What is Options Trading and what are benefits of options trading?

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Understanding Options Trading: 

If anyone tells me that Options Trading is Risky. My Reaction would be:

                                         

A pervasive belief exists that options trading is risky. Firstly, one must understand  that options were introduced as a means of effectively managing risk. Correct application of options in the form of various strategies enables an individual to trade in a systematic manner with reduced risk, provided an individual understands options trading instruments. There is no reason to consider options as risky because at all times the risks and rewards of any given trade are known.

Keypoint: Knowledge of options trading instruments reduces risk in trading.

Getting Confused???       

Let me throw more light on this, Let’s start with understanding of basic elements of any trade.

Remember any Trade consists of 3 parts:

  1. Picking a Stock/share which is expected to go up or down based on your analysis (Technical, fundamental or sentimental whatever one is comfortable with)
  2. Determining exact Entry Point & Exit Points (Stoploss point and Target Point).
  3. Once you know the expected movement & Exact point of Entry & Exit, you can initiate a trade using a trading segment/instrument like Cash/Cash Margin/Futures/Options.

Different trading segments/instruments have different profit potential and has different capital requirements.

Amongst these segments, Futures is relatively much riskier than other trading segments and also requires large capital base to trade.

While Cash/cash margin trades is most preferred and favourite amongst retail traders.

I consider Options as the best trading instrument to trade which carries minimum risk and generates substantial profits compared to capital employed.

When your strategy of Stock picking is good and has high accuracy then one should trade in options segment to maximize the gains.

With options one can profit from Up, down as well as stagnant markets, hence it is important for every trader to understand the options trading thoroughly.

In order to control 100 shares of the stock through a stock purchase I need to spend Rs.100000 whereas I can control the same number of shares with an option for a fraction of the capital, only Rs.15000. So, with stocks I must risk Rs.100000 but with options I only risk a fraction of that capital and still maintain the same control.

‘Buying stock in cash’ is considered directional trading because you only make money on your investment if the stock goes in one direction – i.e UP !

While options trading strategies enables you to make money when the stock moves in any direction whether up, down or even when it remains stagnant.

Grab your Popcorn and Read further, to know why Options trading is best instrument to make quick money from Stock market.

What does it mean when someone says – He’s Long on that Stock OR That He’s Short on that stock?

The first thing to understand that these terms long and short have no reference to time.

When you are long on a stock it means you have bought stock to open a position.

For many this is the only form of trading they are aware of – it is the widely practiced method of buying a stock with the expectation of the stock value rising over time. It is a Debit Trade i.e money gets debited from your Demat Trading Account.

It is equally possible to short stocks. This means you are selling to open a position. In this case you are expecting the stock you shorted or sold to decrease in value such that you can buy it at lowest cost. It is a credit trade i.e money gets deposited/credited to your Demat Trading Account.

Example: Based on your fundamental, technical or sentimental analysis you think that a stock was going to decrease in value and you wanted to profit from the downtrend you could sell the stock without ever having owned it. Let’s say the stock was trading at Rs. 20/share and you sold/shorted 100 shares, your account would now get credited Rs. 2000. If the stock now decreased in value to Rs. 15 you could buy back the stock at Rs.15/share x 100 i.e. Rs.1500 and profit Rs.500 in the trade.

Let’s begin understanding of Options:

What are option?

  • Futures & Options together constitute Derivative Segment.
  • Futures & Options are indicator of future price of Stock/index/commodity, it shows how price of the underlying stock/index/commodity is expected to move in near future.
  • General belief is that Options are risky instruments to Trade.
  • While Truth is Futures is Riskier instrument and requires large capital.
  • Options is relatively low-risk instrument and requires less capital to trade.
  • Options were in fact created as a means for hedging risk or protecting long & short positions in the financial markets.
  • Of course like any other Asset Classes options does have its share of risk, but with proper understanding and right application one can use it to make substantial gains from Stock market.

 Benefits of Options trading:

  • Options can generate substantial gains exceeding 100% and sometimes even 1000% in a small time frame.
  • They can also expire worthless after a set time frame at which point their entire value is worthless. One can use this factor to generate cash flow out of stocks that one is already holding in their Demat account.
  • Correct application of options trading instrument like when to hold it, When to allow them to expire or when to exercise them can help us in making regular money from Stock market.

Options Definition:

  • An Option is a legally binding contract between a buyer and a seller.
  • The contract gives the buyer the right to buy or sell the stock at a “specific price” called the strike price on or before a “specific date” called the expiration date.
  • The Seller is obligated to sell or buy the stock at a specific price (strike price) once the option buyer exercises his/her option.
  •  The option buyer can choose to exercise his/her option anytime prior to expiration date.
  • The option seller must fulfill the terms of the contract if the option buyer chooses to exercise.

Remember: As a trader, we are only interested in Buying & Re-selling of options to make profits within the expiry period. No need to go deep into Exercising of Options.

Important Questions to understand Now:

What are Types of Options? When to Buy options? When to Sell Options? 

Two Options Trading tools exist

  1. Call Option : You can either Buy Call Option or Sell Call Option
  • When you buy Call option it gives you the right to buy the stock at a fixed price within a set time frame.
  • When you Sell Call option (also called as writing the option) you are obligated to sell the stock at a fixed price within a set time frame.
  1. Put Option:  You can either Buy Put Option or Sell Put Option
  • When you buy Put option it gives you the right to sell the stock at a fixed price within a set time frame.
  • When you Sell Put option (write the option) you are obligated to buy the stock at a fixed price within a set time frame.

How are options purchased? What is Lot Size?

  • While Stocks are purchased on per share basis, options are purchased in contracts.
  • For ex: 1 Contract = 100 shares of a particular stock.
  • The number of shares in a contract differs from stock to stock. We call it Lot Size.
  • Eg: Reliance Industries’ 1 Option contract has 125 shares i.e Lot Size of Reliance Options is 125.
  • Infosys 1 option contract =        500       (Lot size of Infosys is 500)
  • Tata Steel  1 option contract =  2000     (Lot size of Tata Steel is 2000)
  • Hindalco 1 option contract =     3500      (Lot size of Hindalco is 3500)
  • These lot sizes are fixed and can ONLY be changed by Stock Exchange Regulator SEBI (Exchange Board)

Why should we use Options?

Number of powerful reasons exist to use options as a trading instrument.

Using Options:

  •  You can Leverage Capital
  • You can Reduce Risk
  • You can Control Stock without owning it
  • Generate increased return on your investments.
  • Options can earn significant percentage returns with reduced capital risk and reduced movement in the underlying stock.

I hope, I still have your attention !

To understand how large amounts of stock can be controlled for lot less capital using options let’s consider the following example.

    Buying Call Options versus Stock purchasing.

Example: We expect Reliance Industries shares will rise in coming days.

If Reliance was trading at Rs. 1000/share and I wanted to buy 500 shares, the total cost would be 1000 x 500 = Rs. 5,00,000. In order to double my money Reliance price must now reach Rs.2000/share.

But what if Reliance instead fell in value to Rs. 900/share. My Rs. 5,00,000 investment would now be worth Rs. 4,50,000. And I would have lost Rs. 50,000.

Now 1 Option contract of Reliance Industries = 500 shares of Reliance Industries.

The 1000 Strike Price Call Option of Reliance is trading at premium of Rs.40/ share.

So to buy 1 Contract of 500 shares it will cost us = 500 x 40 = Rs. 20,000

By paying Rs. 10000 I have got the right to buy 500 shares of Reliance as per Rs.1000/share even if the price of Reliance rises to 1100 tomorrow.

Let’s see 2 Scenario:

  1. Stock price moves from 1000 to 1100 within the set time frame (i.e before the expiry of the Option Contract).
  • In which the Call Option premium price would be worth 100. So the total value of our Option contract would be 100 x 500 = Rs. 50,000.
  • My capital in options increased by over 150% while the actual stock price just increased by 10 %.
  1. Stock price moves from 1000 to 900 within the set time frame (before the expiry of the contract).
  • In which maximum loss that I would incur in case of options is Rs. 20000
  • Thus with proper money management the probability of making money can greatly increase using options.

Advantages of Options Trading:

  • Leverage Capital: A Rs.20000 options purchase was shown to control as many shares as a Rs. 5,00,000 stock purchase.
  • Reduce Risk: For the same decrease in stock price from 1000/share to 900/share the purchaser of stocks lost Rs.50000 while purchaser of Options lost Rs. 20000.
  • Control Stock without Owing it: In this example the buyer of the call option could sell the option when the stock rose from 1000/share to 1100/share without owning the stock.
  • Increased Return on Investment: For the same increase in stock price from 1000/share to 1100/share the percentage investment increase for the stock buyer was 10% while the options buyer had a 150% increase in investment.

Understanding of Options trading Instruments:  “Long Call option, Long Put option, Short Call option & Short Put option”

Long Call Option:  A call can be purchased to open a long call option. As in the case of long stocks it is a debit trade. The call is purchased at the premium value of the options strike price based on the expectation that the stock price will rise. It gives you the right to buy the stock at a fixed price within a set time frame.

So a long call can be used when you expect the stock to trend upwards in a bullish manner.

The Call Purchase gives you the rights to:

(a) Re-Sell the option

(b) Exercise the option

(c) Let the option expire

You do not want to let the option expire because you will lose your investment in the call purchase. You could also exercise the option, in this case you must have the capital available to purchase the stock. So if you have executed a directional trade through the purchase of a call option, you will be focusing on Re-Selling the option at higher premium value than our purchase price and capture the profit.

Example: Based on our stock analysis we believe Share price of Reliance Industries will rise in value from it’s current price of Rs.1000/share and so we purchase a 1000 Strike January Call option of Reliance Industries. Let’s say we buy 1 Contract comprising of 500 shares. Consider January 1000 Srike Call Options price is Rs.10/share i.e Rs. 5000/Contract for a Call option.

So now we have control of 500 shares of Reliance Industries after purchase of a Call option at Rs. 5000. (The control is till the validity or expiration of that Call option contract).

Instead of Call option had we purchased 500 shares of Reliance Industries in Cash, we would have to shell out Rs.500000 at current price of Rs.1000.

Now as per our expectation if Share price moves to Rs. 1020. Within the Validity month of January the share price has moved to Rs. 1020. We have right to Buy this stock at Rs. 1000 till the expiry date of Contract.

In Indian markets Derivatives (Futures & Options) expiry is on last Thursday of every month. One must be aware of the option expiry day before buying any option and must clear their positions before the expiry.

As the share price has increased in value, the Call option value will also increase accordingly. This allows us to re-sell the option at a profit without ever having owned the stock.

We bought it Rs10/share it is now at Rs.20/share. So we can re-sell the option well before the expiry and capture the profit of Rs.10/share on Option value i.e profit of Rs.5000.

Long Put Option:

A Put can be purchased to open a long put position. As in the case of Long/purchasing Call options, this is also a debit trade. The Put is purchased at the Premium value of the Option’s strike price based on the expectation that the share price will fall in near future. It gives you the right to sell stock at a fixed price within a set time frame. A Long put can be used when you expect the stock to trend downwards in a bearish manner,

The Put option value will increase in value as the stock price goes down. So, you can Re-sell that put at a profit as the value of the stock decreases.

The Put Purchase gives you the right to:

(a) Re-sell the Option

(b) Exercise the option

(c) Let the option expire

As we have understood in the case of Call Option, we will not let the option expire as we will lose our investment in that trade. Exercising Put option means selling Stock at a fixed price (you can only do this if we actually own Shares of that company in our Demat Account). So our only focus will be to Re-sell the option to capture the profits as and when option becomes profitable.

Example:

Based on our stock analysis we believe Share price of Reliance Industries will fall in value from its current price of Rs.1000/share and so we purchase a 1000 Strike January Put option of Reliance Industries. Let’s say we buy 1 Put Contract comprising of 500 shares. Consider Options price is Rs.10/share i.e Rs. 5000/Contract for a Put option.

So now we have control of 500 shares of Reliance Industries after purchase of a Put option at Rs. 5000. (The control is till the validity or expiration of that Put option contract).

Now as per our expectation if Share price goes down to Rs. 980. Within the Validity month of January the share price has moved to Rs. 980. We have right to sell this stock at Rs. 1000 till the expiry date of Contract (to exercise this right we need to have shares of Reliance Industries in our Demat account). Thus our focus is to Re-sell the Put option at higher price from our purchase price.

As the share price has decreased in value, the Put option value will increase accordingly. This allows us to re-sell the option at a profit without ever having owned the stock.

We bought it Rs10/share it is now at Rs.20/share. So we can re-sell the Put option well before the expiry and capture the profit of Rs.10/share on Option value i.e profit of Rs.5000.

Short Call Option:

A call can be sold to open a short call position. The Call option of particular stock is sold based on the expectation that the stock price will decrease in value as per our Technical, fundamental or sentimental analysis.

The short call obligates you to sell a stock at a fixed price within a set time frame. Since you are giving someone the right to buy the stock from you, you receive a premium for providing them the right and hence the trade is a Credit trade.

The Premium you receive is the value of the Options Strike price.

In a directional trade the call is sold because we believe based on our analysis that the stock price will decrease in value.

If the Share price rises in value above the strike price of the call you are obligated to sell the shares at the given strike price.

Our only intention in Selling the call option is to Capture premium by allowing the option expire worthless based on our analysis and expectation that the share price will not rise above the strike price within the validity/expiry of the contract.

Example: Consider Reliance Industries trading at Rs.1000/share. Based on our analysis (technical, fundamental or sentimental), we don’t expect the share price to move above Rs.1020 in the current month. So we Sell/Short a 1020 Strike Price January Call option. And current price of 1020 Strike Price Call option is say Rs.5/share.

Now for Selling a 1020 Strike call option we receive Rs.5×500 = Rs.2500 as Premium ( 1 Contract is of 500 shares). The Premium is credited to our trading account.

As expected if the share price remains below 1020 for the set Contract expiry period, the Call option will expire worthless moving to Rs.0.05 by expiry day. And we get to keep the entire premium of Rs.2500 per Contract.

Caution: If the Share price rise above Rs.1020 you will start incurring losses and will have to Square-off the Short Position in Call option at a loss and subsequent amount will be debited from your trading account.

Naked Shorting/Selling of options is considered a Risky trade and must only be executed only if your method of Stock Analysis is one with high accuracy then you can consider making profits by by Short Selling of options.

Short Put Option: Like Short Selling of Call options, we can also sell short a Put option if we expect as per our analysis that Share price is going to rise in near future.

How to read an Options Chain for any stock/index:

Above figure shows Options chain details for Reliance Industries for the expiry month of February 2017. The Spot/cash price of Reliance is 1025. Now different strike prices like 1000, 1020, 1040, 1060 etc. are mentioned along with corresponding Call & put option prices. As per our analysis if we think that Price of Reliance stock is expected to rise in near future, we can Buy Call option of any strike prices like 1020, 1040 0r 1060 by paying the option price. The lot size of Reliance is 500 i.e one Futures & Options contract of Reliance has 500 shares in it.

  • Amount required for buying 1020 Strike Price Call Option = 30.25 x 500 = Rs. 15125
  • Amount required for buying 1040 Strike Price Call Option = 21.05 x 500 = Rs. 10525
  • Amount required for buying 1060 Strike Price Call Option = 14.30 x 500 = Rs. 7150

Note: Remember the expiry date for these Option contracts is 23 Feb 2017 so we must square off our positions by 23 Feb 2017. (It’s always better to buy Options with Strike Prices near to the Spot Price of Stock/index, and square off it as soon as we make profit in it as per our Targets)

Similarly if we expect as per our analysis that price of Reliance Stock will fall down in near future, we can buy Put Options with any of the Strike prices like 1020, 1000.

Summary of Options trading:

Option Expected movement in Stock/Commodity/Index When Share price is Greater than Strike Price of Option When Share price is Less than Strike Price of Option
Buy/Long Call Bullish (price expected to move up) Right to:

Re-Sell Option

Exercise option

Let Option Expire

Option Purchase investment will lose value.
Buy/Long Put Bearish (Price expected to move down) Option purchase investment will lose value. Right to:

Re-Sell Option

Exercise option

Let Option Expire

Sell/Short Call Bearish (Price expected to move down) Obliged to sell Shares if assigned.(One must have shares in Demat Account) Let Option expire & capture entire premium as profit.
Sell/Short Put Bullish (Price expected to move up) Let option expire & capture entire premium as profit. Obliged to Buy shares if assigned.

Options Terminology:

In order to correctly apply your trading techniques and strategies you will need to have a good understanding of options terminology.

Terminology Description
Strike Price All equity options have a specific price at which a stock can be bought or sold if the option is exercised. This is the Srike price or Exercise price.

If we own a Call option we can exercise our right to buy specified number of shares of a particular underlying stock at the specified strike Price. Similarly if we own a Put Option we can exercise our right to sell specified number of shares of a particular underlying stock at a specified strike price.

Expiration Date Expiration or Validity date of Options contract is the last day after which the Option contract ceases to trade and has to be exercised.
In the Money A call option is in-the-money when the market price of the underlying stock is greater than the option’s Strike price.
At the money When the Market price of Stock is at the same price as the Strike Price of the option, the option is said to be at-the-money.
Out of the Money A call option is out of the money when the strike price is higher than the market price of the underlying stock.

A put option is out of the money when the strike price is lower than the market price of the underlying stock.

The entire premium of an out-of-the-money option is due to its time value.

Open Interest Open interest is the number of outstanding contracts or number of open positions for a particular contract.

It is used to determine majority expectation for a particular stock.

Intrinsic value Intrinsic value is the difference between an in-the money option strike price and the current market price of a share of the underlying stock.
Extrinsic value Extrinsic value is any other value that is over and above the intrinsic value.

Eg: Consider Reliance Industries 1000 Strike Price Call. Current value of Call option is Rs.10. Assume the Market price of Stock is at Rs.1005.

Intrinsic Value = 1005-1000 = Rs.5.

Extrinsic value = 10-5 = Rs.5.

Volume For options this is the number of contracts that have been traded in a specific time period.
Implied Volatility  Implied volatility is the assumption of the stock’s volatility that helps determine the option price. Increased implied volatility increases the value of an option and decreased implied volatiity decreases the value of an option. News events such as earnings releases, upgrades and downgrades will affect implied volatility of any stock.
Time Value  Time value or time premium is the difference between the total cost of an option and its intrinsic value, So it’s the amount people are willing to pay over and above the intrinsic value. It is length of time from the date of purchase to the expiration date. The further away the expiration date  the greater the tie value.
Time Decay This is the loss in value of an option over time when all other factors remain constant. As the expiration date of option contract approaches the rate of decrease in options value is fast. If you own a long option it would be prudent to re-sell that option or exercise that option because time decay will be acting against you. So time decay causes long options to lose value. Conversely if you short options, time decay is working for you.
Delta  This is the rate of change of the options price relative to a one unit change in the price of the stock. For example if a call option has a delta of 0.75 then for a Rs.1 increase in the price of the stock the option price will increase by Rs 0.75

Hope the tutorial will help you with better understanding of options trading.

Do share your queries or thoughts in the comment section below.

 

 

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