Learn how to Trade Options
If you wish to learn how to trade options, then it important to understand the markets and techniques which help in optimum utilization of the situation, trader’s capital, and futuristic view of markets in order to generate maximum profits and/or to minimize losses to the trader.
- Understanding Markets: The first and foremost requirement is to have a market view. Options are of 2 types – a call and a put. In trading a call, the investor should have a bullish view of the market, and vice-versa for a put. However, the view should be based on an analysis of the market and political events. Markets are moved by sentiments; hence having the right view is very important for earning profits.
- The Right Product: For each type of view – bullish or bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market., there are two types of products:
- Bullish: Buying a Call or Selling a PutSelling A PutWriting put options refer to the opportunity availed by an investor to own and sell an underlying asset at an exceptional pre-determined price on a future date. The owner has the right but not the obligation to sell off the underlying asset.
- Bearish: Buying a Put or Selling a CallSelling A CallIn writing a call option, a person sells the call option to the holder (buyer) and is obliged to sell the shares at the strike price if the holder exercises it. In exchange, the seller receives a premium from the buyer.
- Exercising a long call or put options have unlimited profits and limited losses in the respective pro-market, while exercising a short call or put options would have limited profits but unlimited losses in another scenario.
- Hence choosing the right product is very important for the required cash flow.
Top 3 Types/Ways to Trade Options
- Through Standardized Platforms: There are registered market vendors providing trading platforms to its customers who offer standard option products and, in exchange, to charge a fixed commission. These are open to all investors, upon completion of basic authenticity requirements by the service provider.
- Brokers: Trading into options can be executed through the registered broker (individuals or broker firms), who complete the client requirements in the market with other parties, and in exchange charge commissions. The commission varies with the standard platform based commission. In such transactions, brokers may provide the advisory function to their clients to help them make investing decisions. The client may even opt for exotic and/or customized products by paying a little higher commissions.
- Self Investments: Bigger firms hold their own trading booksTrading BooksTrading book is the type of book maintained by the bank, financial institution or a stockbroker banks for recording the transactions of the clients who have given them an opportunity to act as the broker or middle person for dealing in securities. as well, apart from providing a platform for trading such options to their clients. Such firms earn from their own risk holding activity into the markets.
Since options are traded on exchange globally, they are regulated with standard provisions. There is hardly any scope of adulteration with outside the market arbitrage. Hence, investors can be secured from their investments.
The below table signifies In-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price. (ITM), At-the-money (ATM) or Out-of-the-money (OTM) cash flows on options:
|Call||Spot > Strike||Spot = Strike||Spot <Strike|
|Put||Spot < Strike||Spot = Strike||Spot > Strike|
The above cash flows should be net of option premium.
The premium of the option is the cost to purchase that option (long or short, call or put), driven by the intrinsic value of the underlying and time to maturity of the option.
Premium = Time Value + Intrinsic Value
As the option approaches maturity, the time value portion of the option starts reducing, and just before maturity, the premium comes near to 0.
Examples of Options Trade
The following are examples of trade options.
Trade Option – Example #1
Call A is traded at $5. An investor with a bullish view goes long call A at the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. of $105. Calculate the profit/loss at the end of maturity if the Spot at maturity is $115. Also, comment if the call was ITM/ATM/OTM to the investor.
- Strike Price: $105
- Call premium: $5
- Spot Price: $115
Total cost paid by investor: $105 + $5 = $110
As Spot in the market is $115, the investor can purchase the underlying at $105 and sell the same at $115, making a profit of $10 on the underlying.
However, net profit = Profit – premium = $10 – $5 = $5.
This call is ITM to the investor.
Trade Option – Example #2
Put B is being traded at $5. An investor with a bearish view goes long putLong PutLong put is a strategy used in options trading by the investors while purchasing a put option with a common belief that particular security's price shall go lower than its striking price before or at the arrival of the date of expiry. B at the strike price of $95. Calculate the profit/loss at the end of maturity if the Spot at maturity is $105. Also, comment if the put was ITM/ATM/OTM to the investor.
- Strike Price: $95
- Put premium: $5
- Spot Price:Spot Price:A spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery. $105
Total cost to be paid by investor: $105 + $5 = $110
However, as Spot in the market is $105, the investor would make a loss if he purchases the underlying at $105 and sells the same at $95. In this scenario, since he is “long” the option, he has a choice to either exercise the same at maturity or not.
If he exercises the option, he will make a loss of $10 (plus the premium paid @$5 to make a total of $15 loss).
However, he would not exercise the option and be restricted to a loss of only the premium amount of $5 paid to purchase the option.
This call is OTM to the investor.
Advantages of Trading in Options
- The benefit of limiting losses by going long on options.
- The benefit of investing now for future expected profits. Sometimes the earnings are much more than expected earnings if the future expected event performs well beyond expectations.
- Investment can be minimal, and risk can be taken on the much larger underlying value, which is not the case while investing in cash stocks.
- It creates a huge leveraged network for investors in the entire market. Enhances the value of money.
Disadvantages of Trading in Options
- If the market moves in the opposite direction to view, losses can be huge.
- Creates a bubble in the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. If not controlled, it can burst the economy.
Limitations of Trading in Options
- A particular market view is required for prediction; however, it may be correct or not.
Trading into options is an important market component, and hence, this product should be studied well before making investments. With a proper understanding of market movements, one can make decent positive cash flows from the markets.
This has been a guide to how to trade options?. Here we discuss types, components of options trading along with examples, advantages, and disadvantages. You can learn more about derivatives from the following articles –