Before you learn to Trade in options, let’s first learn the basics of Options and how it works.
Let’s start with an example related to your daily thoughts, suppose one day, based on your technical analysis, and market study, you just get a strong feeling, or just a prediction that the stocks of Tata Motors which is trading at 2300 might go up to 2500. (2500 is the strike price)
Now if you don’t want to buy the shares of Reliance Industries but you can buy the Option of it because you predict that the stock prices may rise. So you become the Call Buyer because you are exercising the option to buy it. Similarly, if you exercise the option of selling a stock predicting its fall in stock price over a certain period of time, you become the put buyer.
Also, there are two parties to every contract. Since there is a buyer, there has to be a seller also.
There is a call seller to every call buyer and there is a put seller to every put buyer. This was a quick gist of the Options concept, let’s see how is Options defined
What is Option?
An Option is a derivative contract entered by a buyer which allows the buyer to buy or sell an underlying instrument, which could be a stock or an index at a pre-determined price (also known as strike price or exercise price) over a certain period of time. A certain premium amount should be paid by the buyer to the seller. Options trading is a type of contract that gives you the right, at a pre-determined price, to either buy or sell an amount of stock. But you are not obligated to purchase the stock or sell it.
Remember: An Options contract gives you the right but not the obligation to buy or sell the underlying asset.
Let’s also understand the two types of options with simple examples.
When you buy an option that gives you the right to purchase shares is called a call option before the expiry date. Let's use an example to explain option trading.
Example for Call Option :
Suppose, the price of Tata Motors is 1500 as on 10th April 2021 and you believe that the price of this stock may go up to 1800 by the end of the April month. So this becomes a monthly expiry contract. And as you have predicted the prices to go rise it becomes a CALL OPTION contract.
So As you believe that the TATA motors stock should at least reach up to 1800. So, 1800 is your strike price. So the option works in your favor if reaches anywhere around 1800 or beyond 1800.
And by the end of April the TATA motors shares reached 2000.
Would you exercise the Option Contract in this case?
Yes! The prices have gone up beyond the basic target, 1800 that you predicted.
Now, in the same case if the prices of the stock do not go up to 1800 as your predictions, but it goes down by the end of April.
The prices went against your expected direction?
Would you exercise this option contract?
Just as mentioned in the definition, you have the right but no obligation to exercise the options contract.
Whereas the purchase of an option that gives you the right to sell shares is considered a Put option before the expiry date.
Example for Put Option:
Let’s say Reliance industries are currently trading around Rs.2000 and you predict that the price of this stock will fall down to Rs.1900. So you buy the 1900 put option in Reliance Industries. In short, this means you feel that the price of Reliance industries will surely go down from 2000 to 1900 or below.
The Reliance Industries stock price fall below 1900
As you bought the 19 put options and the price fell as expected then you (put buyer) will sell the reliance industries share at 1900.
Conclusion- If the price falls below the strike price in the put option so the buyer of the put option will sell the shares.
For options trading in India, you can purchase any underlying instrument such as stock, commodity, index, or forex.
What is Options Trading in India?
Options trading is when you buy/sell options contract on a recognized stock exchange on a trading platform offered by your stock broker. Trading in options is often referred to as trading in derivatives since options contracts derive their value from the underlying instruments.
And as we discussed earlier, you can buy or sell options in a day without having to think about exercising the options because options trading offers you the right but no obligation to exercise the right.
You also don’t have to worry about suffering huge losses against wrong predictions because you just need to pay a certain amount of percentage as a premium in order to buy an option.
Options give you the right to purchase a larger number of shares for a small sum of money (called a premium) compared to purchasing a stock.
Let’s take an example of premium
For example, by paying Rs.72.50 for a particular strike price that has 505 underlying Reliance shares, you can purchase 1 call option contract from Reliance.
Regardless of the current stock price, a reliance call option with a strike price of Rs. 1900 gives you the right to buy 505 Reliance shares at Rs. 1900.
You would need around Rs 959500 (1900* 505) to directly buy 505 reliance shares.
Do You Need an Options Trading Account?
Buying Options is not like buying stocks. Options trading just requires you to go through a few very quick steps in order to get started.
Step 1- Select a Good Options Broker
Step 2- Create a brokerage account and get started.
While finding the right broker, look for brokerage firms that offer the tools, research, guidance and support you in need. This is especially important for investors who are new to options trading.
Yes, and that’s all. Just find a suitable opportunity and you are now all set to start trading options in a live account.
Does it bother you that why don’t need a Demat account for options trading unlike trading in stocks? Options contracts are cash-settled, and the underlying instruments are not delivered. Hence, you don't need an account with demat. For trade-in options, a trading account associated with your bank account is enough.
How many shares can you trade while buying/selling an option?
Options can only be traded in lots. And a lot size refers to the number of underlying resources you buy in one transaction.
A fixed number of underlying resources requires a single lot size. For instance, 1 batch of Infosys call or put options has 1200 shares underlying Infosys.
For trading options, full-service stockbrokers charge Rs. 50 to Rs. 100 per lot. Whereas, for trading options, discount brokers charge a low flat Rs. 20 per lot.
Full-service stockbrokers charge Rs. 50 to Rs. 100 per lot for trading options. Whereas, discount brokers charge a low flat Rs. 20 per lot for trading options.
Need Margin Money
Options trading requires you to maintain a minimum amount in your account. This acts as a margin amount that has to be equal to the premium amount multiplied by the underlying contract value.
As options are considered fairly risky so just if you incur a loss on a day then the difference amount can be immediately made good from the margin. Hence you need to maintain a margin account with your broker and you need not put up the entire value of the trade.
For example, to buy 1 lot of Reliance Industries Nifty Call options (that has an underlying value of 35) and currently premium trading at Rs. 1500, you need to have Rs. 1500 x 35 = Rs. 52,500 cash in your account.
But, for selling options contracts there are exchange stipulated margins requirements based on the volatility of the underlying instruments that are higher in comparison to buying options.
In general, you need to keep at least Rs. 1.5 Lakhs to Rs. 2 Lakhs of funds in your trading account depending on your trading requirements
An Investor can also trade other financial instruments such as futures and options and also stocks (if available with their broker) through the Margin account.
Find Liquid Options for Trading
Liquidity refers to how easy it is to sell or convert an option contract to cash. Liquid options are the options that are frequently traded and are popular among investors. The best way to measure option liquidity is by looking at the daily volume and open interest. A particular stock has on an average 15-20 call options available.
The most liquid option is the one whose strike price is close to its current stock price
For example, Bank NIFTY stock shows the following ‘call options contract’ with different strike prices. And an equal number of ‘Put options’ are available for trading. For trading options, you need to have the most liquid options contract so that you can buy/sell at any moment.
NSE India list of the most active call option details.
All that you need to know before trading in Options
Considering the volatility of the stock market and its unpredictability, you must know by now that options trading can be a bit more complex than stock trading. But when done correctly, options trading has the potential to give you large profits than traditional stock investments. To buy a stock you just need to identify the stocks that you’d like to buy and place an order with your broker. Trading in options requires market study, learning advanced strategies and a string analysis of the product you wish to deal with. The process for opening an options trading account includes a few more steps than opening an investment account.
Options trading can be fairly risky, and if done correctly, it can give limitless profits and only limited losses. If that sounds exciting to you. Here’s how to get started with options trading in a few steps:
Learn the requirements for opening an account
Firstly, to start you need to be prepared to take this first step i.e. one should learn and study the market which includes learning about the options available in the market, searching for the right trading options, looking for the most liquid options.
Once you have decided which options you want to buy and you have possibly reasonable predictions in mind for the market you will need to open an options trading account with the broker online. Opening an options account needs you to have a large amount of capital to trade.
And considering the complexity of predicting the movement of multiple stocks at a given time the broker needs to be aware of the investor’s potential to bear risk before granting them a permission slip to start trading options.
Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks, and their financial preparedness.
You’ll then need to provide the broker with certain other details as follows:
Investment objectives - This may include your income, growth, capital preservation, or speculation.
Trading experience - The broker will want to know your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year, and the size of your trades.
Personal financial information - Your liquid net worth (or investments easily sold for cash), annual income, total net worth, and employment information.
The types of options you want to trade.
Based on your preferences and answers, the broker will ideally assign you an initial trading level which generally ranges between 1 and 4. Based on your answers, the broker typically assigns you an initial trading level (typically 1 to 4, though a fifth level is becoming more common) that is your key to placing certain types of options trades.
And this process of screening should be carried on both ends. The broker you choose to trade options with is your most important investing partner.
Decide which direction you think the stock is going to move
This determines what type of options contract you take on. If you think the price of a stock will rise, you’ll buy a call option. If you think the price of a stock will decline, you’ll buy a put option.
As a refresher, a call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price (called the strike price) within a certain time period. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.
Predict how high or low the stock price will move
An option stock becomes more valuable when the option is about to expire and closes ‘in the money. ‘In the money means above the strike price (for the call) or below the strike price (for a put). You will prefer buying the option with a strike price that you can predict well during the option’s lifetime.
You can’t choose a random strike price. Option chains data presents a range of available strike prices. The spread between strike prices is standardized across the industry based on the stock prices— for example, Rs.50, Rs.100, Rs.200, or even Rs.500.
Just like discussed in the first part of this article.
For example, if you believe the share price of a company currently trading for Rs.100 is going to rise to Rs.120 by some future date, you’d buy a call option with a strike price less than Rs.120 (ideally a strike price no higher than Rs.120 minus the cost of the option, so that the option remains profitable at Rs.120). If the stock rises above the strike price, your option is in the money.
Similarly, if you believe the company’s share price is going to dip to Rs.80, you’d buy a put option (that gives you the right to sell shares) with a strike price above Rs.80 (ideally a strike price no lower than Rs.80 plus the cost of the option, so that the option remains profitable at Rs.80). If the stock drops below the strike price, your option is in the money.
Determine the time frame in which the stock is likely to move
Every options contract has an expiration date which indicates the last day to exercise the option. Here, too, you can’t just pull a date out of nowhere. You can only choose the expiry dates from the ones offered to you when you call up an option chain.
Expiry dates can range from days to months to years. Daily and weekly options are known to be the riskiest and are saved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out.
The option can hold time value, regardless of whether the stock trades below or above the strike price. An option’s time value declines as expiry approaches. The options buyers would prefer not to watch their bought options decrease in value, as then it would possibly expire uselessly if the stock ends below the strike cost. In the event that a trade has gone against them, they can still sell any time value left on the option and this is almost certain if the option contract is longer.
Hence a longer expiration contract is also known to be helpful.
An Options Trader must always believe that “Analysis and forecasting is a two-step process and without either of them, he can’t survive long in the market.”