Lesson 2: Basics of Options trading
What Are Options?
Options are tradable contracts that investors use to speculate about whether an asset’s price will be higher or lower at a certain date in the future, without any requirement to actually buy the asset.
Let’s take a very simple example to understand options trading.
Consider that you are buying a stock for Rs. 2000. But the broker tells you about an exciting offer, that you can buy it now for Rs. 2000 or you can give a token amount of Rs. 20 and reserve the right to buy it at Rs. 2000 after a month, even if the stock increases in value at that time. But that token amount is non-refundable!
You realise that there is a high chance that the stock would cross Rs. 2020 and thus, you can breakeven at least. Since you have to pay only Rs. 20 now, the remaining amount can be used elsewhere for a month. You wait for a month and then look at the stock price.
Now, depending on the stock price, you have the option to buy the stock from the broker or not.
In the world of trading, options are instruments that belong to the derivatives family, which means its price is derived from something else, mostly stocks. The price of an option is intrinsically linked to the price of the underlying stock or INDEX.
Options vs. Stock trading
Advantage of Options:
- You can protect stock holdings from a decline in market price.
- You can increase income against current stock holdings.
- You can prepare to buy stock at a lower price.
- You can position yourself for a big market move, even when you don’t know which way prices will move.
- You can benefit from a stock price’s rise or fall without incurring the cost of buying the stock outright.
Types of Options
There are only two types of Options i.e Call & Put Options. We will understand them in more detail.
Call Option:
Purchasing a call option means that you are bullish about the market and hoping that the price of the underlying stock may go up.
In order for you to make a profit, the price of the stock should go higher than the strike price plus the premium of the call option that you have purchased before or at the time of its expiration.
Put Option
Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down.
let’s summarize what the four terms mean:
- Short call – Here we are betting that the prices will fall and hence, a short call means you are selling calls.
- Short put – Here the short put means we are selling a put option
- Long call – It means that we are buying a call option since we are optimistic about the asset’s price
- Long put – Here we are buying a put option.
Options Payoff diagram
Payoff diagrams are a way of depicting what an option or set of options or options combined with other securities are worth at option expiration.
Options Pricing
An option’s premium is comprised of intrinsic value and extrinsic value.
Intrinsic value is reflective of the actual value of the strike price versus the current market price. Extrinsic value is made up of time until expiration, implied volatility, dividends and interest rate risks.
When the call option stock price is above the strike price or when put option stock price is below the strike price, the option is said to be “In-The-Money (ITM)”, i.e. it has an intrinsic value.
On the other hand, “Out of the money (OTM)” options have no intrinsic value. For OTM call options, the stock price is below the strike price and for OTM put options; stock price is above the strike price.
If you subtract the amount of intrinsic value from an options price, you’re left with the time value. It is based on the time to expiration.
How to Start Trading Options?
#1. You Need an Options Trading Account
First, you need to set up a brokerage account.
There are different brokerage companies, broadly you can categorize into Discount broker or service broker. Here are the factors to decide which broker to choose!
You need the following documents to open an options trading account
- Aadhaar Card
- PAN Card
- Canceled Cheque showing IFSC or MICR Code
- Salary Slip, IT Return or Form -16 (for F&O segment)
You need to choose F&O (derivatives) while account opening. I would suggest you open a Fyers Demat account.
Compare the features of discount brokers from this link; Learn more
#2. Decide what kind of trader you want to be?
There can be different ways to make money from Options, you can;
- Trade Intraday directional & non-directional strategies
- Place Hedging strategies for weekly or monthly Options
- Use Options as Hedging for your Investment portfolio!
Not sure which is the right way to for you, please submit the form below, we will guide you to make better decisions:
Do you want to achieve consistent returns from Options Trading?
Thank you
Please click on next lesson to learn more!