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 bearish, there are 2 types of products:
- Bullish: Buying a Call or Selling a Put
- Bearish: Buying a Put or Selling a Call
- 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.
- Right Investment: Based on complete market analysis and the investor’s risk-taking capacity, the right amount needs to be invested in such options.
Top 3 Types/Ways to Trade Options
- Through Standardized Platforms: There are registered market vendors providing trading platforms to its customers which 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 books 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-money (ITM), At-the-money (ATM) or Out-of-the-money (OTM) cash flows on options:
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 price 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 put 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: $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 would 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.
- 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 into the opposite direction to view, losses can be huge.
- Creates a bubble in the financial market, if not controlled 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 –