The covid 19 pandemic has renewed the interest in stock markets and has led to an influx of many new investors and traders. Many traders and investors are relatively small and novice so they need to have a thorough understanding of the stock markets and the related concepts to have a profitable long-term or short-term portfolio. There are many ways of trading stocks or derivatives in the markets. One of the many ways of trading is options trading. However, before taking a plunge in options trading it is essential to understand what it means and a few basic strategies of options trading that can help in making sound investment decisions.
Given below is the meaning of options trading and the basic options strategies that can be used by any trader.
What is options trading?
Options are a form of contract that provides the investors the option but not an obligation to buy or sell any instrument or securities. There are two basic options in this kind of trading namely call options and put options. Call options provide the traders with the option to buy any security while the put options provide the option to sell.
In options trading, traders can buy or sell the options with the right to exercise them anytime before their expiration. Options trading is relatively less expensive than investing in stocks as well as is quite flexible. Investors and traders can also sell their options to a third party before their expiration.
What are the basic options strategies used by most traders?
Options trading involves understanding basic concepts of buying and selling a call option or a put option or a combination of both to gain maximum advantage. Some of the common strategies involved in options trading are discussed below.
a. Bull Call Spread
A bull call spread is an options trading strategy relating to the bullish view of the stock. In this strategy, the trader buys and sells an equal number of call options with a higher strike rate. These options have the same underlying and expiration date. The spread in this strategy is the difference between the higher and lower strike price. Under this strategy, the profits and losses both are limited hence, the traders can use this strategy when they are moderately bullish on the stock.
b. Bull Put Spread
This is another options strategy used when the trader has a bullish view of the stock or the index. The trader buys a put option of a lower strike price and sells a put option of a higher strike price. LIke bull call spread, the put options should have the same underlying stock as well as the same expiration date. The difference between the strike prices is the net profit earned by the trader.
c. Call Ratio Back Spread
This is one of the simplest options strategies available to traders and is used when they are highly bullish on the stock or the index. Under this strategy, the trader buys 2 call options and sells one call option. The potential for profits is unlimited in this strategy in the event of an upward trend in the market and in the case of a downward trend, the profits are limited. The trader is thus in the position to gain profits either way and the possibility of losses is quite limited.
d. Bear Call Spread
This is a strategy used by the traders in the bearish market or when they are bearish on the underlying stock or index. The trader, in this case, buys the call option at a specified strike price and sells a similar call option at a lower strike price. Similar to previous strategies, the underlying stock and the expiration date of the options have to be the same. The potential profit and the loss potential in this strategy are limited for the trader.
e. Bear Put Spread
This strategy is also applied by traders in a slightly bearish market i.e. if the traders expect the stock or the index to go down but not too much. The traders in this case buy a put option at a strike price and sell a put option at a slightly lower strike price. Like the above options strategies, the underlying stock, and the expiration date of the options have to be the same.
f. Synthetic Call
This is another strategy used by traders with a bullish view of the stocks or index along with a risk of a downward trend. Under this strategy, the trader buys put options of the stocks held by them that they expect to have an increase in the prices. The traders make profits in the case of increasing prices of the underlying stocks whereas the losses will be limited to the extent of the premium paid for the put option in case of decreasing prices.
g. Synthetic Put
This is the strategy used by the option traders when they have a bearish view of the stock or the underlying index but at the same time are worried about the potential increase in the prices. The traders make profits when there is a decline in the prices of the underlying stock or index.
h. Long and Short Straddles
This is a market-neutral strategy where the trader buys or sells the call option or the put option. The strike price and the expiration date of the options have to be the same. Traders, therefore, benefit from the position where they can potentially make profits if the stock prices move in either direction. In a long call, traders buy a call option and a put option, whereas in a short straddle the traders sell a call option and a put option.
i. Long and Short Strangles
Strangles are a modification of the straddle strategy. In this strategy, the trader sare required to buy out-of-money call and put options. In a long strangle, the traders have to buy one out-of-money call option and put option and in a short strangle, the trader has to sell one out-of-money put option and call option. In the former case, the profit potential is unlimited, and the loss is limited to the net premium outflow. In the latter case, the loss potential is unlimited and the maximum profit will be up to the premium received by the trader.
j. Long and Short Butterfly
This is another market-neutral options strategy. It combines the bull and bear spread that have a fixed risk and limited profit. While applying the long butterfly, the trader will buy one in-the-money call option, write at-the-money call options, and buy one out-of-money call option. In the short butterfly strategy, the trader will have to sell one in-the-money call option, buy 2 at-the-money call options, and sell an out-of-money call option. It is important to note that the options with the higher and lower strike prices should have the same distance from at-the-money options.
Conclusion
Options trading is part of the derivative markets that have an advantage over other derivative markets instruments like forward and futures contracts as it provides the trader with an option to buy or sell the security rather than have an obligation. For effectively using options trading, it is necessary for the traders to understand the basic concepts and strategies of options trading. After understanding the various options strategies, traders can limit their risks as well as increase their profit potential by applying suitable options strategies based on their risk-return expectations.
FAQs
Some more examples of options strategies used by traders are,
-Strip
-Iron condor
-Married put
-Covered call
-Max Pain and PCR Ratio
Some of the basic rules to be followed by options traders with small capital (an option trade with less than Rs. 2,00,000) are mentioned below,
-Define the maximum holding period.
-Limit the trade value to approximately 5% per trade and a maximum of 10% of the overall capital at any point in time.
-Avoid trading in stocks that are currently in news.
-Avoid trading on events that have unknown outcomes as the potential of loss due to volatility increases.
-Limit the number of open trades for better focus and reaction to the market fluctuations.
Yes. A Demat account and trading account are necessary for options trading.
No. All the registered brokers may not prove the benefit of trading in Futures and Options. Hence, the traders have to open their Demat account and trading account with a broker that provides such a facility.
Options trading is quite tricky and needs a good understanding of the markets and their volatility. Apart from this, the traders need to have a few basic qualities that will help them make better trades and potentially make a profitable portfolio. These qualities are
-A disciplined approach towards trading by sticking to their risk-return profile.
‘-Rome was not built in a day.’ Similarly, one cannot be an expert in options trading from day one. Patience and constant learning is the key to being a good options trader.
-The traders also need to be able to adapt to the changing market scenarios and strategize accordingly.
