Introduction to options
Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specified date (the expiration date). The underlying asset can be a stock, bond, commodity, currency pair, index, or any other tradable instrument.
These strategies use options contracts to create positions aligning with the trader’s/investor’s objectives. An investor/trader must have enough knowledge around the topic to use these strategies effectively.
Options strategies work by leveraging the flexibility of options contracts. Traders/investors buy/sell these contracts in a specific combination to form a strategy. These combinations of options contracts are then used for hedging and diversifying purposes.
Options trading is a crucial method in trading because of its ability to help traders in profiting from market movements, managing risk and enhancing their overall trading performance. Skilled investors/traders can potentially speculate with lesser capital to earn major profits.
Beginners should focus on getting familiar with options before starting their options journey. You can start deploying single leg (Options strategies involving only one contract) options strategies at the start. Here are the 4 basic options strategies that you should know.
- Long Call
A “Long Call” refers to a trading strategy where a trader buys a call option and believes that the underlying stock will rise in future. A Long Call gives the trader a right but not a necessity to buy the underlying stock at a pre-decided price and time. The option buyer has to pay a premium to the option writer for buying this right.
Let’s assume that an investor believes the price of stock will rise in the coming week. This stock is currently trading at Rs.50 and he expects the stock to trade at Rs.55 by the coming week.
As he is short of funds, he decides to purchase a long call option with the strike price of Rs.55 and an expiration of one week. He is paying a premium of Rs.2 to the option seller for this option contract.
This trader will profit only if the stock’s price rises above Rs.55 within the next week. He will incur a loss if the underlying stock stays below the Rs.55 level.
The Long Call strategy has a limited risk with the potential of unlimited profit. The risk in this strategy is only limited to the premium paid. Meaning, the option buyer will only incur a loss to the extent of the option’s price only.
- Short (Naked) Call
A Short Naked Call options strategy involves a trader selling a call option without owning the underlying asset. It is compulsory for the call option seller to sell the underlying asset at the specified strike price if the option is exercised by its buyer.
A trader sells a call option when he thinks that the underlying stock will either decline or stay below a specific price level for over a specific period of time.
For example, let’s say that a trader believes that the price of a specific stock will not rise above the level of Rs.50 till next week. He decides to sell a call option with a strike price of Rs.50 and an expiration of one week.
This trader will profit as long as the stock remains under the Rs.50 level. He will only incur a loss in case the stock rises above the Rs.50 price level and the option buyer decides to exercise his rights. In this case, the option seller will have to sell the stock at Rs.50 regardless of the market price.
The risk in the Short Naked Call strategy is unlimited. The trader in the above case will start incurring losses as soon as the stock crosses the Rs.50 level. As there is no upper limit for the stock to rise, the risk in this strategy is unlimited while the reward is limited till the extent of the option’s premium.
- Long Put
A “Long Put” refers to a trading strategy where a trader buys a put option and believes that the price of the underlying stock will decline in the future. A Long Put gives the trader a right but not an obligation to sell the underlying stock at a pre-decided price and time. The Put option buyer will have to pay a premium to the Put option seller for acquiring this right.
Let’s assume that an investor believes the price of stock will fall in the coming week. This stock is currently trading at Rs.50 and he expects the stock to trade at Rs.45 by the coming week.
As he is short of funds, he decides to purchase a long put option with the strike price of Rs.45 and an expiration of one week. He is paying a premium of Rs.2 to the option seller for purchasing a Long Put.
This trader will profit only if the stock’s price falls below Rs.45 within the next week. He will incur a loss if the underlying stock stays above the Rs.50 level.
The Long Put strategy has a limited risk with the potential of unlimited profit. The risk in this strategy is only limited to the premium paid. Meaning, the option buyer will only incur a loss to the extent of the option’s price only.
- Short (Naked) Put
A Short Naked Put options strategy requires a trader to sell a put option without owning the underlying asset. It is compulsory for the put option seller to sell the underlying asset at the specified strike price if the option is exercised by its buyer.
A trader sells a put option when he believes that the underlying stock is going to rise or stay above a certain price level over a specific period of time.
For example, let’s assume that a trader believes the price of a specific stock is not going to fall below the level of Rs.50 till next week. He then decides to sell a put option with a strike price of Rs 50 and an expiration period of one week.
This trader will earn money as long as the stock traders above the level of Rs.50. He will only suffer a loss when the stock falls below the level and the put option buyer decides to exercise his rights. In that case, the put option seller will have to buy the stock at Rs.50 regardless of its market price.
The risk in this strategy is unlimited. Meaning, the trader in the above case will start suffering losses as soon as the stock goes below the Rs.50 level. As the stock price can continue to go lower, the risk in this strategy is theoretically unlimited while the reward is limited till the extent of the option’s premium.
What Do Option Strategies Mean?
Options Strategies are a set of predefined combinations of options contracts. Options Strategies are used in achieving a trader/investor’s objective in the stock market. These strategies involve buying and selling of complex options pairs to capitalize price movements, hedge against risks and manage a portfolio of stocks.
Options Strategies can be categorized into 2 types. Bullish and Bearish. Bullish option strategies are deployed when a trader believes that the market will rise whereas Bearish option strategies are deployed when a trader thinks that the market will decline.
These strategies can be simple as well as complex. Some examples of option strategies include Straddle, Strangle, Spreads, Iron Condor, Covered Call and Protective Put.
How Do Option Strategies Work?
Option Strategies work by helping traders achieve their trading objective with a combination of option contracts. Option Strategies do this by posing as a great tool to profit from specific market conditions and hedging against risk.
Options contracts are derivatives that give the buyer a right but not a necessity to buy or sell its underlying asset at a pre-decided price and time. As an option buyer, you can either exercise your right or resell the contract to another party. As an option seller, you charge a premium to the option buyer for his rights and you are obligated to sell the option at a pre-decided price if the buyer decides to exercise his rights.
How to know which Option strategy Should be Used?
Knowing which option strategy to use requires experience. There is no option notebook or option strategies cheat sheet. Deploying the right option strategy requires the analysis of factors like your market outlook, risk appetite and your goals. Let us look at 3 more indicators/factors that influence a trader’s decision on which option strategy to use.
- Market Volatility: Traders use directional option strategies at times when the market is experiencing high volatility. Whereas, they will use strategies that benefit from theta decay at times of calm market.
- Suitability of the Strategy: Skilled traders always use option strategies that match with their trading goals and the characteristics of the underlying stock. They also use different strategies according to the market situations as different strategies work well in different situations.
- Time Period: Option strategies can differ on the basis of time period. Some strategies work best for short-term gains while some work better in long-term positions. Knowing the time horizon helps you in choosing the right expiration date for your strategy.
Beginners should remember that research, continuous monitoring of your positions and adapting quickly to market changes are crucial parts of options trading. Beginners should consider paper trading first to gain confidence before deploying strategies with real capital.
What is the Importance of the Basic Options Strategies?
Basic options strategies save traders from a lot of trouble due to their flexibility and versatility. Here are 4 reasons why basic option strategies are important in trading as well as investing.
- Effective Risk Management: Option Strategies are an effective tool in managing and limiting risk with a systematic approach. Basic options strategies help investors in protecting their portfolios from big drawdowns in adverse market conditions.
- Generation of Income: Markets are mostly sideways. Some basic option strategies like covered call allow traders to take advantage of this. They help investors/traders in generating income from their existing stock positions.
- Speculation: Simple option strategy lets traders speculate on the direction of the underlying stock’s direction without actually owning the stock. Skilled traders profit from both directions by buying a simple call or put option contract.
- Leverage: Options also allow traders with leverage. This allows traders to take on big positions with a smaller account size. Leverage can make your returns 10x bigger but as the reward increases so does the risk.
Basic options strategies are crucial in trading because of their flexibility. However, it is important to learn and practice these strategies effectively before applying them in real life. These strategies are a great tool when deployed correctly.
What are the Advantages of Options Strategies for Trading?
Option Strategies are beneficial in trading because of their features. Following are 3 main advantages of Options Strategies in trading.
- Flexibility: Option strategies offer a wide range of methods that suit different market conditions. It helps traders in choosing strategies according to their risk tolerance. This flexibility allows traders to adapt with changing market conditions.
- Hedging: Option strategies are mainly deployed for hedging purposes. Hedging is a method used in order to safeguard an investor’s main investment against unusual market behavior. For example, an investor panics because he owns a stock which is facing a short-term decline. He can instead buy a put option to counter-balance his portfolio and manage his risk effectively. This way, hedging provides traders with a level of insurance in volatile markets.
- Liquidity: Options are mostly liquid when they are close to the current trading price of their underlying asset. This makes it easier for traders to enter and exit their positions at desired prices. High liquidity also ensures reduced trading costs.
It is important to note that despite its advantages, options are inherently risky. Traders should only use them after they have a good understanding around the subject.
What are the Disadvantages of Options Strategies for Trading?
Option strategies are an effective way to trade in the markets but it does have its disadvantages. Following are the 3 main disadvantages of Options Strategies in Trading.
- Options are complex: Using options effectively requires a trader to learn about its fundamentals like option greeks, etc. These concepts can be complex for beginners. Deploying option strategies for managing risk also requires a significant amount of knowledge and experience first.
- Theta Decay: All options have an expiration date. Option contracts become void or valueless once it expires. This means traders only have a limited time window to see their predictions come true. Traders can face significant losses if the underlying stock does not move as per the trader’s expectations within the right time.
- Constant Monitoring: Options are very volatile trading tools. They require constant ongoing monitoring of the current market situations in order to analyze their performance and make necessary adjustments.
Therefore, traders are suggested to understand these disadvantages thoroughly and carefully consider their risk appetite and trading objectives before getting involved in option trading.
What are the Different Levels of Options Trading?
Options Trading is often classified into 4 levels or tiers which determines the types of options strategies you can deploy. Brokerage firms set these levels in order to ensure that traders have the necessary experience and the knowledge to deploy more advanced trading strategies. Here are the 4 different levels of options trading.
- Level 1: Level 1 is also known as covered call writing. Traders are only allowed to buy and sell options contracts (Including covered calls) that involve owning the underlying stock and selling call options against it.
- Level 2: Traders can start buying and selling options contracts as well as long calls and long puts on level 2. Long calls give traders the right to buy the underlying stock while long puts give them the right to sell the underlying asset.
- Level 3: Level 3 allows traders to deploy more advanced options strategies which include spreads. Spreads require a trader to buy and sell option contracts with different strike prices or expiry dates simultaneously to increase potential profits.
- Level 4: This is the most complex level for options trading. Level 4 grants traders the ability to trade in all types of options strategies including strategies like naked option writing, straddles and strangles. These strategies have higher risks and involve a deeper understanding of option metrics.
These levels can have variations in their requirements depending on the brokerage firms. Traders can also need to meet certain criteria such as account size and trading experience to access higher levels.
How To Start Trading Using Options Strategies?
Starting your trading journey with options strategies will require lots of learning and understanding the associated risks. Here is a 5 step guide to help you start trading using option strategies.
- Understanding the Basics: Firstly, you should focus on learning as much as you can about options trading as a beginner. Learn about the different option strategies available. Understand the basics of options which includes the call and put options, strike price, expiry date and option greeks. You can easily find books and courses around this subject for free on the internet.
- Paper Trading: Open a virtual account on any trading software. Apply what you have learnt so far in your paper trading account. Keep a journal and monitor yourself. It is a valuable way to gain experience as well as test different strategies before deploying real capital.
- Developing a Plan: Develop a trading plan by defining your goals and risk appetite. Determine the type of options you want to trade for example, equity or index options. Your plan must outline your entry, exit, position sizing and risk management strategies.
- Choosing Option Strategies: Choose option strategies which you can execute effortlessly, which matches with your personality and risk tolerance. Common options strategies include covered calls, buying/selling of spreads and straddles.
- Executing and Monitoring Trades: You are ready now. Start executing your preferred strategy and closely monitor. Ensure that you are entering correct details including the option symbol, quantity and order type. This information is crucial when you are using option contracts.
Always remember to save your capital. Options trading is ruthless and won’t give you a chance to recover your losses. This is why the first and foremost thing to learn while trading options is to manage your risk effectively.
When Do the Options Trade During the Day happen?
Options trade usually happens in the regular trading hours of the market. Options trading happens as soon as the market opens. The Indian stock market opens from 9:15 am to 3:30 pm (IST) from Monday to Friday.
Where Do the Options Trading happen?
Options Trading happens in stock exchanges all around the world. Here are 3 top stock exchanges where traders exchange option contracts.
- CBOE (Chicago Board Options Exchange): CBOE or Chicago Board Options Exchange is one of the largest and most renowned option exchanges in the world. It is known for pioneering options trading and introducing listed options in the year 1973.
- NASDAQ Options Market: NASDAQ options market is well known for its high-speed execution and transparency. This is why traders are attracted towards this exchange for options trading.
- Eurex Exchange: Eurex Exchange is a European exchange which is one of the largest derivatives exchanges globally. It provides a good platform for the traders looking to hedge exposure in the European markets.
These exchanges are some of the best platforms for options trading. They provide liquidity, data transparency and offer different types of options contracts. This helps traders in choosing from a diverse range of options strategies.
Can Options be Traded for Free?
No, Options cannot be traded for free. Options trading attract fees from both the broker and the exchanges in which you deal in.
Are the Options Strategies Risky for Trading?
Yes, Options Strategies are risky for trading. Options trading is only for skilled traders that can deploy advanced option strategies effectively. Beginners should first understand the basics of options and the risks associated with it before considering trading with options.
Are Options for Trading Very Complex but Rewarding?
Yes, Options are complex but they are very rewarding. Option traders always have enough options to manage risk and generate income in different market scenarios. The flexibility and versatility of options makes it a very rewarding tool for the traders who use it the right way.
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