Teaching options trading to a first time investor

Understanding about options is useful to an investor too. Most investors are wary of options as they consider them to be high risk products. That is not the case. Options are actually very useful when it comes to managing risk and for capitalizing on market volatility. Here are some basics you need to learn before you embark on options.

What are options?

Options are a right to buy or sell an asset without the obligation. Since it is a right without an obligation, you have to pay a premium to the seller of the option. A right to buy is called a call option while a right to sell is called a put option. When options trade in the market, the price of the option is nothing but the value of this “right without obligation”.

What are calls and puts?

As we saw earlier, a call options is a right to buy and a put option is a right to sell. How to apply the same? If RIL is currently quoting at Rs.960 and you expect the price to go to Rs.1000, then you can buy a Reliance 980 call option at a price of Rs.4. When the price of the option reaches Rs.1000, the price of the option will have gone up to more than Rs.20. You can just reverse the option and book profits. When you expect prices to go down, you can buy put options. When you buy a call or put option, your loss is limited to the premium paid but profits can be unlimited.

Understanding in-the–money (ITM) and out-of-the-money (OTM) options

This is one of the most important aspects of options. An option is in-the-money when the price of the stock is above the strike price in case of call options. If the price of SBI is Rs.260, then the Rs.250 call option will be ITM. Similarly, the Rs.270 call option will be OTM. In case of put options the reverse rule will apply. If the stock price is lower than the strike price then it is ITM and if the stock price is above the strike price then it is OTM. In the above case, if you are buying SBI put options then Rs.270 put will be ITM and Rs.250 put will be OTM.

What is time value and intrinsic value of an option?

To understand time value you need to grasp ITM and OTM thoroughly. An ITM option has intrinsic value and time value. An OTM option only has time value. If the price of SBI is Rs.260 and the Rs.250 call option is trading at Rs.14, then Rs.10 (260-250) will be the intrinsic value and the balance of Rs.4 will be the time value. Of course, in case OTM call and put options, the entire premium will be time value.

When to buy call and put options

The decision to buy calls and puts will depend on your price outlook. For example, if you expect the stock price to go up, you can buy a call option and if you expect the price to go down then you can buy a put option. In both these cases, your risk is limited to the amount of premium paid but profits can be unlimited. When you buy calls and puts, the OTM option may appear to be cheap. But since it is fully time value, it also loses value as the option expiry approaches.

What exactly is option expiry?

In India all options expire on the last Thursday of the month. There are 1-month, 2-months and 3-months currently available in India. Bank Nifty also offers weekly options for trading.

When to sell call and put options

An option seller has a negative view on the stock. The option buyer believes that the stock price will go up or go down and buys calls or puts accordingly. A call option seller believes that prices will not go above a certain level and a put option seller believes that prices will not go below a certain level. Remember, the maximum gain of the option seller is the premium received but the losses can be unlimited if the price moves in the opposite direction. That is why stop losses are critical.

Using options for trading

In India, options can be exercised on the day of expiry (that is you get the difference between market price and strike price). But the more popular method of trading options is to reverse your positions. If you have bought an option, you can sell it in the market and book the profit or loss. Liquidity is not an issue in most of the index and stock options.

Using options to hedge your portfolio

More than trading, options should be actually used for protecting against risk. How does that work? If you have bought Tata Motors at Rs.345 in the cash market, you can protect by buying an Rs.340 put option at Rs.3. Your total cost goes to Rs.348 (345+3), but then your total risk is limited to just Rs.8 {345-340) + 3}. Thus, even if Tata Motors goes down to Rs.250, your total loss will be limited to Rs.8 only. On the up side, your profits can be unlimited above Rs.348.

Using options to reduce cost of holding

If you are holding Tata Motors stock as in the above case, you can sell higher OTM calls. Since – calls will expire worthless, the premium will be your income. You can do this consistently for a number of months and reduce your overall cost. There is not much risk on the upside but there is risk is on the downside.

Do option buyers make money?

Globally, it is estimated that 80% of all option buyers do not make money. That may be misleading because most options are bought for hedging their risk and not for trading at all. On the other hand, options are sold largely for trading. But, since option sellers are savvy traders, making money by buying options is surely difficult.