Option trading can be a little daunting if you are a new investor. It can appear to be a little complicated compared to the old, familiar asset classes like stocks, shares, bonds, and mutual funds. However, there are several advantages of options trading, and if you go into it armed with some knowledge and awareness, there are opportunities here that you may want to exploit. Moreover, it could be a good addition to a diversified portfolio.
Before going into topics like option trading tips, let’s first understand what an option is. An option is a derivative whose value derives from an underlying asset. There are two kinds of derivatives – futures and options. A futures contract gives you the right to buy or sell a certain asset at a fixed price at a future date. An options contract gives you the right, but not the obligation to do so.
An example of an options contract will make this clearer. Suppose you expect the share price of ABC company, currently at Rs 100, to fall. You then buy an options contract to sell the share at Rs 100 (this is called the `strike price’). If the ABC price then falls to Rs 90, you would have made Rs 10 on each option. If share prices were to rise to Rs 110, then naturally you wouldn’t want to sell at Rs 100 and incur a loss. In that case, you have the choice of not exercising your right. So, you don’t have to suffer any loss.
Here are some concepts you should understand before you go in for options trading:
- Premium: Premium is the price you pay for entering into the options contract to the seller of the option or `writer’. You pay the premium to the broker, which is passed on the exchange and thereon to the writer. Premium is a percentage of the underlying and is determined by various factors, including the intrinsic worth of the options contract. Premiums keep changing according to whether the option is in-the-money or out-of-the-money. They’re higher when it’s in-the-money and lower when not.
- In-the-money: An options contract is said to be in-the-money when it is able to make a profit when sold at the moment.
- Out-of-the-money: This situation occurs when the options contract cannot make money when sold at the moment.
- Strike price: This is the price at which the options contract is struck.
- Expiration date: An options contract is for a fixed period of time. It could be one, two or three months.
- Underlying asset: This is the asset on which the option is based on. It could be stocks, indices or commodities. The price of the option is determined by the price of the underlying asset.
Options and futures are freely traded on the stock exchange. Even ordinary investors can go in for options trading and, if lucky, they can make profits from doing so. Here are some option trading tips that should help you get started
• Bullish or bearish?
In options trading, you are betting on the movement of stock prices. So, your choice of option will depend on whether you expect prices to rise or fall. There are two kinds of options – call and put. A call option gives you the right, but not the obligation, to buy a certain stock at a certain price. A put option gives you the right to sell a stock. If you expect stock prices to increase, a call option should be your preferred choice. If prices are falling, a put option would be a better choice.
• How much will it move?
The amount you can make from option trading is the difference between the strike price of the options contract and the market price of the underlying asset (like stocks). So you have to gauge the extent of the price change. Higher the price change, more your profit will be. This requires keeping a close watch on the developments in the market.
Various factors influence stock prices, and you have to take into consideration these factors while doing options trading. There are external as well as internal factors that affect the stock price. External factors include changes in government policy, international developments, monsoons, and so on. Internal factors are those that affect the workings of a company, like a change in management, in its profits etc. In short, it’s not all that different from trading in stocks. The same factors come into play here too. The only difference is that you are not putting your money in the underlying asset, but only on the price changes.
So the success of option trading depends on getting the strike price right.
• What’s the premium?
Here’s one more of the options trading tips – look at the premium. As we have mentioned earlier, premium is the price you pay to enter into an options contract with the seller. There are many factors that determine the premium. One of the main factors is the `moneyness’ of the premium – that is whether the options contract can make money or not if sold at the moment. One thing that you should remember in options trading is that premiums will be higher when the options are in-the-money. They are lower when they are out-of-the-money. So your returns from options trading will depend at which point you have purchased the contracts. Higher the premium, lower your returns. So when you purchase options contracts that are in-the-money, you will pay higher premiums and make less money. There could be more profits by buying options that are out-of-the-money, but they involve more risk too, since it’s difficult to say when, if at all, they will be in-the-money.
• Time horizon
Another thing to remember about options trading it’s not a long-term investment. An option is an instrument to make the opportunities presented by short-term movements in prices. All options have a specific expiration date at the end of which settlement is done, either through physical delivery or cash. However, you cannot choose the expiry date at random. In India, the expiry date is on the last working Thursday of the month. Options are available for near-month (1 month), next month (2) and far month (3).
Of course, you can buy an options contract any time before the expiration date. So there’s scope to trade in options for even a day or two. Of course, this is far riskier than options contracts for longer-term periods.
The best options trading strategy will depend on a variety of factors like your investment goals, and risk appetite. But you would do well to consider the above factors before you venture into options trading.
How to trade in options in India
Not that you have an idea of how to trade options, you can take the plunge. Derivatives were introduced in Indian stock markets around 20 years ago, including options and futures. The National Stock Exchange provides trading in futures and options contracts on nine major indices, and over 100 securities.
You can trade in options through your broker, or using your trading portal or app. However, there may be additional financial requirements for options trading, like minimum income. You will have to provide additional details like income-tax returns, salary slip, and bank account statements.
When you are well-versed on how to trade options, there are sophisticated options trading strategies in India, like a straddle, strangle, butterfly and collar, which you can use to maximise returns.
Broking companies like Angel Broking offer option trading services, which you can avail to your advantage.