What is Option Trading? A Complete Guide to Beginners

Options Trading has gained a lot of popularity in India in recent times. Due to the easy access to investing skills and steps required for trading in Options, many self-taught investors are beginning to trade in options in India. 

Option trading is one of the derivatives and it is generally used as a hedge against losses.

What is option trading?

Options trading let’s investors buy or sell stocks, ETFs etc. for a predetermined price and on a specific date. This form of trading also allows buyers the flexibility to refuse from buying the security at the specified price or date. While option trading may seem complex when compared to regular stock trading, it can help investors fetch larger profits when security prices rise. This is because the investor does not have to pay the security’s full price in an options contract. Similarly, options trading can help in limiting losses if the security prices go down. This concept is known as hedging.

Just like futures contracts help to minimize the risk for buyers by establishing a predetermined future price of an underlying asset, options contracts offer the same benefit, however, without the obligation to buy. Here are some of the commonly used terminologies in option trading:

Option writer

Options writer is the seller of an options contract. In contrast to the buyer in an options contract, the seller does not have any rights and should sell the assets at the agreed price once the buyer decides to execute the options contract on or before the agreed date. This is done in exchange for an upfront payment from the buyer.

Stock option

This type of option has stock as the underlying asset. The other option category that is defined as per the underlying asset is Index option. Stock options are a derivative instrument in which the underlying asset is a stock. All stock options have lot sizes, different strikes and different expiries. 

This is a derivative similar to Futures. However, unlike Futures, the investor’s profit/loss will not be dependent on the movement in corresponding stock. Not all stocks have respective options or futures derivatives. Only a few stocks are permitted by SEBI to have derivatives in options and futures.

What are the commonly used terminologies in Options trading?

Investors who start trading in the derivatives segment may come across various terms that may sound like jargons. Here are some Options-related terminologies that investors should know about:

• Premium: The upfront amount paid by the buyer to the seller towards the privilege of an option contract.
• Strike price or exercise price: The predetermined price at which an asset can be bought or sold.
• Strike price intervals: These are the different price intervals at which an options contract can be traded. The exchange determines the strike price intervals at which the assets can be traded. There are generally a minimum of 11 strike prices announced for every option type in a given month. 5 of these prices are above the spot price, 5 prices are below the spot price and one price is the same as the spot price.

Types of Options

Options are of two types, the ‘Call Option’ and the ‘Put Option’. Here are the details:

Call Option

The ‘Call Option’ gives the owner of the option the right to buy an asset at the strike price on or before the expiry date. In return, he/she has to make a premium payment upfront to the seller. Call options tend to gain further value as the underlying asset’s value increases. In online quotations, Call options are abbreviated as ‘C’.

Put Option

The Put Option gives the owner of the option the right to sell a specific asset at the strike price on or before the expiration date. For this, he/she has to pay a premium up front. Since one can sell a stock at any point, in case the stock’s spot price falls within the contract period, the holder is hedged by the strike price that has been pre-set against the fall in price. This is why put options tend to be more valuable during falling prices of the underlying stock.

In case the stock’s price increases during the contract period, the seller loses only the premium amount and does not incur a loss of the asset’s entire price. In online quotes, Put options are abbreviated as ‘P’.

How is pricing for options contracts done?

Options can be bought in the spot market for availing an underlying asset at a fraction of the asset’s actual price. This can be done by paying an upfront premium. This is the price of entering an options contract with the seller.

Let’s now understand some terms related to the pricing of options contracts:

• In-the-money: A call option is ‘In-the-money’ when the underlying asset’s spot price is more than the strike price. A Put Option is ‘In-the-money’ when the asset’s spot price is lower than the strike price.
• Out-of-the-money: You will make no money by exercising the option, as it leads to negative cash flow if exercised immediately.
• At-the-money: A no-profit, no-loss scenario, this option results in zero cash flow if exercised immediately.

Things to remember while trading in options

Here are some of the important factors to consider while trading in options:

• Illiquidity–In India, the volume of stock options trading is low. This results in many stock options being illiquid, as very few contracts are traded. Illiquidity of a stock option contract can negatively impact trading strategies and trader’s profitability.
• Fair value of options–As the bid-ask spreads in stock options contracts are significantly wider, it may be difficult for stock options traders to estimate the fair value and price of an option contract. The contract bid can be Re. 1 while the ask could be Rs. 8. This can be tricky for a trader to determine the correct fair value of the option.
• There is no physical document exchange while entering an options contract. The transactions are only recorded and routed through the stock exchange.
• Since options trading requires traders to know some of the complex terminologies, it is best for new investors to gain sufficient trading knowledge before foraying into options trading.

Conclusion

To trade in options, investors must try to get familiar with some of the commonly used jargons and their meanings. This will help in fetching maximum benefits from options trading, as an investor can decide upon the right strategy and market timing.

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