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 practicing 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. 

How does Option Trading Work? 

After option trading, let’s look into how it works. Buying and selling financial contracts are known as options. 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.

 

Options Trading Strategies for Beginners

The following are some options trading strategies:

Long-Call Options Trading Strategy

Buying call options on a stock or asset is part of a long-term call option strategy. This grants the right, but not the responsibility, to purchase an item at a defined price.

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.

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.

Short Put Options Trading Strategy

Selling put options on an asset you do not own is part of a short put options strategy. When the investor believes the asset's price will remain stable or grow, they employ this technique.

Long Straddle Options Trading Strategy

It 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 major price change, he or she will employ this method.

Short Straddle Options Trading Strategy

Selling both calls and putting options with the same strike price and expiration date on the same asset is the short straddle options trading strategy.

What are Options Contracts?

An Option is a contract that gives the buyer of the option the right, but not an obligation, to buy or sell the underlying asset on a stated date at a stated price. The buyer of the option buys a right to buy or sell. The seller of the option sells (writes) the right to buy or sell to the buyer of the option. Now comes the sticky part. Why should the seller of the option give the buyer such an unfair advantage? They would do it for a price. In other words, the seller of the option charges the buyer of the option for the right to buy/sell the asset. The price of this right is called the option premium or the option price. When you trade options, you trade these rights in the options market. If the right is more valuable, the option is more valuable, and if the right is less valuable then the option is less valuable.

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.

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 you anticipate a large price change. Quarterly results, budgeting, and changes in senior management are all frequent sources of uncertainty. A trader can build a strategy that provides profits regardless of the direction of the underlying asset's price by mixing options.
  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: Using options as a hedging mechanism decreases the risk associated with current holdings. Combining options allows traders to practically remove any risk connected with a deal.

Know more about Derivative trading

Different ways of Trading an Option

If you have bought or sold an option (call or put), you normally don’t wait till expiry. You can square off the position even during the expiry. An options position (buying an option or selling an option) can be initiated through your trading account like buying or selling any other equity. You just need to define the strike and expiry of the option you want to buy. Buyers of the option only have to pay the premium margins while the seller of the option has to pay the VAR margins and the MTM margins daily. Here are 3 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 trading positions in options 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.

Breaking up an Options Contract

Options in the Indian market can be a call option (right to buy) or a put option (right to sell). The table below lays out the complete relationship between the buyer and the seller of call and put options and the respective pay-offs to both. 

Action

Expectation

Option Premium

Payoff

Buy a Call OptionStock will go upPays the premium to the seller of the callUnlimited profit after premium cost is covered
Sell a Call OptionStock will not go above a priceGets the premium from the buyer of the callProfit is limited to premium. Unlimited loss if price goes up
Buy a Put OptionStock will go downPays the premium to the seller of the putUnlimited profit after premium cost is covered
Sell a Put OptionStock will not go below a priceGets the premium from the buyer of a putProfit is limited to premium. Unlimited loss if the price goes down

Typically, a call is a right to buy, and a put is a right to sell. You can buy a call when you are bullish, and you can buy a put when you are bearish. Remember, options are asymmetric contracts in that buyers and sellers have different sets of rights and obligations. That is the principal difference between a futures contract and an options contract.

Intrinsic Value and Time Value

  • Intrinsic Value: This is like the real money part of an option. Imagine you have the right to buy Reliance shares at Rs 2,500, and the current market price is Rs 2,509. The difference (Rs 9) between this is the intrinsic value. It's what you'd get instantly if you exercised the option, without considering what you paid for it.
  • Time Value: This is the extra part of the option's price beyond its 'real money' value. So, if an option costs Rs.22.50 and the intrinsic value is Rs9, then the remaining Rs13.50 is the time value. This part reflects the chances the option has to gain more value before it expires. It's like the speculative or extra worth of the option.

Conclusion 
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 go 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.

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