What is Option trading

Option trading in the share market is buying or selling contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset, like a stock, at a predetermined price (the strike price) before or on a specific date (the expiration date). These are derivative contracts whose value depends on the underlying asset’s price, volatility, and time to expiration. People use options for speculation, hedging existing holdings, or generating income.

Key Concepts
Underlying asset: The actual stock, ETF, or other security that the option contract is based on.
Strike price: The fixed price at which the holder can buy or sell the underlying asset.
Expiration date: The final date on which the option contract can be exercised
Premium: The price paid by the buyer to the seller for the option contract.
Call option: Gives the buyer the right to buy the underlying asset.
Put option: Gives the buyer the right to sell the underlying asset.
Derivative: An option is a derivative security because its value is derived from the performance of an underlying asset.

How it works

As a buyer: You pay a premium for the option contract. If the asset’s price moves favorably, you can exercise your right to buy or sell at the strike price, or sell the contract itself for a profit. If the price moves against you, you can let the option expire worthless, and your loss is limited to the premium you paid.
As a seller (writer): You receive the premium upfront. If the buyer exercises the option, you are obligated to fulfill the contract. If the option expires worthless, you keep the entire premium.

How people use it

Speculation: Traders can use options to make a leveraged bet on the future direction of a stock’s price without needing to buy the stock itself.
Hedging: Investors can use options to protect their existing stock holdings. For example, they can buy put options to protect against a potential price decline in a stock they own.
Income generation: Option sellers can collect premiums from selling options to generate an income stream, although this comes with significant risk if the market moves against them.

Is option trading better than stocks?

For all but advanced investors, stocks are probably the better choice than options at all times, but an easier way to buy them is through stock ETFs. You’ll get diversified exposure to a stock portfolio, reduced risk and the potential for nice returns.

Can I do option trading with 5000 rupees?

With ₹5,000, traders may explore low-premium contracts or single-leg option purchases, but the choice of instruments will be limited, and risk awareness is crucial.

What is the success rate of option trading?

The success rate for options trading is low, with a common statistic suggesting that about 90% of traders lose money and only a small percentage, such as 7% according to a SEBI study, are profitable over a multi-year period. However, some individual traders and specific strategies report higher win rates, sometimes exceeding 80%, by using methodologies that include deep understanding of market fundamentals, risk management, and exit strategies.

Types of Options

There are two types of options:

Call Option:-

A call option gives the buyer the right but not the obligation to purchase an asset at a predetermined price on a specific date. The value or premium of the call option increases with an increase in the value of the underlying asset.

Put Option:-

A put option gives the buyer of the contract the right but not the obligation to sell an asset at a predetermined price on a specific date. The value of the put option is inversely related to the underlying asset. A fall in the price of the underlying asset will increase the premium of the put option.

What is Options Moneyness?

For beginner options traders, understanding the moneyness of an options contract is vital. The moneyness of an options contract is the difference between the strike price of an options contract and the present price of the underlying asset.

A call option is known to be in-the-money (ITM) when the price of the underlying is higher than the strike price. If the strike price is similar to the price of the underlying, the option is at-the-money (ATM). In the case when an option’s strike price is higher than the price of the underlying, the option is out-of-the-money (OTM).

Meanwhile, if a put option’s strike price is lower than the price of the underlying, it is OTM. If the put option’s strike price is higher than the price of the underlying, it is in ITM. Similar to the call option, if the strike price of the put option is similar to the price of the underlying, it is ATM.

Typically, the value of an options contract increases the more in-the-money it is. Whereas OTM and ATM options expire worthless.

Option Trading Strategies

Options are handy tools for traders as they allow them to benefit from any up-move, down-move, or even sideways movements in the market. There are numerous options trading strategies for beginners as well as for experienced traders.

Primarily, options trading strategies are directional or non-directional.

Directional strategies are used when a trader expects the market to move in a particular direction. Meanwhile, non-directional strategies are useful when the market moves sideways or is trading in a range.

Let’s look at an example of an options trading strategy

One of the most accessible options trading strategies for beginners is going long on a call or put option.

Suppose stock ABC is trading at Rs 200. The trader expects the stock price to move to Rs 250. To benefit from this up-move, he purchases a call option of the 230 strike price which has a premium of Rs 100.

The price of ABC moved from Rs 200 to Rs 250, which led to an increase in the premium of the call option from Rs 100 to Rs 300 resulting in a profit.

But if the price moved contrary to the trader’s expectations, the call option’s premium would decline. The call option would expire worthless if it is ATM or OTM on expiry, resulting in a loss of the premium of Rs 100.

In the case the trader expected the price of ABC to fall to Rs 150, the trader could have purchased a put option and benefitted from the down-move.

Traders can also short-sell an option. If a trader short-sells an options contract, he will benefit from the decline in the premium. However, if the trader has not hedged the positions, the losses can be unlimited.

Benefits of Trading Options

One of the key benefits of options trading is the potential upside that it offers. Since options are leveraged positions, the potential for profits can be substantial.
Options are flexible tools allowing traders to create and deploy complex strategies to benefit in various market scenarios.
Options contracts can also be used by investors to hedge their investments and reduce the overall risk.

Disadvantages of Trading Options

Options trading is complex and requires experience and involvement.
Since options are leveraged, the potential for the downside can be equally large as the upside, which increases the risk.
Options trading can be volatile and is affected by multiple factors. As a result, it is not suitable for all types of traders and investors.

Key Points to Remember While Trading Options

Here are some key points to remember while trading options:

Select the correct strike price as the premiums of an option are affected by how in-the-money an option is.
It is of utmost importance to manage your risk. Select the appropriate lot size and place stop-loss orders to prevent steep losses.
Conduct your own research and analysis instead of relying on tips.
Study and research different strategies that can allow you to benefit in various market conditions.