Most people associate investment with purchasing stocks on the stock market, and many are likely unaware of terms such as options trading.
After all, Buying and holding stocks for long-term gains is one of the more common investment strategies. It’s also a perfectly reasonable way to invest, provided you know which stocks to buy or use a broker who can provide you with advice and guidance on such matters.
This approach is known as a buy-and-hold strategy, and it can help you increase your wealth over time, but it doesn’t provide much if any, short-term gains.
It’s relatively easy for traders to be more active if they want to, thanks to various online brokers that allow investors to make stock exchange transactions with just a few mouse clicks.
Many people trade online part-time or full-time, buying and selling frequently to capitalise on shorter-term price fluctuations. They often hold on to their purchases for only a few weeks, days, or hours.
Numerous financial instruments can be traded actively. Options, in particular, have proven extremely popular among traders, and options trading is becoming increasingly popular.
In today’s blog, we will discuss in detail what options trading is all about and how traders can do options trading
Let us start from the basics- what is options trading and what are the key terms used in options trading-
What is Options Trading?
When trading stocks, there are two ways to make money: take a long or short position on a specific stock. If you expected the value of a particular stock to rise, you would take a long position by purchasing it to sell it later at a higher price.
If you expected a particular stock’s value to fall, you would take a short position by short-selling it and hoping to repurchase it later at a lower price.
There is more flexibility in how trades can be executed in options trading and many more ways to profit.
It should be noted that options trading is far more complicated than stock trading, and the entire concept of what is involved can be very intimidating to beginners. There is certainly a lot you should learn before you start options trading.
Having said that, most of the fundamentals aren’t that difficult to grasp. Once you’ve mastered the fundamentals, it’ll be much easier to understand what options trading is.
Purchasing an options contract is similar to purchasing stock. You are taking a long position on that option, expecting its value to rise. You can buy options contracts by deciding what you want and how many you want to buy and then placing a buy-to-open order with a broker. This order was named after you are opening a position by purchasing options.
There are essentially two ways to sell options contracts. If you have previously purchased contracts and wish to realise profits or reduce losses, you would sell them by placing a sell-to-close order. Because you are closing your position by selling options contracts, the order is named as such.
What are the key terms used in Options Trading?
- American Style Option: A type of option that can be exercised at any time, unlike the European Style option, which can only be exercised at expiry
- At-the-Market: A financial transaction where the order to buy or sell is executed at the current market price.
- At-the-Money Spot: An option whose strike price is equal to the current market price in the cash spot market.
- At-the-Money Forward: An option whose strike price is equal to the current market price in the forward market.
- Call Option: A financial contract gives the owner the right but not the obligation to buy a specific amount of the underlying financial instrument at a particular price with a specific maturity date.
- Commodity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which is a commodity index.
- Currency Swap: A currency swap involves the exchange of an interest in one currency for the same in another currency.
- Delta: The change in the financial instrument’s price to changes in the price of the underlying cash index.
- Equity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which is an equity index.
- European Style Option: An option that can be exercised only at expiry as opposed to an American Style option
- Forward Contracts: An over-the-counter obligation to buy or sell a financial instrument settled privately between the two counterparties.
- Futures Contracts: An exchange-traded obligation to buy or sell a financial instrument.
- Gamma: The degree of curvature in the financial contract’s price curve to its underlying price.
- Hedge: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk.
- In-The-Money Spot: An option with positive intrinsic value for the current market spot rate.
- In-The-Money-Forward: An option with positive intrinsic value to the current market forward rate.
- Option: The right but not the obligation to buy (sell) some underlying cash instrument at a specific rate on a particular expiration date.
- Premium: The cost associated with a derivative contract refers to the combination of intrinsic and time values.
- Put Option: A put option is a financial contract giving the owner the right but not the obligation to sell a particular amount of the underlying financial instrument at a pre-set price.
- Spot: The price in the cash market for delivery using the standard market convention.
- Strike Price: The price at which the holder of a derivative contract exercises his right.
- Theta: The sensitivity of a derivative product’s value to changes in the date, all other factors staying the same.
As we are now well acquainted with the basics of options trading, let us start discussing about the two main types of options that options traders use-
Type of Options
There are two types of Options:
1. Calls
A call option is a financial agreement between the holder and the writer. The call holder is the contract’s owner; they have purchased the right to buy the underlying security. The seller of the call is known as the writer, and they sell the contract for a fee that the holder pays. The agreement would specify the strike price, underlying security, and expiration date.
The asset on which the contract is based is the underlying security. For example, if you purchased a call based on Company X shares, you would be purchasing the right to purchase shares in that company.
2. Puts
Put options are one of the two main types of options contracts, the other being calls. A put is a contract that grants the contract owner the right to sell the relevant underlying asset at a predetermined price by a predetermined date.
The person who purchases the put contract pays a fee in exchange for the right, but not the obligation, to sell the underlying security. This is known as exercising an option. If the buyer of the options contract exercises their option, the other party to the contract must purchase the underlying security at the agreed-upon price.
How to trade Options?
Before we start trading options, we need to open a Demat Account with a broker-
How to start Options Trading?
You must establish your expertise in options trading before you can begin trading. Opening an options trading account requires more capital than opening a brokerage account for stock trading.
Before you dive into options, it’s best to have a firm grasp of trading and option trading basics. The next step is to describe your investment goals, such as capital preservation, income generation, growth, or speculation.
Your broker may impose additional conditions, such as disclosing your net worth or the kinds of options contracts you intend to trade.
To start trading in the options market, we must understand whether the traders are active in call options or put options. To analyse this, we need to study the options chain.
let us discuss what an option chain is and how to analyse options chain:
What is the Options Chain?
An option chain is a detailed representation of all available option contracts for an asset (stock, index, currency, or commodity). It provides a quick picture of all available put and call options for the asset and pricing, volume, and open interest details, which can help a trader analyse the market and take appropriate and immediate action.
Let us analyse how to analyse the option chain:
- Contract Name – The contract name is a name given to it for identification purposes.
- Last Trade Date – The last trade date specifies the date and time of the most recent trade. The matching of prices by buyer and seller is referred to as trade.
- Strike Price – A contract in which an owner buys or sells an asset at an agreed-upon price and date. The strike price is the agreed-upon price at which the owner will buy or sell the asset when the contract expires.
- Last Traded Price (LTP) – The last traded price is the price at which the option contract was traded.
- Bid Price – The bid price shows the highest bid in the market for this contract. It is usually the best market price a trader is willing to buy.
- Ask Price – The asking price of this contract in the market. It is usually the best market price a trader is willing to sell.
- % Change -% Change indicates the percentage difference between the most recent LTP and the previous LTP. % Change equals Change*100/Previous LTP.
- Volume – The number of contracts traded in a market for a specific agreement is called volume. It represents the market liquidity for this contract.
- Open Interest – The number of open positions for a specific contract that has not yet been closed out, expired or exercised.
Open Interest is one of the most critical components of the options chain, as it tells us about the strength of the ongoing trend. Let us discuss how to read open interest in detail-
What is Open Interest?
Open interest, or OI, is the total number of options or futures contracts of a particular security or index not closed or delivered on a particular business day.
How is open interest calculated?
Let’s try to understand open interest by an example. Let’s say we have a trader A who buys 1 future contract of Reliance Industries from trader B (the seller here), then the open interest of that security (Reliance) is 1.
Now another trader, C, wants to buy 2 futures contracts of the same security (Reliance in this case) from trader D (seller), then the open interest rises by 2 and becomes 3. Now, if trader A wants to sell (unwind) his/her position and the counterparty is either B or D, then the open interest of the security will reduce by that quantity (one in this case).
A unwinds his position, and the counterparty (sell Reliance futures) is a new entrant, say E, then the open interest will remain unchanged. This is because while Trader A has squared off his position, E’s position is still open. (This is because only the trader’s hands are exchanged; no new contract is sold or written).
Below is a simple table to understand the calculation of open interest,
In conclusion, if a new buyer (trader A) buys 1 contract and a new seller (trader B) sells 1 contract, the open interest will increase by one contract. If one old buyer (trader A) and one old seller (trader D) are closing an existing position, open interest will decline by 1. However, if an older buyer sells his contract to a new buyer, the open interest will not change.
How to interpret open interest and its relation with price movement?
Tracking open interest alone does not signify much information; however, its relation with price movement will give much information regarding the current trend in the particular contract to the trader and investors.
Below is the chart showing the relation between Open Interest (OI) and contract price.
From the above chart, we can conclude,
- Open Interest Rising: Indicates that the present trend (uptrend, downtrend or flat) is likely to continue.
- Open Interest Falling: Gives an Indication that the present trend (uptrend, downtrend or flat) is likely to change or end.
Unlike volumes, the change in open interest does not give any directional view of markets. However, it does give a sense of strength between bullish or bearish trends. Generally, if a sudden high open interest is backed by a rapid increase or decrease in the stock prices or index, then it’s time to be cautious. This situation simply indicates that there is a lot of buzz and leverage in the market. So any sudden good or bad news could trigger a big upswing or downswing in the stock or index.
Determining the Support and Resistance using Option Chain
We know time plays one of the key factors in options trading. Due to this reason, we experience more sellers’ presence in the market than buyers.
A call options seller stands on the Bearish side, and a Put options seller holds a bullish view of the market. So if a huge Open Interest build-up is visible at any particular strike price, then it is obvious that it signifies something important.
This huge addition in OI for any certain strike price defines the possibility of calculating support and resistance level. For the call option if at any certain level huge OI is present, it depicts a possible resistance level and for the put option addition in OI signifies a possible support level at that strike price
As we know, the OI is only applicable for future and Options contracts. We can identify potential support and resistance level by taking the help of Open interest from the options chain.
Suppose in a security price’s call option OI has been built upon a certain level, And the same is for the put option. So we can assume that two zones could be the possible Resistance and Support zone for security.
We have taken the Nifty option chain of the 20th October expiry month. As we can see in this picture, in the call option (CE) segment, there is a huge addition of OI in the 17300 Strike price in another hand, for put options (PE), there is also significant addition of OI in the 17000 strike price.
So, we can easily calculate support and resistance for Nifty. It has a resistance level of 17300, and we can take 17000 classes for Support.
As we now know how to calculate the support and resistance using open interest, let us discuss some options trading strategies:
What are Options Trading Strategies?
Options can make the most of bullish market conditions, just as bearish options strategies can be used to make the most of bearish market conditions. The beauty of options is that they allow you to work markets in both directions. Moreover, you can combine options with other options and futures to create elegant hybrid strategies to trade on bearish market opportunities because options are non-linear.
Types of Options Trading Strategies
Let us discuss some bearish options strategies:
1. Bear Call Spread
A Bear Call Spread Strategy involves purchasing and selling a Call Option with a lower strike price on the same underlying asset and expiry date.
When you sell a Call Option, you are compensated with a premium; when you buy a Call Option, you are compensated with a premium. As a result, your investment cost is significantly reduced. Furthermore, the technique is less risky because the return is limited to the difference between the premium received and paid.
This strategy is used when a trader believes the underlying asset price will fall moderately. This method is known as the bear call credit spread because it receives a net credit upon entering the trade.
The maximum risk is the difference between the strike prices minus the net credit received, including commissions. The potential profit is limited to the net credit, and the potential loss is limited to the spread minus net credit.
Below is the payoff diagram of this strategy:
2. Bear Put Spread
The investor must buy an in-the-money (higher) put option and sell an out-of-the-money (lower) put option on the same company with the same expiration date to execute this strategy. The investor incurs a net loss as a result of this technique.
The Bear Put Spread strategy’s overall effect is to lower the cost of buying a Put and raise the breakeven point (Long Put). The approach requires a bearish perspective because the investor will only profit if the stock price/index declines. This method comes with low risk and a low profit.
The maximum profit is realised if the stock price is at or below the Short Put (lower strike) strike price at expiration. The maximum risk is equal to the spread cost, including commissions.
Below is the payoff diagram of this strategy:
3. Strip
The Strip Option Strategy has a strong bearish bias and opts for a volatile market. The Strip is a net debit approach that is a little bit modified from the Long Straddle. With this minor tweak, we are long on Put with one more lot as we have a bearish bias. In the long strap, we are long on ATM Call and Put option with equal lots.
The maximum profit is unlimited. When the underlying price closes at the Strike Price of the Call and Put purchased, the Maximum Loss under Strip will occur.
Below is the payoff diagram of this strategy:
4. Synthetic Put
The synthetic put options strategy combines a short stock position with a long call option on the same stock to represent a long-put option. It’s also known as a long synthetic put. An investor who is short a stock buys an at-the-money call option on that same stock. This action is taken to protect the stock’s price from rising.
The maximum risk is limited to the strike price-price at which the underlying is sold+ call premium paid. The profit is unlimited.
Below is the payoff diagram of this strategy:
5. Bear Butterfly Spread
In the short butterfly spread, the two long calls at the middle strike (or ATM) and one short call at the lower and upper strikes make up this strategy. The expiration dates of each option must match. Additionally, the centre strike must have equal distances from the upper and lower strikes (also known as wings) (or body).
The maximum loss is limited to Net Premium Paid. The net credit obtained fewer commissions represents the highest profit potential, and this profit could be made in two ways.
Below is the payoff diagram of this strategy:
6. Bear Iron Condor Spread
A short iron condor spread is a four-part trading strategy that consists of a bear call spread and a bull put spread where the short Put’s strike price is lower than the short call’s strike price. The same day is the expiration date for each choice.
The maximum risk is equal to the difference between the strike prices of the bull put spread (or bear call spread) less the net credit received. The maximum profit potential is equal to the net credit received less commissions.
Below is the payoff diagram of this strategy:
You can practice more such strategies in ElearnOptions
7. Bear Put Ladder Spread
The bear put ladder spread is a variation on the bear put spread. This options trading strategy is also used to profit from a security’s price decline, but it includes an additional transaction that lowers the initial investment required to establish the spread.
Like the bear put spread, it is best used when the security price is not expected to fall significantly. It is also known as the long put ladder spread, and it can result in significant losses if the downward price movement is greater than expected.
The potential profit is limited, and the maximum profit is made when the underlying security’s price falls somewhere between the strike prices of the put options written.
Let us discuss some bullish options strategies:
8. Bull Call Spread
A bull call spread comprises one long call at a lower strike price and one short call at a higher strike price. Both options have the same underlying stock and expiration date. A bull call spread is set up for a net debit (or net cost) and profits as the underlying stock price rise.
If the stock price rises above the strike price of the short call, profit is limited, and potential loss is limited if the stock price falls below the strike price of the long call (lower strike).
The potential profit is limited to the difference between the strike prices minus the spread’s net cost (including commissions). The maximum risk is equal to the spread cost plus commissions. If the position is held to expiration and both calls expire worthlessly, a loss of this amount is realised.
Below is the payoff diagram of this strategy:
9. Bull Put Spread
A bull put spread involves writing or short-selling a put option while concurrently purchasing another put option with the same expiration date but a lower strike price (on the same underlying asset).
The bull put spread is one of the four primary forms of vertical spreads, with the bull call spread, bear call spread, and bear put spread being the others.
The premium obtained for the short put leg of a bull put spread is always more significant than the premium received for the long put, implying that receiving an upfront payment or credit is required to begin this strategy.
Potential profit is limited to the net premium received by fewer commissions, and this profit is realised if the stock price is at or above the short put (higher strike) strike at expiration and both puts expire worthlessly. The maximum risk equals the difference between the strike prices minus the net credit received, including commissions.
Below is the payoff diagram of this strategy:
10. Call Ratio Back Spread
A call ratio backspread is an option spreading strategy bullish investors use to limit losses while expecting the underlying security or stock to rise significantly. The strategy combines buying a larger number of call options with selling fewer calls at a different strike but with the same expiration date.
While the downside is protected, gains can be substantial if the underlying security rises significantly due to the ratio feature.
The maximum potential loss occurs if the underlying stock price is at the higher strike price of the two calls purchased when the options expire. However, because the strategy involves the purchase of two call options, the potential profit from a rise in the underlying stock price is theoretically unlimited.
Below is the payoff diagram of this strategy:
11. Synthetic Call
Investors and traders utilising the synthetic long call strategy buy a stock because they have an optimistic outlook. But what if the stock price falls instead? As an investor, you wish you had some protection from a price decline.
Thus, purchase a Put on the stock. As a result, you have the option to sell the shares at the strike price. The strike price can be above (ATM strike price) or below the price you paid for the shares (OTM strike price).
Losses are limited to Stock price + Put Premium-Put Strike price. The Profit potential is unlimited when this strategy is implemented.
Below is the payoff diagram of this strategy:
12. Bull Butterfly Spread
A long butterfly options trading strategy consists of purchasing one call option at a lower strike price, selling two calls at a higher strike price, and then purchasing one call at an even higher strike price. The strike prices are equally spaced apart, and all calls have the same expiration date.
This butterfly options strategy limits the risk to the net debit paid. The maximum profit potential can be obtained if the stock price is equal to the strike price of the short calls (centre strike) at expiration. This profit is equal to the difference between the lowest and middle strike prices less the net cost of the position, including commissions.
13. Bull Condor Spread
Long Iron Condor Options Strategy involves selling a lower strike put, buying a lower-middle strike put, purchasing a higher middle strike call, and then selling a higher strike call.
Each option traded under this strategy should belong to the same underlying and have the same expiration. Usually, the lower and lower-middle strike puts are OTM puts, whereas the higher-middle and higher strike calls are OTM calls.
The maximum loss is limited to the extent of the net premium paid. The profit equals to lower-middle strike price-lower strike price-net premium paid.
14. Bull Call Ladder Spread
The bull call ladder spread is an options trading strategy designed to profit from increased security prices. It is similar to the bull call spread in that it is best used when you expect a security’s price to rise but not dramatically.
The main reason for using the bull call ladder spread rather than the more straightforward bull call is that it involves an additional transaction, which reduces the initial cost of implementing the strategy.
Bull Call Ladder is a Net debit strategy where we will have limited profit; Maximum profit will be if the market stays in between higher and middle strike price i.e., the difference between Middle strike and lower Strike Call less net initial outflow.
Maximum Loss is unlimited if the stock moves above the breakeven point.
When developing options strategies, it is important to analyse options greeks, which we will discuss in the next section-
What are Options Greeks?
Factors like Option Greeks, Options Premiums and demand-supply of the markets influence each other. Although these factors work independently, they are all linked with one another. The option’s premium shows the outcome of all these factors.
The most important thing when trading in an option is to analyse the change in premium. An options trader needs to understand how these factors play their role before trading in options.
Let us discuss options Greeks:
1. Delta
Delta is option greek that measures the options’ price change (which is the premium) which results from a change in the underlying security. The value of Delta ranges from 1 to 0 for calls and 0 to -1 for puts.
Call Options have a positive delta which means between 0 and 1. This means that if the price of the stock price goes up, the price for the call will go up, other factors being the same. For example, If a call has a delta of .50 and the stock goes up Rs.1 then the price of the call will also go up to about Rs. 0.50. Now if the stock’s price goes down by Rs. 1, then the price of the call will also go down about Rs 0.50
On the other hand, Put Options have a negative delta that ranges between -1 and 0 as they have a negative relationship with the underlying security, i.e., the put’s premium decreases when there is a rise in the prices of the underlying security.
So, we can say that for Call options-
- Call options have a positive Delta that ranges from 0 to 1.
- At-the-money options generally have a Delta near 0.5.
- The Delta will increase and reach 1 when the call option gets deeper in the money.
- The Delta of ITM call options will get closer to 1 when it nears expiration.
- The Delta of OTM call options will get closer to 0 when the expiration approaches.
Similarly, for put options, we can say-
- Put options have a negative Delta that ranges from -1 to 0.
- ATM put options usually have a Delta near -0.5.
- The Delta will decrease and approach -1 when the option gets deeper in the money.
- The Delta of ITM put options will get closer to -1 as it nears expiration.
- The Delta of OTM put options will get closer to 0 as it’s near expiration.
2. Gamma
Gamma is an option Greek that measures the rate of change in an option’s delta for per unit change in the underlying stock’s price and helps the options traders to gauge what to expect in the near future.
The Gamma of an option measures this change in delta for the given change in the underlying. As Delta is only good for a specific moment, Gamma tells us how much the option’s Delta should change as the underlying stock’s price or index increases or decreases. We can think of Delta as speed whereas Gamma as acceleration.
As the change in delta is for the change in the underlying value, which Gamma captures, hence it is referred to as the 2nd order derivative of the premium.
One should remember gamma: Smallest for deep out-of-the-money and deep-in-the-money options and Lowest when the option gets near the money. Also, it is Positive for long options, whereas negative for short options.
3. Theta
Theta is another option Greek that measures the price change of an option for a one-day decrease in its time to expiration. Simply put, Theta tells us how much the price of an option should decrease when the option nears its expiration.
We can say that theta is the enemy of the option buyer, whereas it is usually the option seller’s best friend.
As options lose value near their expiration, Theta helps us estimate how much value the option will lose every single day, if other factors remain the same. One should note that the Theta of at-the-money options generally increases near their expiration.
You can read more about Option Greeks from our ELM School Module
4. Vega
Vega is another option Greek that measures the amount call and put prices will change for a one-point change in implied volatility. Simply put, it tells us how much an option’s price should move when the underlying stock or index’s volatility increases or decreases.
One should keep the following points in mind regarding vega:
- Vega can change without price changes of any underlying asset, as it changes due to a change in implied volatility.
- Vega can increase due to quick moves in the underlying asset.
- Also, Vega falls when the option gets near to its expiration.
5. Rho
Rho is an option Greek that measures an option’s price change per one percentage point change in interest rates. It tells us how much the option prices will rise or fall if the risk-free interest rate increases or decreases.
Also, when trading options, it is also important to analyze the maximum pain levels at which the index or the stock is trading-
What is Maximum Pain Theory?
The max pain theory holds that if the underlying asset’s price remains fixed at the strike price, options traders, particularly call-and-put sellers, can lose much money.
The maximum pain price is the price at which most open options contracts are trading. It’s known as open interest. It is the price at which most option holders will lose money at expiration.
Maximum pain is the possibility that most traders who purchase and hold options contracts until expire will lose money. And, because there is a greater than 80% chance that the option sellers will profit, the maximum pain theory has some validity.
There are also some derivatives indicators which option traders can use to analyze the calls and puts-
What is Put-Call Ratio?
A put-call ratio is typically used as a derivative indicator. It is intended to help traders effectively determine the sentiment of the options market. This ratio is calculated by taking the open interest for a given period and dividing it by the volume of options trading.
This particular ratio, also known as PCR, is a contrarian indicator and is primarily concerned with option build-up. This type of indicator aids in determining the market’s bullish or bearish influence.
In other words, it assists traders in determining whether a recent market increase or decrease is excessive. Based on this information, traders decide whether to take a contrarian call in the current market.
To combat mispricing in the securities market, such an investment strategy is based on purchasing or selling investment units in response to market conditions.
You can join our comprehensive course on Masterclass on Advanced Options Strategies
After discussing the basics of options trading and how to trade in options, let us discuss how options are taxed:
How Stock Options are taxed?
Your broker will charge you for the services that enable you to trade. The fees will change based on the brokering house.
- Securities Transaction Tax
STT is applicable on all sell-side transactions for both futures and options contracts. SEBI will charge it.
- Goods & Service Tax
This fee is charged on the brokerage amount and is about 18% of the brokerage and transaction fees.
- SEBI Turnover Tax
SEBI will charge it, which amounts to Rs 10 for every crore value of trade transacted
- Stamp Duty
Additionally, you have to pay stamp duty at the specified rates.
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Bottomline
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Frequently Asked Questions(FAQs)
How does option trading work?
Purchasing an options contract is similar to purchasing stock. You are taking a long position on that option, expecting its value to rise. You can buy options contracts by deciding what and how many you want to buy and then placing a buy-to-open order with a broker. This order was named after you are opening a position by purchasing options.
Is Options Trading better than stocks?
When you want to keep risk to a minimum, options may be a better option. Options may be a way to limit your risk within certain parameters because they may enable you to earn a return similar to that of a stock while investing less money. When you’re an experienced investor, using options can be a good strategy.
What is options trading with example?
Trading options is frequently used to safeguard stock positions, but traders can also use options to predict price changes. By purchasing put options, a trader might, for instance, hedge an existing wager made on the price rise of an underlying security.
Is option trading easy?
For novice investors, options trading may sound risky or complicated, and as a result, they frequently steer clear. However, some fundamental options strategies can assist novice traders in hedging market risk and protecting their downside.
Which is better intraday or options?
Intraday trading is a better choice than positional trading, which will cost you more money if you have a tight capital budget. How much risk you’re willing to take is something else to consider. Trading during the day carries a high level of risk.
