Options trading: What it is and how it can help investors

Once you take your initial steps into the world of investments, you may start to come across newer concepts and strategies. One such concept that is popular among seasoned investors is options trading.

This strategy allows investors to optimise return potential or hedge against risk by speculating how the stock market or specific securities, like stocks or bonds, may move in the future.

Though a bit tricky, understanding options trading can help you make informed decisions and manage the risk-return profile of your investments.

This article simplifies options trading, describing how it works, its participants, terminology, advantages, risks, and more.

• Table of contents

• Understanding the concept of options trading
• Options trading for beginners
• Functions of option trading
• Some basic other options strategies
• Participants in options trading
• Terminology in options trading
• Levels of options trading
• Advantages of trading in options

Understanding the concept of options trading

Options trading involves buying and selling special contracts called ‘options’. An option is a contract that lets you buy or sell something (like a stock, bond, ETF etc) at a set price (called the strike price) on or before a certain date (called the expiration date).

There are two main types of options:

• Call option: Gives you the right to buy the asset.
• Put option: Gives you the right to sell the asset.

Significantly, an option gives you the right, but not the obligation, to buy or sell the security.

Options trading for beginners

Here are some of the options trading strategies used by investors

Long call: Buy a call option to buy a stock at a set price before expiry. Can be suitable if you expect the price to rise. Profit is unlimited, but loss is limited to the cost of the option.

Long straddle: Buy both a call and a put option at the same price and expiry. Useful if you expect big price moves in either direction. Loss is limited to the cost of both options if the price doesn’t change much.

Long put: Buy a put option to sell a stock at a set price before expiry. Can be suitable if you expect the price to drop. Profit is high, and loss is limited to the option cost.

Short call: Sell a call option, agreeing to sell the stock at a set price. Profit if the price stays the same or drops, but loss can be huge if the price rises.

Short put: Sell a put option, agreeing to buy the stock at a set price. Profit if the price stays the same or rises, but loss can be large if the price drops to zero.

Short straddle: Sell both a call and a put option at the same price and expiry. Profit if the price stays stable, but losses can be huge if it moves significantly.

Read Also: How mutual funds trade: A complete guide

Functions of option trading

When a trader buys or sells an option, they get the right to use it at any time before it expires. However, they are not required to use it when the option expires.

Long call

A long call means buying a call option, betting that the stock price will rise significantly before expiry. For example, if ABC company’s stock rises from Rs. 450 (strike price) to Rs. 475, you can buy at Rs. 450 and profit Rs. 25 per share. After deducting the Rs. 20 premium, your net profit is Rs. 5 per share. This strategy uses less capital than buying stocks directly and can offer higher return potential.

Covered call

A covered call is when you sell a call option while owning the stock to reduce risk and earn income. For example, if you own 1,000 XYZ company shares at Rs. 1,500 each and sell call options with a Rs. 1,600 strike price for Rs 50 premium, you earn Rs. 50,000 upfront. If RIL stays below Rs. 1,600, you keep the premium as profit. If it rises above, your loss is reduced by the premium earned.

Long put

A long put means buying a put option, expecting the stock price to drop before expiry. For example, if Company A’s stock falls from Rs. 2,500 (strike price) to Rs. 2,300, then you sell at Rs. 2,500, making Rs. 200 per share. After deducting the Rs. 150 premium, your net profit is Rs. 50 per share. This strategy uses less money than directly shorting stocks and offers high returns with limited risk if prices drop.

Short put

A short put is when you sell a put option, expecting the stock price to reach Rs. 1,200 and you sell a put with a Rs. 1,250 strike for Rs. 50 premium. You keep the premium if the stock stays above Rs 1,250. But if it falls to Rs. 1,220, your break-even is Rs. 1,200, and you still make a profit, but less.

Married put

A married put combines owning the underlying asset and purchasing a put option. This strategy protects against significant losses while allowing for potential gains.

Example: You buy shares of a company and simultaneously purchase a put option. If the stock price drops significantly, the put option limits your losses.

Some basic other options strategies

Protective collar: Used by asset owners, this strategy involves buying a put option for protection and selling a call option to offset costs.

Long straddle: Buy both a call and put option with the same strike price and expiry.

Vertical spreads: Buy and sell options of the same type with different strike prices but the same expiry.

Long strangle: Buy a call and a put option with different strike prices, but the same expiration date.

Participants in options trading

• Buyer: Pays a premium for the right to buy or sell at a specific price later.
• Writer: Gets paid to agree to buy or sell if the buyer exercises.
• Call option: Right to buy at a set price before expiry.
• Put option: Right to sell at a set price before expiry.

Terminology in options trading

• Premium: The price paid by the buyer to the seller for the option.
• Expiry date: The date when the option expires.
• Strike price: The price at which the option can be exercised.
• American option: Can be exercised any time before the expiry date.
• European option: Can only be exercised on the expiry date.
• Index options: Tied to an index (e.g., Nifty, Bank Nifty) and settled in European style in India.
• Stock options: Based on individual stocks, giving the right to buy or sell shares, settled using American style in India.

Levels of options trading

Level 1: Write covered calls and protective puts.

Level 2: Add buying calls/puts, and long straddles/strangles.

Level 3: Add long spreads and ratio spreads.

Level 4: Add uncovered options, short straddles/strangles, and uncovered ratio spreads.

Advantages of trading in options

• Leverage: Control large positions with relatively small capital.
• Flexibility: Multiple strategies to suit different market conditions.
• Hedging: Protect existing investments from adverse price movements.
• Income generation: Generate income through premium collection.

Conclusion

Options trading is a versatile and powerful tool for investors. While it offers significant potential rewards, it also carries risks that require careful management.

FAQs:

How to do options trading?

To start options trading, open a brokerage account, understand the basics of options, and choose a suitable strategy. Begin with simple strategies like buying calls or puts.

Is option trading stable?

Options trading is volatile and risky. However, with the right strategies and risk management, it can help hedge portfolio risk and optimise return potential.

Can I do option trading with Rs. 5000?

Yes, some basic strategies like buying long calls or puts can be initiated with Rs. 5,000.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.