7 things to remember before stepping into options trading

Guide to Technical Research | Published on 17th October 2019 | 204

An option trading is very different then trading into equities. One important difference between equities and options is that equities give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price (Strike Price) on a specific date (Expiry Date).

Two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock/index at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock/index at the strike price any time before the expiration date.

It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there would always be a counter party who is selling it. Trading ‘option’ is more like betting on horses at the racetrack. There they use pari-mutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer’s gain is the option seller’s loss and vice versa; any payoff diagram for an option purchase must be the mirror image of the seller’s payoff diagram.

Lets us now understand, as a buyer of options what rights he owes and as a seller of an option what his obligation is.

Suppose, ‘XYZ’ is trading at 920 levels in cash market segment and 940 call options is trading at premium `18 (Lot size=500). ‘A’ is bullish in XYZ and hence buys 940 call, while ‘B’ being pessimistic on same writes 940 call option. Hence, ‘A’ pays 9000(18*500) and B receive same for writing option.

Scenario 1- Stock move up to 980 levels on expiry

In this case, view of a buyer of call options stands right. Hence, he gains profit of `11,000 (different between spot & strike price minus the premium paid and multiplied by the lot size). While the same is the losses for writer of call options.

Scenario 2-Stock corrects to 900 levels on expiry

In this case, view of a seller of call options stands right. Hence, sellers gains the total premium receive i.e. – 9000. While on the other hand the buyer losses only the premium he paid.

         BUYER SELLER
Premium Pays premium Receives premium
Risk Risk is limited to premium paid Unlimited if stock/index moves above strike price
Reward Unlimited Limited

After reading all this, you must be aware of what options are and how option trading works. Now, you need to know few things before stepping into options trading:

Selection of strike prices:

People have a tendency to buy things at a cheaper rate and the same concept they apply while trading into options also. Hence, traders generally look to buy deep out of the money strikes, which are available at low premium; but, the probability of getting that strike price in-the-money is very low. Since, we trade into options with a limited period to exercise our rights; one should prefer at-the-money or slightly out-the-money strike prices as the probability of it getting exercise is high.

Behaviour of time value in options:

Premium in options consists of two components, intrinsic value and time value. Suppose, XYZ is trading at `920 and 900 call option is trading at `32. Here, 900 call is already `20 in-the-money, which is the intrinsic value. While, the remaining `12 is the time value of 900 call option which gets decay as the expiry approaches.

Avoid trading in illiquid options:

Traders should initially check whether there is sufficient volume in the strike price they are looking to trade.

 Avoid averaging in same strike:

Those traders who have bought options either call or put and are incurring losses due to stock/index moving either in opposite direction or trading in a range should avoid averaging in same strike prices. Averaging is not advisable but those who want to do it should select the nearest strike to add on to their positions, as once the stock moves in the direction expected, the at-the-money strike will fetch more profit due to which your losses will reduce or will get covered completely.

Aggressive positions during stock result:

Retail traders with lack of knowledge should avoid buying options one or two days prior to quarterly results as implied volatility (IVs) jumps higher and due to which option premium shoots up. And even though stock moves in your favour or remains subdued, you may end up losing due to cool-off in IVs.

Selection of Expiry:

Traders having view on a particular counter should also take time into consideration. Suppose, trader is expecting 7% move in a stock within 3-4 weeks and the current expiry is closer then trader should prefer next month expiry.

Building a Proper Strategy:

There are many people who tend to adopt single trading strategy, either they only buy options or they only sell options. But, the best part of options trading is that one can use different strategy as per market scenario. They can buy both call and put options (Long straddle) or sell both (Short Straddle) as per volatility expected in the counter. They can also buy and sell different strikes of call options (Bull call Spread) or buy & sell different put options (Bear Put Spread) if they are mildly bullish or bearish. Similarly, there are various such strategies which a trader should explore as per market conditions.