A basic guide to Options Trading

As the market keeps on speculating and is never steady, every investor has to go through the speculation, which allows the investors to make money. If you have the skills to speculate correctly, then options trading can bring good opportunities for you to make money, so let us find out what terms you should know and how to do options trading.

First, let us start by understanding what options trading is. Options trading involves the tradable contract that can be either sold or bought at a predetermined rate in the future. To execute the contract, you have to pay a nominal price known as a premium.

You must be familiar with the terms involved in options trading to perform your best; we shall see them one by one in this section.

Strike Price: The strike price can be said as the price mentioned in the contract. The contract will be exercised at this price. The underlying asset can either be purchased or sold at the strike price. It is also known as the exercise price. The strike price is the price of the underlying asset on which two parties involved in the contract can exercise their rights.

Expiry Date: Expiry date is the date until the terms and conditions and its price are valid. In Options trading, monthly contracts expire on the last Thursday of the month, while weekly options contracts expire every Thursday. If Thursday is a holiday, they expired on the previous trading day.

Call Option: It is a contract between the buyer and seller to buy the stock (100 shares) at a prefixed price on the expiry date, the buyer has the right to purchase the shares, but at the same time, he is not obliged to buy.

Put Option: It is also a contract between the buyer and seller to sell the stock (100 shares); in this type of contract, the contract holder has the right to sell the share but, again, is not obliged to sell.

Let us see how options trading works with an example to get a clear picture of options trading.

Options trading example

Imagine the company XYZ shares are currently being traded at INR 500, and you feel that it can rise up to Rs.560. So, you can use your prediction to monetize your wealth with the help of options trading. You enter into the contract with the strike price of Rs.560 and the weekly or monthly expiration date.

The options contract offers you the right to buy the stock from the contract holder anytime before it expires. Let's say the prediction was correct, and the price went up to Rs.610.

So in this scenario, you can exercise the stock and buy them at 560, and sell them at 610, to make a profit from the difference amount.

You can make a profit of Rs.50 per share (610-560) Rs.5,000 per 100 shares of XYZ company, and Rs.10,000 for 200 shares, keep adding like this. Now, this is the scenario if the prices increase, but imagine the alternative, what if the price remains constant or decreases?

In such a case where the price either stays constant or decreases, there is not much loss incurred, but only the premium paid will be gone, as it is non-refundable.

How to start options trading?

You must now be clear with the terms used in the options trading and might be feeling curious, how can you also start doing options trading and earn huge profits? So read the below steps carefully, how you can do that.

The first step is opening a trading account: If you already have an equity trading account, contact your broker. He will be able to help you out in enabling the futures and options contract. You might need to present some documents, such as proof of income, tax-paying history, and others. Nowadays, it is very simple to open a trading account. There are some platforms on which you can open a free trading account with a minimal cost.

Your broker might want some information, which he has to keep confidential regarding your goal, your experience, your financial capabilities, risk-bearing capacities, etc., to check whether or not you are ready to do options trading. If he finds your profile suitable enough, you will be asked to provide the document mentioned above for KYC purposes. Once the KYC is done, you are welcomed into the world of limitless opportunities for wealth maximization.

Choose the options you would like to trade with. Choosing the best option is the next step generally; there are call options and put options; with a call option, you can buy the stock, and put option, you sell the stock. It would help if you also considered the strike price and expiry date. Remember, in the case of call options, the strike price will be more than the current price, and in the put options, the strike price will be lower than the current market price.

The third stage is to determine the strike price. Suppose you feel that the price of share X will go up from the current market price of Rs.100 to 140, then in this scenario, you can buy a call option having a price less than Rs.140, and in case you are getting feeling that it will fall from Rs.100 to 75 or 80, then you can buy the put option of price greater than Rs.100.

The fourth and last step is to determine the expiry date of the options trading contract. As discussed earlier, weekly contracts expire every Thursday, and monthly ones expire on the last Thursday of that month. The longer the period in contract expiration, there is more probability of rising the stock price high, so you have to choose the Expiry Date wisely.

Benefits of Options Trading

After understanding the concept of Options trading with examples, there isn't any room for explaining the advantages, but I will go through them briefly to brush up your mind.

1. No obligation attached: When you have entered into the options trading contract to either sell or buy the shares, you have all the rights to execute a trade, but in case the situation is not in favor, you might skip executing. You are not legally bound or obliged to execute that trade.

2. Potential for higher returns: the second benefit is that it holds the capacity to get you higher returns, but again you should be very careful in selecting the strike price and timeframe; also, you need to control your emotions, in best and worst both the conditions.

3. It can be used as a tool for hedging; if there are many speculations in the market price, you can hedge them to protect from significant loss.

4. Liquidation is easy: As options trading provides you with a wide array of instruments to choose from, such as stocks, index products, currencies, etc., you can liquidate your money instantly. Your money is not locked in the name of processing time, which is seen generally in shares trading.

Disadvantages of Options Trading

Fortunately, there are no such disadvantages of involving yourself in options trading. The only one I can recall is you can lose the premium paid for entering into the contract if you don't execute it. Other than that, there are no disadvantages.

Conclusion

I hope you must be clear with what you need to know before entering into options trading and how it works, its terminology, and its pros and cons. Please let me know if you are still confused in the comment section below.