Things to know about buying options.
When should a trader buy an option (call or put)? Typically a trader would buy call option on the index or stock when they expect the price to go up sharply. They would buy put options when they expect the price to go down sharply. In both cases, the accent is on the word “sharply”. The option trade has to make profits after covering the option premium paid, so a sharp movement on either side is needed when you buy options. But, that is not all, there are a few more things to know about buying options.
Here is an 8 point checklist.
- In India, you can buy call and put options of different strikes for 1-month, 2-months and 3-months maturity. Normally, only the near month options are very liquid. Focus on liquidity as less liquidity options may have a higher cost of exit.
- When you buy call or put options, there is no daily mark to market margin to worry about. Once the premium margin is paid, you are done since that is the maximum loss. However, due to physical delivery, last week attracts higher margins for ITM options.
- When you buy an option (call or put), there are 3 parameters to gauge. Firstly, movement must cover premium and more. Secondly, ratio of profit to premium cost must be at least 2X to justify risk. Thirdly, factor wasting options into your costing.
- What is the one factor that really makes calls and puts more valuable? It is volatility. More volatile the stock price, more valuable the call and put would be. Why is it so? Higher volatility means higher probability of the stock / index moving sharply either ways. However, you can refuse the option if price goes against you by just forfeiting the premium. That is why volatility makes call and put options more valuable.
- Options attract lower securities transaction tax (STT) compared to futures. That is because STT on options is charged on premium value and not on notional value. However, remember that options margins for ITM options can go up in the last week due to the compulsory delivery requirement for stock options.
- Option price and option premium are one and the same. They represent the price of the right without the responsibility and is paid by the buyer to the seller of the option. Option premium has 2 components viz. intrinsic value and time value. For example, assume the call option of Reliance 2700 strike is quoting on NSE at Rs38. If the spot price of RIL is Rs2,728, then out of the premium of Rs.38, intrinsic value of the option will be Rs28 (2728-2700) while the balance of Rs10 (38–28) will be the time value.
- An option is a wasting asset. Hence, the time value of the option keeps reducing and becomes zero on expiry date. That is why traders buy options at the start of the month. Despite higher time value, the time allows movement to justify the premium costs.
- Options are dynamic. They are meant for hedging risk, but options can also be used for speculative trading. It is a good way of taking a low risk leveraged trade. Also, you can use put options in Nifty to protect portfolio value. Options can also be combined as strangles to play volatility, even without knowing direction.
The checklist is a good starting point before you buy call or put options.