How to do Options Trading: A Beginners' Guide

How to do Options Trading: Beginners' Guide Overview

The stock market provides an opportunity to its varied risk takers, some like to take minimal risk and invest in mutual funds, debts, etc while some opt for the higher risk by trading in securities directly. However, the utmost daredevils in terms of the finance market are those who take their chances in futures and options trading. Not only is the market highly unpredictable and volatile but is at the extreme ends of risk and returns.

Trading in derivatives like futures and options is a task in hand, an investor needs to make speculation on the future direction of the stock market, and to do so he must be aware of the various techniques that make such trades a viable investment opportunity. Options trading however has an upper hand than that of the futures trading, specifically when it comes to the fulfillment of a contract and witnessing losses. Let us find out how.

What are Options?

Option contracts provide its holder a right but not the obligation to accept or make a delivery on or before a specified future date at a stated price. Now the investor does not actually need to buy the stock but pays a premium to purchase a contract based on his speculations and is given an option to exercise his right to buy/sell on the designated date as the case may be. 

However, this option is given to only one party who makes the speculation while the other party who has accepted the offer is obliged to exercise the contract as per the discretion of the holder of the contract. 

The option that gives the buyer a right to receive a delivery and obligates the other party to make the delivery is called the call option. Also, an option that gives the seller the right to make the delivery at a designated rate is called the put option.

Let us now understand the important terms that are related to options trading.

Options Trading Basics: Important Terms Related to Options Trading

Before diving into the tricky structure of options trading in India and how you can make a wise decision while trading into options, let us understand a few important jargons that may help you to understand the nitty-gritty related to the investment in options more clearly.

1. Derivatives: Option contracts are a type of derivative which means they derive their value from an underlying asset i.e. in the case of options the price of a given stock dictates its value.
2. Expiration date: The future date on or before which the options contracts need to be executed.
3. European Options: There are two types of options contracts classified on the basis of the time at which they can be exercised. One of which is a European option. European style options are those contracts in which the options can be exercised only on the expiration date. Options traded in India are of European style.
4. American Options: American options are another type of options contract based on time where the options can be exercised on or before the expiration date.
5. Premium: It is the upfront payment that a contract holder needs to pay to enjoy the privileges of an option contract i.e. making a call at an expiration date whether to exercise the option or not.
6. Strike Price or Exercise Price: As mentioned in the discussion above, it is the pre-decided price at which the contract shall be exercised at the designated date.

How to do Options Trading?

Let us understand how options trading can be carried out with an example:

Let's say an investor X is of the opinion that the stock price of ‘Y Technologies’ is overpriced in the market currently and hence he can expect that the price may fall down in the future. With this speculation, the best option for him shall be to buy a put option so that he can sell the contract at the current higher price i.e. the spot price.

Assuming the following:

Spot price- Rs 1040

May Put at 1050 at Rs 10

May Put at 1070 at Rs 30

Now X purchases 1000 stocks of Y Technologies, Put at strike price of Rs 1070 and Put price at Rs 30 i.e. the premium he shall have to pay altogether to purchase the contract is Rs 30000.

Aftermath, there can be two scenarios as discussed below:

Option 1: May Spot price at Rs. 1020

Option 2: May Spot price at Rs 1080

In the first case, if X exercises the right to sell 1000 stocks at Rs. 1070- the current price of which is Rs 1020, he shall be able to earn (1070-1020)= Rs 50 per Put. This amounts to Rs 50,000 and thus the net income is (50,000-30,000)= Rs. 20,000.

Now in the second case, the May spot price is more than the strike price, so the investor must choose to not exercise the contract at this lower price as it shall entail further losses. Now making this contract lapse the investor shall be at the ultimate loss of Rs 30000 in total. 

This is how market factors play an important role in the trading of options in India and hence an investor must gauge all the proximities before engaging himself in options trading so as to maximize his returns and minimize the high risk associated with the investment in options trading.

Stock Options Trading: Pros and Cons of Trading in Options.

Let us now take a look at the pros and cons of investing in Options contracts in India in 2022:

Positives:

• Huge leveraging power: This is because an investor can take an option position that is equal to a stock position, at a much lower margin. For instance, if an investor orders 200 shares of a stock at Rs 80 in the stock market he shall have to pay Rs. 16000 instantly. Instead, if he opts for call options of equal weightage, he shall only have to pay Rs 4000 premium at the option of earning high returns in the future. This leads to cost efficiency
• Higher Flexibility: They provide the investor the flexibility to understand how things may work out at a future date and time and if their speculations turn out to be wrong, they shall not be obligated to execute the trade and let the contract lapse. Hence, providing an opportunity for hedging against the current investments.
• Can fix the stock price: This means an investor gets the right to choose a specific strike price for a fixed duration that may perfectly align with his trading requirements. Hence providing the freedom to make a call at the expiration date whether or not to exercise the option at the spot price. 

Negatives:

• Very Complex: This may be very complicated for first-time investors and hence they may deem fit to avoid options trading until they have perfected their trading skills and have taken grasp on the market dynamics. This may however become time-consuming and frustrating at some levels but the investor needs to understand the importance of the fundamentals so as to avoid depletion of funds when a trade does not work in the right favor and due to high leveraging of stocks.
• Very Short-sighted in nature: This may trigger only short-term capital gains. Also, the investment that an investor must have held for less than one year is highly taxed in India as per the ordinary income in comparison to a much lower, long-term capital gains rate for investments owned by an investor for over a year. Thus adding extra cost sometimes.
• Various factors to be considered: Options traders need to take into account varied factors for their profitability such as commissions that may range from a flat fee to a contract-based cost. And after taking everything into consideration they can thereafter account for their profitability.

Options trading is thus not everyone’s cup of tea. It is wise to take into consideration various strategies and start with small investments initially so as to understand the market objectives before taking a leap toward any complicated investment opportunity. However, with technological advancement and innovations, trading in options is now accessible from broader perspectives and has comparatively become easier to catch the pitfalls of options trading in India today.

Important things to remember:

1. Do Not Blindly Follow Hot Tips

No matter how credible the source is, never follow a stock marketing tip blindly without conducting thorough research personally. Always select the stocks after doing proper research and analysis on the performance as well as the companies. While some tips can work out to give you huge benefits, the wrong ones can push you down under the risk pretty quickly. 

2. Eliminate Loser Stocks from Portfolio 

There is absolutely no guarantee that a stock will rise after a great fall. Know that it is extremely important to be practical about what is possible and what's impossible in the stock market. So, upon realizing that a stock is performing poorly in your portfolio, accept your mistake and sell it immediately to prevent further losses. 

3. Don't Exceed Your Investment Budget Abruptly 

While it's true that long-term investments are way better than other forms of investment, you shouldn't exceed your investment budget in a haste. Instead, decide on a fixed amount and invest it across various good stocks. Rather than investing in only one stock, divide your budget evenly across multiple good-performing stocks and shares.