Options Trading is also known as Derivatives Trading. It is a form of contract using which you get the right to buy or sell stock at a fixed price. This price is already pre-determined and does not change even if the stock value goes lower or higher. But in this kind of contract, you are not bound to buy or sell the amount of stock. You can use a trading platform to buy or sell an Options Contract from the stock exchange.
- Options Contracts gain value from underlying instruments.
- Options give you the ability to spend a small amount, usually a premium, and purchase a higher number of shares, in contrast to buying a stock.
- In day trading options, you can choose to buy/sell options, but it is not necessary for you to have to exercise the right
- Call Option is buying an option that offers the right to purchase shares before the agreed expiry date.
- Put Option is buying an option that offers the right to sell shares before the agreed expiry date.
Let us understand the above-stated scenario with a simple layman’s example:
Pravin is a gaming freak. He knows a dealer (Gaurav) who has a set of rare games currently in vogue. Pravin can spend Rs. 1 lakh to purchase the set. But Gaurav expects to get Rs. 1.50 lakhs by selling the set within 6 months, as the demand for the games increases. But if no one else is prepared to give him more than Rs. 1 lakh for the set, then the price may come down to Rs. 70,000 once the trend fades out.
Here is a look into what can happen next:
- Pravin wants the set of games but does not want to spend more than Rs. 1 lakh.
- So, Gaurav offers Pravin an option (the right) to purchase the set for Rs. 1 lakh (strike price).
- But Pravin can get this right only if he is ready to pay Gaurav Rs. 30,000 as an upfront fee for 6 months.
- Pravin gets the right to purchase or not purchase the gaming set anytime in 6 months. Also, Gaurav (as per the promised terms) can sell the set only to Pravin in this period.
- If the demand for the game pushes up the base price of the game to Rs. 1.50 lakhs, then Pravin benefits from using the right.
- If the demand for the game goes lower, the price falls to Rs. 70,000, and then Pravin does not have to necessarily purchase the set. But he also loses out on Rs. 30,000 (upfront money).
In Options Trading, the upfront money paid is called the premium. The price at which you are prepared to purchase the security is the Strike price. In the given example, the strike price was Rs. 1 lakh. The upfront fee you pay to purchase an Option Contract is known as Premium. In India, you can purchase any instrument such as commodities, forex, index, or stock in Options Trading.
Here is an illustration by applying all the above-discussed logic:
- For instance, you can purchase 1 call option contract of Company A. For this, you need to pay Rs. 67.05 for a particular strike price that has 520 underlying company shares.
- The Company A call option with a strike price of Rs. 1560 gives you the right to buy 520 company shares at Rs. 1560, irrespective of the current price of the stock.
- So, you will need Rs. 8, 11,200 to directly purchase 520 Company A shares.
Types of Options Trading
Depending on the trading strategy you choose, you can opt for day trading or positional trading as follows:
1. Options Day Trading
This is just like the day trading of stocks. You can buy or sell an option contract according to the price action. Now as per the indicators and tools used to analyze the stock, you can trade as per the selected investment strategy. For instance, you can opt for a highly liquid Option Contract.
And then based on your view, you can trade several times (buy or sell, and sell or buy). The total profit or loss will depend on the number of trades you close in profit. It also depends on the turbulence in the Option price.
2. Options Position Trading
Here, to meet your Option strategy, you will buy or sell multiple options. The ultimate goal is to have a profitable cash flow till you hold the Options. You need to view the particular security before building the Option positions. The intention is to restrict the loss from multiple options.
It takes effort, time, and thorough calculation to build a suitable Option position. So, you need to pick a strategy after understanding the capital required. Also, you must know the cash flow details. This will help you to understand the Option position properly. Here is one of the strategies:
- For instance, buy a Call Option at a specific strike price, and sell the same number of calls that carry a higher strike price.
- But to get profit, both Call Options must have the same date of expiry. The maximum you will lose is the premium amount if there is a loss.
- But if you gain a profit, then it is the difference amount between the strike prices of the involved Call Options, subtracting the total premium paid.
What Do You Need for Options Trading?
Here are the essentials of Options Trading in India:
1. Trading Account
You will need a trading account. Several stockbrokers provide online trading platforms. You need not have a Demat account as Options Contracts require settlement by cash. You will require a bank account linked to your trading account. Trading happens in a lot of fixed numbers of instruments.
Brokers may charge a small fee for Options Trading. To open an Options Trading account, you will need a PAN Card, Aadhaar Card, IT return or Form 16, salary slip, cancelled cheque bearing the MICR of IFSC code.
2. Sufficient Funds
As the purchase is in a lot, the amount of risk is higher in Options Trading. So, you will need the premium amount * value of the underlying contract. For instance, you buy 1 lot of Company B Call Options with an underlying value of 30. The premium you have to pay is Rs. 900. Then you must have at least Rs. 900 x 30 = Rs. 27,000 in your account.
However, to sell an Options Contract, you have to abide by the exchange margin requirements. The risk is higher in this case than buying Options. So, you must keep at least Rs. 60,000 or so in your trading account as per the given example.
3. Most Liquid Options
You must look for the most liquid Options Contract. This will allow you to buy or sell as per suitability. The most liquid Options are the ones with a strike price close to the current stock price. You can go on relevant online platforms to check the most active Options Contract and their details.
Options Trading diversifies your trading portfolio. If you practice Options Trading correctly, then you can earn excellent returns. But you must have a well-thought-out strategy, and maintain discipline when trading. Options Trading also carries a high risk as several factors impact the Options and their underlying instruments. So, you must not place the entire investment amount in a single trade.
You never know when the position of the asset can change. Thus, allocate only 2% to 5% of the capital in one go. This will reduce the risk, and leave you with capital to trade further. Place a stop loss to avert the risk of bigger losses when the prices go down suddenly.