Options may be a suitable choice if you want to diversify your portfolio beyond stocks, mutual funds, and bonds. That said, both the risks and the benefits can be substantial. You could well have heard that it’s tough to begin options trading or that it’s exclusively for experienced investors. The truth is that, with the proper knowledge, almost any investor can experiment with options. Are you considering joining the options trading trend? This blog on options trading cuts through the jargon to get to the heart of this versatile type of investing. You should also know about index options, as it is an important aspect of derivatives trading, and don’t miss out on the opportunity to start derivatives trading now with Share India.
Table of Contents
Defining Options Trading
Trading in options entails using financial instruments that grant the buyer the right to purchase or sell a certain investment at a particular price and date. A contract known as an option is connected to a financial instrument, such as a stock or other property. Options contracts are valid for a predetermined amount of time. When you purchase an option, you get the opportunity but not the obligation to trade its underlying security. It is referred to as exercising the choice if you choose to do so. With Share India’s option calculator, you can easily see how changes in the underlying stock price, volatility, and time to expiration will affect the value of your options.
Working of Options Trading
Options trading takes place in lots. A single lot size for a specific asset always contains the same number of underlying instruments. In contrast to buying options, however, selling options contracts have greater exchange-mandated margin requirements due to the implied volatility of underlying assets.
Types of Options
There are basically two types of options; Call and Put.
- Call: Call options give the buyer the right to buy an asset at a specific price on a fixed date.
- Put: Put options give the buyer the right to sell an asset at a predetermined price. Similar to call options, Put options also have a certain expiration date.
To buy both calls and puts, the investors must pay a fee called the premium to the option seller.
Benefits of Options Trading
The following are some ways that engaging in options contracts might enhance any current investing plan.
Alternate Forms of Income
Trading options can give investors access to alternate forms of income production during periods when rates of interest are at historic lows. Every solid portfolio has traditionally been built on investments that provide interest. However, it was back when inflation and interest rates were roughly equal. Therefore, options provide investors with a suitable path for generating income, much like dividend equities do.
Risk Reduction
Options trading can lower the risk in your portfolio of investments. You may effectively safeguard your portfolio from some of the potential loss should stock market values fall by combining an options trading approach with an investment in the shares of the underlying asset. This is referred to as risk hedging.
Assist in Gain Advantage
Investors should understand how to trade options because they allow you to employ leverage, which is the second reason. Leverage may be effective when used correctly, but for the unprepared and naive, it can be destructive.
Trading Options and Stocks Together
Combining options with stock investments makes sense since options are a great addition to stock investments. Since options are just stock derivatives, their prices are simply generated from the stock they are traded against.
Options Trading Example
Let’s say a trader thinks XYZ stock is overpriced at the present share price of ₹79. A trader purchases a put option with a strike price of ₹67 at ₹5, anticipating a price fall. In other words, even if the stock price continues to fall, the trader has purchased the right to sell XYZ’s shares for ₹67. The trader will get ₹7 in profit if the stock does drop, say to ₹55 per share (difference between ₹67 and ₹55, adjusted for the cost price of ₹5).
Strategies in Options Trading
Investors have a wide range of option trading methods at their disposal. Here are the most often-used option trading methods:
Covered Call Technique
In this somewhat cautious strategy, an investor purchases a stock and afterwards sells the call option for a profit. The investor can keep the additional gains if the share price increases.
Bull Spread
The bull call spread approach entails the purchase and sale of call options with various strike prices. The investor might potentially profit from the difference between the two options by purchasing the one with a lower strike price for a cheaper price.
Long Put Approach
The investor purchases a put option. The investor can earn from the difference in the prices of stocks at the time of buying and selling the options contract. Even if the stock price declines, the options holder has the right to sell the asset at the price prevailing at the time of purchase.
Iron Condor Approach
This sophisticated strategy entails the simultaneous purchase and sale of both put and call options having various strike prices by the investor. The investor can earn when the stock price remains inside the band of the strike price. Learn more about the PCR ratio and how it can help you trade stocks at Share India.
Conclusion
Delving into options trading involves understanding the dynamics of calls and puts, comprehending key terms like strike prices and expiry dates, and grasping various strategies to navigate market fluctuations. As a powerful tool for risk management and speculation, options trading empowers investors to tailor their approach to market conditions. With due diligence, strategic planning, and a thorough understanding of the options market, investors can leverage this financial instrument to potentially enhance their portfolio performance and achieve their financial goals.
Frequently Asked Questions (FAQs)
What is an option?
An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, during or before a certain period of time.
Is it recommended to use limit or market orders when trading options?
When engaging in options trading, it is recommended to employ limit orders. Opting for market orders relinquishes control over the fill price, potentially leading to less favourable executions. Market orders should only be considered as a last resort in options trading.
Can a novice trader try an options strategy?
While it’s technically possible for a novice trader to attempt an options strategy, it’s generally not recommended. Options trading involves complexities that require a deep understanding of the market, making it more suitable for experienced individuals. Novice traders may find stocks a more suitable starting point before venturing into the complexities of options trading.
