When it comes to Investing in stock market there are a lot of choices available for an Investor or a Trader and Option Trading is one of them. Understanding the components of options trading clearly outlines how much advantage a trader has with trading options.
Without a doubt, people who have sufficient knowledge of a certain trade have better chances of profiting from it. In the same way, a trader who is knowledgeable in option trading has better control of his profits and easily can avoid losses.
In this article, the basic concepts of Options Trading will be presented with examples. Let it be noted that the information covered here is intended for neophytes in option trading.
What is Options Trading?
Options trading is a segment of trading stocks, bonds or any type of assets that acts more like a contract with a premium amount. This allows for liberty to buy or sell the asset but does not necessarily oblige the holder to exercise his powers within a certain duration.
In layman terms, it simply means “buying” the right to buy or to sell an asset within a specified time-frame. It should be noted that buying and selling the options is very different from buying the stock itself.
What are Options?
An option contract is an agreement wherein the owner has the right to buy or sell a security or an asset at a particular price on a fixed date in the future. Options can be traded on via DEMAT Account on trading days except for NSE Holidays.
Must read the step-by-step guide on how to start investing in Stock Market.
It is called an option contract because the owner of the contract is not committed to carrying out the obligation of the contract if he or she feels that it is unprofitable.
What is an Option Chain?
An Option Chain is also known as an Option Matrix, containing a list of all available option contracts, both puts and calls, for given security. It shows all puts, calls, strike prices, and pricing information for a single underlying asset within a predefined maturity period.
What are the types of Options?
There are two types of options: the calls and the puts. Both of them work in exactly opposite principles.
The calls are options that provide the right to holder where he/she can buy a certain asset at a specific price, during a specific period. This investment will be profitable only if the stock price would increases during the period of the option. Calls are also oftentimes considered long positions.
In simple terms, call options give the right to the owner to buy the underlying asset in the contract at a price for a specific duration. Again, it is not a contractual obligation.
Options Trading Examples – Call Option
X and Y agreed on a call options contract wherein X will buy from Y, 100 shares (equivalent to one option) of Company A at Rs. 200 (strike price) what will expire on the fourth Thursday of December. The current price of the share is Rs. 200.
At the expiry date (also called maturity date), the share price of Company A remains at Rs. 250. X can then exercise his right to buy the share for Rs. 200 and thus, yielding Rs.50. Meanwhile, if the share price goes down to Rs.220, X can still earn Rs.20 by simply exercising his rights as stated in the contract. In whichever way, any amount higher than the strike price at the end of the option contract will become the profit of the owner. But before it can happen, the owner who decides to pursue his right has to have his money ready to pay for the amount.
However, if the share price goes down below Rs.200, say Rs.180, on the maturity date, it will be too expensive for X so he can just ignore the contract since he is not obliged to carry it out. He will only lose the minimal amount he paid for the contract called the Option Premium. Y, on the other hand, will keep the asset and the premium, which in a sense, is his profit.
The puts, on the other hand, are options that provide a holder to sell the asset at a certain price, within a specific period of time. This will yield profit for the holder if the stock price will depreciate during that time-frame. Conversely, puts are often seen as short positions.
In other words, In put options, the buyer has the right to sell an asset to the writer (the seller). Just like the call asset, it is bounded by a contract which states that the underlying asset will be sold at a specific price and a particular date (contract expiry date). But the similarity ends there. In put options, the writer has to buy the underlying asset at the strike price if the buyer exercises this option.
Option Trading Examples – Put Option
Let us continue with X and Y. X bought call options from Y but he could also buy put options from Y. If X buys put options, it means that he buys the right to sell Company As shares at Rs.200 on December 1. If the price of shares goes down below Rs.200 on the expiry date, X can exercise his right and can still sell it at Rs.200, thus making a profit.
Buying put options allows investors to earn a profit when the price of shares drops at the end of the contract on the contract expiry date.
Profit potentials are unlimited for the buyers of put options, especially if the market begins to sell-off or we can say decline. On the other hand, risks are limited for the buyer if the market goes against them.
Options are only sold in share lots these lots may be a set of 20, 40, 75 or 1000 shares. So if the share price is Rs.200, you will have to pay Rs.40,000 for a lot consisting of 20 shares for each option contract plus the Option Premium.
What are the styles of options trading?
There are two option trading styles:
- The American Style Options
- The European Style options.
The difference between the two lies on the date when the option can be exercised.
In European Style options can only be exercised after the expiration date.
American Style option, on the other hand, provides more leeway as it allows the option to be exercised from the day of purchase until the day it expires.
Most stock traders hold the common misconception that the style of options depends largely on the geographical location where the trade was made and it’s wrong.
Actually, the names American and European styles are just terminologies to separate one style from the other. It does not necessarily mean that when one Trader trades in Europe, the trading style adopted is automatically a European Style or vice versa.
Who are the Buyers & Sellers in Option Trading?
These two types of options then lead to four different types of traders namely, the buyers and sellers of the calls, and the buyers and the sellers of the puts.
But, buyers and sellers of options are further distinguished by their general names: buyers are called holders and sellers are called writers for both Calls & Puts.
Buying and selling of options comprise a quite complicated scheme of trade. For the holders of calls and puts, an options contract does not oblige them to participate in the trade through either buying or selling options. They have, at their disposal, their rights to either maintain an asset or to dispose of it.
However, for writers of calls and puts, the contract necessitates that they either buy or sell an asset at a specific price.
In reality, while trading options the transactions do not happen between two persons. Buying or selling of options contract can happen without knowing the identity of the other party.
Options Trading for Whom?
Options Trading is not suitable for all traders, considered by the experts. Because Trading Options is a risky approach to the market because of its sharp price movement.
But it has other advantages over this. Options Trading has limited risk and unlimited profits. You put a small premium on risk for buying a lot of shares that may cost a huge amount in Cash.
Your highest risk is your Premium Amount for a particular Call or Put Option but profits are on unlimited end.
Advantages of Options Trading
Options Trading has many advantages that other segments don’t. The best advantage for this Option Trading segment is you need to pay a small premium for buying a lot of shares that may cost a huge in cash.
And also your highest risk is only that small premium that you’ve paid for the particular Option call.
Another advantage of Trading Options is unlimited profits over limited risk. As I told you earlier you are putting a small premium on risk to buy a Share’s lot and getting the unlimited profits.
Conclusion – Options Trading
Options trading is by nature, a speculative type of trade and In trading-speak, it suggests that this kind of trading best suits those who seek risks and enjoy taking them.