With online trading becoming the predominant way to trade in the markets, you can trade options with a few clicks on your trading app. Now, options trading is generally associated with terms like high profits, limited downside, and high risk. The latter two terms may seem contradictory, but, in fact, they both hold true. When you trade options, the downside is limited, however, if you trade irresponsibly, you can lose a lot of money instantly. On the other hand, if you trade diligently, options trading can prove to be a very lucrative venture. However, many options traders underestimate the risks involved and end up falling into the “irresponsible trader” category.
So, here is a complete guide to get you started with options trading. Let us start by understanding what options contracts are. Then, we will cover the specific concepts related to options like calls, puts, premiums, and the option chain.
What are Options?
Options contracts fall under the category of derivatives, and they state an agreement between a buyer and seller. As they qualify as derivatives, the value of the contracts depend on the price of an underlying asset, like a stock or index. At the same time, these contracts have a fixed lifespan and expire on a date called the expiry date. Now let us learn what the agreement is.
The agreement in an options contract pertains to the transaction of the underlying asset. On the expiry date, which is known to both the buyer and seller of the contract, the buyer gets the choice to transact the underlying asset at a predetermined price. Simply put, on the expiry date, depending on the nature of the options contract, the options buyer can opt to buy or sell the underlying asset. The options seller, on the other hand, is given no such privilege of “choice”, and is obliged to buy or sell the asset, as per the contract.
Call & Put Options
The ending of the previous section may seem a bit confusing—how can the options buyer sell and option sellers buy? The answer to this question lies in the fact that there are two types of options—Call Options (CE) and Put Options (PE).
Call options allows the options buyer to buy the underlying asset at a predetermined price. On the other hand, a put allows the options buyer to sell the underlying asset at a predetermined price. To put it out in a more straightforward way, an options trader will buy calls if the price of the underlying asset will undergo apprections before expiry. While, they buy puts if they feel the underlying asset’s price will see a fall before expiry.
So, for example, assume in the month of November the current value of the is 18,000, but it is expected to fall to 17,500 before expiry. In this case, an options buyer may purchase Nifty 18000 PE. So on the expiry, if the Nifty’s value drops to 17,300, the options buyer can choose to sell units of the Nifty at 18,000. In that case, the options seller is needed to buy each unit at 18,000. On the other hand, if the value hovers around 18,000 the buyer can simply choose to not sell the underlying asset. In this example, “18000”, is the strike price, which is the predetermined price to trade the underlying asset.
So, if options buyers can execute the transaction if it is in their favour and decline it if it is not, then what is it to lose for options buyers? To buy options, the options buyer pays a fee called premium to the options seller. If they hold the contract until expiry and decide not to execute it, in the event the scenario does not favour them, the premium can expire worthless. Hence, we associate the phrase “limited downside” with options buying, as the amount one can lose is limited to the premium.
However, if circumstances favour their bet, the value of the premium starts appreciating as well. That is because of the demand for that particular contract with that particular strike price increases. Therefore, most options buyers trading online, choose to exit their positions before the expiry date, and make their money on the premium. What this means is if they purchase a call by paying a premium of 200 per unit they sell it before the expiry for a higher price, and the same goes for puts. At the same time, the underlying asset is transacted in lots, where one lot may consist of 50 units. Now not many would want to buy 50 units of the Nifty Trading at 17,000.
You can get all the information regarding the strike price of different options contracts, both calls and puts, their last traded price, and other contract-specific details by viewing the Option chain. In simple words, the options chain is like a chart that portrays detailed information related to all the available option contracts of a stock. You will learn more about it when you study options in greater detail.
You may have noticed how the article mainly only focused on options buying, and not so much on options selling. As someone who is considering to venture into options trading, you are better off sticking to options buying initially. Options selling does not have the label of “limited downside” attached to it. However, if you have just started online trading or are planning to do so, it is best that you take your time and acquaint yourself with the market before venturing into any sorts of derivative trading.