What is Options Trading in Derivatives?

What is Options Trading in Derivatives?

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Options trading allows you to buy an underlying asset without obligation, such as buying a stock through an options contract. The market price must be higher than the agreed price for the option to be valid. If the market price is less than the contract price, there is no interest in the contract, and the option premium is sunk cost. Beginners should focus on managing downside risk and keeping the trading process simple. Options trading involves understanding call and option examples to understand the concept better. Exploring options trading examples and practising in the real market can provide a better understanding of option trading. An example in India illustrates the concept. Remember that Derivatives and options are two sides of the same coin; in fact, the latter is a subset of the former. Let’s understand the option trading meaning in detail.

The two kinds of options that traders should be aware of are:

  • A call option entitles the holder to purchase an asset at a specific price before the option's expiration date, but it does not impose any obligations.
  • Put options provide its holders the choice, but not the duty, to sell an asset by the specified date at a specific price.

How Does Option Trading Work?

Options are financial contracts for buying and selling. The call option holder has the right to purchase the underlying asset at a preset price, whereas the put option holder has the right to sell the underlying asset at a given price. Traders can benefit from options trading depending on the underlying asset's movement, and profitability is affected by factors such as strike price and market volatility.
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Table of Content

  1. How Does Option Trading Work?
  2. Options Trading Strategies for Beginners
  3. Advantages Of Options Trading
  4. What are the Levels of Options Trading?
  5. Different Ways of Trading an Option
  6. Options Related Terms
  7. Participants in Options Trading - H2 
  8. Profitability Scenario in Options

Options Trading Strategies for Beginners

The following are some options trading strategies:

  1. Long-Call Options Trading Strategy: A long-term call option strategy involves buying call options on a stock or asset. This strategy grants the right, but not the responsibility, to purchase an item at a defined price.
  2. Short Call Options Trading Strategy: An investor uses a short call option strategy to sell call options on something they do not own. If the buyer exercises the option, they must sell the asset at the strike price.
  3. Long Put Options Trading Strategy: Long put options entail acquiring a put option on a certain asset. When the asset price falls dramatically, the investor employs this method.
  4. Short Put Options Trading Strategy: Selling put options on an asset you do not own is part of a short put options strategy. This technique is employed when the investor believes the asset's price will remain stable or grow.
  5. Long Straddle Options Trading Strategy: This strategy entails simultaneously purchasing a call option and a put option on the same asset with the same strike price and expiration date. When an investor anticipates a major price change, he or she will employ this method.
  6. Short Straddle Options Trading Strategy: Selling both calls and put options with the same strike price and expiration date on the same asset is the short straddle options trading strategy.

Advantages Of Options Trading

Options trading offers several advantages, including:

  1. Leverage: One of the primary benefits of trading options is leverage. Option trades demand only a premium payment, not the total transaction amount. As a result, traders may take on high-value trades while requiring little cash.
  2. Cost Effectiveness: Options allow traders to utilise less capital while still profiting. The return on investment is substantially higher than in other investing opportunities. Options have great cost efficiency because of the low premium amount.
  3. Risk Involved: The risk involved with options is smaller than that connected with futures or cash markets. The risk of loss with options is equivalent to the premium paid. Writing or selling options, on the other hand, may involve higher risk than acquiring an underlying asset.
  4. Options Strategies: Options trading also allows you to earn in both rising and declining markets. There may be occasions when you are unclear which way the market will move but anticipate a large price change. Quarterly results, budgeting, and changes in senior management are all frequent sources of uncertainty. By mixing options, a trader can build a strategy that provides profits regardless of the direction of the underlying asset's price.
  5. Flexible Tool: Options provide extra investing opportunities and are versatile instruments. Aside from price fluctuation, investors may benefit from time and volatility movements.
  6. Hedging: Options are a hedging mechanism that decreases the risk associated with current holdings. Combining options allows traders to practically remove any risk connected with a deal.

What are the Levels of Options Trading?

Each trader must complete a questionnaire with the brokerage business before beginning option trading. A brokerage business sets levels for traders to authorise various categories. 

Level 1: You can write covered calls and protected puts at this level. 
Level 2: Level 1 AND open long straddles and strangles; purchase calls or puts.
Level 3: Consists of both Level 2 AND long open spreads, long-side ratio spreads.
Level 4: Use uncovered options, short straddles and strangles, and uncovered ratio spreads in addition to Level 3.

Different Ways of Trading an Option

An options position can be initiated through a trading account, defining the strike and expiry of the option. Buyers pay premium margins, while sellers pay VAR and MTM margins daily. There are three ways to deal with an options position.

  • If you have initiated a long or short position in options, you can just leave the position to expiry. On the date of expiry of the option (last Thursday of the month) the exchange will close the position and debit or credit the losses/profits on the position to you.
  • The second method is to exercise the option, but this is only available to the buyers of the option and not to the seller. However, in India, all index and stock options are European options so they can only be exercised on the day of expiry.
  • Lastly, the most common way of closing options trading positions is to reverse the position. If you have bought an option, just sell the same quantity of the same strike, and your position is squared off. The same applies to sold options. This is the most popular and common method of closing options positions. 
    Read more about Options Trading vs Intraday Trading.

Options Related Terms

Many phrases that may appear foreign to you may come up when trading in the derivatives market. Here are some terms linked to choices that you should be aware of.

  • Premium: The amount that an option buyer must pay the option seller is known as the option premium.
  • Date of Expiration: Often referred to as the exercise date, the expiration date is the date that is stipulated in an option contract.
  • Strike Price: The contract's entry price is known as the strike price. It's commonly known as the workout price.
  • Stock Options: A stock is the underlying asset in these options. The contract holder may buy or sell the underlying shares at the agreed-upon price. The American settlement technique is permitted for these choices in India.
  • Index Options: When the underlying asset is an index, the options are known as index options. Settlement in the European model is permitted in India.
  • Strike Price Intervals: The various strike prices at which an options contract can be exchanged are known as strike price intervals. The exchange where the assets are exchanged determines them.

Participants in Options Trading - H2 

  1. Buyer of an Option: Who pays the premium to purchase the right to exercise his option on the seller/writer.
  2. Writer/seller of an Option: The person who gets the option premium is required to sell or purchase the asset if the buyer exercises the option.
  3. Call Option: A call option gives its holder the choice—but not the obligation—to purchase an asset before a specific date at a predetermined price.
  4. Put Option: A put option gives its holder the choice—but not the obligation—to sell the asset at a predetermined price before a specific date.

Profitability Scenario in Options

  1. The Money-Meaning Option
    An in-the-money (ITM) option is one that, if promptly exercised, would result in positive cash flow for the holder.
    For instance, a call option on the index is considered in the money if the current index value exceeds the strike price (spot price > strike price).
  2. Option for At-the-Money
    An at-the-money (ATM) option is one that, if it were executed right now, would result in zero cash flow or neither a profit nor a loss.
    For instance, in the preceding instance, the option is ATM if the current index value equals the strike price (spot price = strike price).
  3. The Option Without Money
    An option that, if exercised right now, would result in negative cash flow is known as an out-of-the-money (OTM) option.
    For instance, in the aforementioned scenario, the option is considered out-of-the-money (OTM) if the index value is less than the strike price (spot price < strike price).

Finally, what is option trading in the share market? In short, options trading is diverse and offers traders several opportunities in all types of markets. While options are high-risk trades, traders may use simple tactics with little risk. A risk-averse investor might benefit if they do their in-depth research. You can explore different types of trade in the stock market with the help of a stock market app. However, before investing, it is critical to understand the risks and consider several situations. 

FAQs on Options Trading in Share Market

Experienced investors who are familiar with the market and have time to observe it are likely to do well in options trading compared to beginners. 

For a thorough grasp of option trading, you can consult online courses, option trading books, and websites. 

Options methods can assist you not only make more money but also cover losses (in proportional or absolute terms).

While Options Trading is a little more complicated than Stock Trading, it can help you make significantly higher returns if the price of the investment rises.

Options in the stock market include call options, which allow purchase at a specified price, and put options, which enable sale at a predetermined price within a set timeframe.

Some brokerage platforms offer commission-free options trading, but depending on the broker, there may still be fees for exercising options or other associated costs.