wants to purchase 100 shares of a company with a share price of Rs 100 each, they will have to spend Rs 10,000. But in the case of options, they can buy one contract of 100 shares at just Rs 500. Traders can use the rest of the money at their discretion, and earn high profits on the bets.
- Potential for higher returns in the short term: Options have a higher potential to give better returns than equities in the short term. However, the trader must use the right strategies. Since traders are spending less money through options and making almost similar profits as equities, the profit percentage is higher in options.
Disadvantages of options trading
- Complex: Options trading can be very complex as it involves three decisions, direction, time, and price. Traders must consider all three things before implementing an option strategy.
- Additional hurdle: In India, one needs to open a demat account and trading account to trade shares. Though the same demat account works for options trading, there is an additional hurdle which is a compulsion. SEBI mandates all investors to sign the options trading agreement, which lists all risks involved in options trading.
- Uncertainty of gains: Every option strategy works on future expectations and assumptions. The trader earns profits only if the share prices move in a direction as predicted by the trader. Else, the chances of making losses are high.
- Trading fees and commissions: Compared to equities, trading fees and commissions are high in the case of options trading. The more complex the strategy, with more calls and puts, the higher the expenses.
- Tax: All gains in options trading are short-term gains and are taxable as per the short-term capital gains tax rate, which is 15%. Hence, the trader loses a part of the gains in the form of taxes.
Things to Remember While Trading in Options
- Losses: In options trading, the investment is only a small margin amount, lesser than the capital used to buy shares. This can make traders forget the magnitude of losses they will incur if the market doesn’t move in their favour.
- Liquidity: When trading in options, having an exit plan is a must. Trade only in those options with high liquidity. Otherwise, there are chances for funds to block and might also end up making losses. A low-priced option might look attractive, but it is often less liquid than a high-priced one. Hence it is important to balance profitability with affordability and liquidity.
- Hedging: Option trading can be very confusing at first. Beginners must combine options with a regular trade to minimize risk and better understand how options work. It is better to use options for the purpose of hedging first. Ideally only seasoned trades must use it to speculate and make profits.
- Option strategies: The option strategies matter the most when traders want to hedge, speculate, or make profits. Using the right strategy is the key to making money and minimizing risk.
Frequently Asked Questions
You won’t need a considerable amount of money to start trading options. You can start with an amount as small as Rs 2 lakhs. As you understand options trading better, you can increase your capital.
SEBI decides the lot size and uses it to control price quotes in the market. A lot size is a total number of contracts in one option (call or put). It is the minimum number of shares one can buy in one transaction. The standard option contract size is 100 shares.
Technically anyone can trade in options, but it is best to gain some market knowledge before trading in options. This is because the losses are enormous, and one might burn their pockets without proper knowledge.
It is difficult to say which is better, options or stocks. Options are better for active traders, whereas stocks are better for long-term investors. Both options and stocks complement each other in a portfolio as one can use stocks for long-term wealth creation, and options for short-term hedging.