Are you a novice investor? If so, stock options trading must be familiar to you as one of the most well-liked investing instruments. This financial tool has become very popular since it allows traders and investors to diversify their holdings.
Even though trading stock options can be quite profitable, if investors don’t understand the process well, they could lose a lot of money. Nine out of ten individual traders experienced net losses between FY19 and FY22, according to a SEBI report. In FY22, the average was ₹1.1 lakhs.
This post will dive into the terminology used in investing and cover the principles of purchasing options in stock markets.
What is Stock Options Trading?
Purchasing and selling option contracts is part of stock options trading. These contracts, which are linked to an underlying asset, give investors the option to trade a specific quantity of that asset on a specific date at a specific price.
The amount you pay upfront for any stock option is called the premium, and the pre-negotiated price is known as the strike/exercise price. And the expiration/maturity date oe exercise date is the specified date in the future, upto which the option buyer can buy or sell the underlying asset/stocks.
The nicest thing about trading stock options is that it does not require you to make forced purchases or sales of assets. Rather, it grants you the “right” to trade contracts for stock options.
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How Does Stock Options Trading Work?
There are two main categories of stock options when you begin to explore options in stock markets: call options and put options.
Call Options
If you are interested in investing in a company. You have a feeling that the value of the company’s stocks is going to go up in the future, so instead of buying the stock outright, you decide to use the call option.
You agree to pay a certain amount as a premium for the option to buy shares at that strike price. But you are not obligated to do so.
Now, if the stock price of the company rises above that agreed-upon strike price, you have the option to exercise. On the other hand, if the stock price doesn’t rise or even goes down, you can simply let the option expire without using it.
As the price of the underlying stock rises, so does its value. Call options are, therefore, beneficial in bull market conditions.
Let’s say you think ABC’s stock will rise to ₹130/share in the next one month, but it is presently trading at ₹100/share. Thus, you purchase call option contracts for ABC, each with a month maturity date and a strike price of ₹110/share for ₹10 per share premium.
Even though the market price of ABC’s stock is ₹130, you can purchase it at the lower strike price of ₹110 if the company’s price exceeds ₹130 as predicted within the month. At that market price, you can then sell the shares right away and profit by ₹130-₹110-₹10,(Spot price-Strike price-premium paid) or ₹10 per share.
You do not need to exercise the call option if the share price falls below ₹110. You will just lose the initial option premium of ₹10 per share.
Put Options
If you’re an investor and have a feeling that the value of a particular stock might decrease in the future. This is where a put option comes into play.
It is a tool that allows you to bet on the potential decline in the stock’s value.
You pay a premium for the right, but not the obligation, to sell a certain number of shares at a predetermined price, which is the strike price.
If the stock price declines below the strike price, you have the option to sell at the higher agreed-upon price, thus minimising your losses. On the other hand, if the stock price remains stable or even increases, you’re not obliged to sell.
When the price of the underlying stock declines, the value of the put option rises. Put options are therefore helpful in bear market conditions.
Assume, that the price of ABC Co’s shares is ₹100. You believe it is overpriced and that, within a month, it will fall to ₹75. Thus, you purchase a monthly put option contract with a strike price of ₹90/share. The only cost to exercise the contract is the ₹10/share option price.
Even though the current market price of the stock is lower, you can sell it at the higher strike price of ₹90/share if the stock price drops below ₹75 as you desire. At the higher strike price of ₹90, you can then sell the shares and profit by ₹90-₹75-₹10 (Strike price – Spot price – premium) = ₹5/share.
You just lose the option premium and are spared from using the put option if the price of the stock stays above ₹75.
Benefits of Options Trading in Stock Markets
Even though trading stock options is a little more complicated than trading stocks, you can lock in larger returns if the asset price increases. This is because an options contract does not require you to pay the full purchase price of the shares.
Comparably, if the stock price swings against your expectations for a put or call, stock options trading might help you minimize your losses. You ought to let the options contract expire in such circumstances. In this manner, your losses will match the premium plus any related trading costs.
Things to Know Before Buying Options in Stock Market
There are a number of things to take into account before choosing stocks for options trading
Buyer of an option
The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise the option on the seller/writer.
Seller of an option
The seller is the one who receives the options premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
In-the-money
A Call option is said to be in-the-money if the strike price is lower than the underlying asset price.
Correspondingly, a Put option is said to be in-the-money if the strike price is higher than the underlying asset price.
Out-of-the-money
A call option is said to be out-of-the-money if the strike price is higher than the underlying asset price.
Correspondingly, a put option is said to be out-of-the-money if the strike price is lower than the underlying asset price.
At-the-money
An option, call or put, is said to be at-the-money when the underlying asset price is equal or very close to the strike price
Intrinsic Value
The option premium can be broken down into two components- Intrinsic Value and Extrinsic Value.
Intrinsic value is the inherent value of the option.
For the ITM Call option, it is the asset price minus the strike price.
For the ITM Put option, it is the strike price minus the asset price.
For OTM options, there’s no intrinsic value.
Extrinsic Value/Time Value
For In-the-money options, time value is the options premium minus the intrinsic value.
An option that is At-the-money or out-of-the-money has only time value.
The rate at which the price of an option increases over time is known as its time value. Compared to put options, call options have a higher time value. This is so that call buyers have an extended period of time to decide whether or not to buy something at the strike price. As a result, they have a longer time until any future expiration dates to reap the benefits of exercising their option.
Volatility
Compared to typical stock trading, stock options trading is more volatile. Analysts believe that high-volatility equities have the greatest profit potential.
Trading stock options is the best alternative for investors who want to make a name for themselves by capitalizing on erratic occurrences like changes in the economy or worldwide trends that may cause price volatility until the options expire.
Risk Tolerance
Those with large budgets and a penchant for risk typically purchase or sell stock options. This investment approach also offers short- to medium-term benefits. The shorter window of opportunity makes trading stock options more uncertain.
Understand the risk/reward profile of each option strategy thoroughly. Refrain from overcommitting and control risk by sizing your positions and diversifying your holdings.
Trade Stock Options With Confidence
Even though stock options trading appears to be quite simple and has higher profit margins, inexperienced investors may run into problems. It is important to comprehend the kind of stock option you are buying, just like you would with any other investment. If your thesis goes south, you can end up losing your hard-earned cash.
Before attempting the real thing, try to gain a sense of how stock options trading operates by using online simulators, if at all possible. Start small and work your way up to more aggressive stock options tactics when you’re ready. Better start by concentrating on a few equities you are familiar with and placing a bet you can afford to lose.
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Conclusion
In conclusion, This blog provides invaluable insights into the world of option trading, offering a glimpse into the strategies that will help to enhance financial portfolios. We are happy to launch our mentorship program which is starting from 2nd December 2023,This is not just a chance to learn; it’s an invitation to embark on an adventure with me, Crack the mysteries of the market and transforming your approach to trading. Seize the opportunity to skyrocket your skills and dive headfirst into the thrilling world of options. Your path to financial triumph awaits – claim your spot in the upcoming batch and let the journey to success begin! Don’t miss the bus; it’s time to ride the wave of financial empowerment!
FAQ’s
Investors and traders can purchase and sell shares at predetermined prices using futures and options (F&O), two types of stock market derivatives. When trading F&Os, shareholders book their profits or incur losses based on their speculation. Even though they are both derivatives, futures and options have different qualities.
Options contracts do not impose buying or selling obligations on traders, but futures contracts do. While traders can exercise options contracts at any time within the specified period, they must execute futures trading only on the day specified in the contract. Moreover, there is no entry fee to exercise futures contracts, while options contracts charge traders a premium.
To choose the best stocks for options trading, use these suggestions:
- Select Highly Liquid Stocks: These are stocks with tight bid-ask spreads and active options markets.
- Options premiums are higher for volatile stocks, which means that there could be larger potential returns.
- Examine the price chart and technical indicators of the share to find trends, levels of support and resistance, and possible entry and exit points.
- Recognize The Option Greeks, Like Delta, Gamma, Theta, And Vega, To Examine How Your Options Positions Are Affected By Changes In The Share Price, Time Decay, And Volatility.
Writing (Selling) Options Contracts Of Stocks At A Pre-Decided Price On A Fixed Date Is Part Of The Options Selling Strategy. When traders think the share price won’t rise above the strike price before the option expires, they will sell call options contracts. On the other hand, they sell put options contracts with the belief that the share price won’t go below the strike price prior to the expiration date of the option.
The predetermined price at which traders buy or sell stock is known as the exercise price of a stock option, often known as the strike price. Regarding Call Options, the price at which traders purchase shares is known as the exercise price. In contrast, the price at which options traders sell the underlying shares is known as the exercise price in the case of put options.