Once you take your initial steps into the world of investments, you may start to come across newer concepts and strategies. One such concept that is popular among seasoned investors is options trading.
This strategy allows investors to optimise return potential or hedge against risk by speculating how the stock market or specific securities, like stocks or bonds, may move in the future.
Though a bit tricky, understanding options trading can help you make informed decisions and manage the risk-return profile of your investments.
This article simplifies options trading, describing how it works, its participants, terminology, advantages, risks, and more.
Table of contents
- What is options trading?
- Types of options: Calls and puts
- Options trading for beginners
- Functions of option trading
- Some basic other options strategies
- Participants in options trading
- Terminology in options trading
- Levels of options trading
- Advantages of trading in options
- Risks associated with options trading
- How to start options trading
What is options trading?
Options trading involves buying and selling special contracts called ‘options’. An option is a contract that lets you buy or sell something (like a stock, bond, ETF etc) at a set price (called the strike price) on or before a certain date (called the expiration date).
There are two main types of options:
- Call option: Gives you the right to buy the asset.
- Put option: Gives you the right to sell the asset.
Significantly, an option gives you the right, but not the obligation, to buy or sell the security.
How does options trading work?
Options trading works through a contract between a buyer and a seller. The buyer pays a premium to acquire the option, while the seller receives takes on the obligation to honour the contract if the buyer chooses to exercise it. In India, options are commonly available on stocks and market indices traded on recognised exchanges.
An options contract includes key elements such as:
- Strike price: The predetermined price at which the asset may be bought or sold.
- Premium: The amount paid by the buyer to acquire the option.
- Expiry date: The date on which the contract expires.
- Lot size: The number of units covered by a single contract.
The value of an option can change based on factors such as price movement in the underlying asset, time left until expiry, market volatility, and the strike price.
When an investor buys an option, the maximum loss is generally limited to the premium paid. However, the option seller, also known as the writer, assumes an obligation if the buyer chooses to exercise the contract and may face substantially higher losses depending on market movements.
For example, if an investor purchases a call option and the underlying asset’s price rises above the strike price, the option may gain value. Conversely, if the expected price movement does not occur before expiry, the option may lose value and could expire worthless.
Types of options: Calls and puts
Call options:
Give the buyer the right to buy the underlying asset at the strike price.
- Used when expecting prices to potentially rise (bullish view).
- Example: Buy Nifty call at 24,000 strike for ₹200 premium. If Nifty rises to 24,500, profit from the difference minus premium.
Put options:
Give the buyer the right to sell the underlying asset at the strike price.
- Used when expecting prices to potentially fall (bearish view).
- Example: Buy Nifty put at 24,000 strike for ₹150 premium. If Nifty drops to 23,500, profit from the difference minus premium.
Examples for illustrative purposes only.
Options trading for beginners
Here are some of the options trading strategies used by investors
Long call: Buy a call option to buy a stock at a set price before expiry. Can be suitable if you expect the price to rise. Profit is unlimited, but loss is limited to the cost of the option.
Long straddle: Buy both a call and a put option at the same price and expiry. Useful if you expect big price moves in either direction. Loss is limited to the cost of both options if the price doesn’t change much.
Long put: Buy a put option to sell a stock at a set price before expiry. Can be suitable if you expect the price to drop. Profit is high, and loss is limited to the option cost.
Short call: Sell a call option, agreeing to sell the stock at a set price. Profit if the price stays the same or drops, but loss can be huge if the price rises.
Short put: Sell a put option, agreeing to buy the stock at a set price. Profit if the price stays the same or rises, but loss can be large if the price drops to zero.
Short straddle: Sell both a call and a put option at the same price and expiry. Profit if the price stays stable, but losses can be huge if it moves significantly.
Read Also: How mutual funds trade: A complete guide
Functions of option trading
When a trader buys or sells an option, they get the right to use it at any time before it expires. However, they are not required to use it when the option expires.
Long call
A long call means buying a call option, betting that the stock price will rise significantly before expiry. For example, if ABC company’s stock rises from Rs. 450 (strike price) to Rs. 475, you can buy at Rs. 450 and profit Rs. 25 per share. After deducting the Rs. 20 premium, your net profit is Rs. 5 per share. This strategy uses less capital than buying stocks directly and can offer higher return potential.
Covered call
A covered call is when you sell a call option while owning the stock to reduce risk and earn income. For example, if you own 1,000 XYZ company shares at Rs. 1,500 each and sell call options with a Rs. 1,600 strike price for Rs 50 premium, you earn Rs. 50,000 upfront. If RIL stays below Rs. 1,600, you keep the premium as profit. If it rises above, your loss is reduced by the premium earned.
Long put
A long put means buying a put option, expecting the stock price to drop before expiry. For example, if Company A’s stock falls from Rs. 2,500 (strike price) to Rs. 2,300, then you sell at Rs. 2,500, making Rs. 200 per share. After deducting the Rs. 150 premium, your net profit is Rs. 50 per share. This strategy uses less money than directly shorting stocks and offers high returns with limited risk if prices drop.
Short put
A short put is when you sell a put option, expecting the stock price to reach Rs. 1,200 and you sell a put with a Rs. 1,250 strike for Rs. 50 premium. You keep the premium if the stock stays above Rs 1,250. But if it falls to Rs. 1,220, your break-even is Rs. 1,200, and you still make a profit, but less.
Married put
A married put combines owning the underlying asset and purchasing a put option. This strategy protects against significant losses while allowing for potential gains.
Example: You buy shares of a company and simultaneously purchase a put option. If the stock price drops significantly, the put option limits your losses.
Strategies in option trading
Protective collar: Used by asset owners, this strategy involves buying a put option for protection and selling a call option to offset costs.
Long straddle: Buy both a call and put option with the same strike price and expiry.
Vertical spreads: Buy and sell options of the same type with different strike prices but the same expiry.
Long strangle: Buy a call and a put option with different strike prices, but the same expiration date.
Participants in options trading
- Buyer: Pays a premium for the right to buy or sell at a specific price later.
- Writer: Gets paid to agree to buy or sell if the buyer exercises.
- Call option: Right to buy at a set price before expiry.
- Put option: Right to sell at a set price before expiry.
Key terms in options trading
Some notable terminology in option trading is:
- Premium: The price paid by the buyer to the seller for the option.
- Expiry date: The date when the option expires.
- Strike price: The price at which the option can be exercised.
- American option: Can be exercised any time before the expiry date.
- European option: Can only be exercised on the expiry date.
- Index options: Tied to an index (e.g., Nifty, Bank Nifty) and settled in European style in India.
- Stock options: Based on individual stocks, giving the right to buy or sell shares, settled using American style in India.
Levels of options trading
Level 1: Write covered calls and protective puts.
Level 2: Add buying calls/puts, and long straddles/strangles.
Level 3: Add long spreads and ratio spreads.
Level 4: Add uncovered options, short straddles/strangles, and uncovered ratio spreads.
Advantages of trading in options
- Leverage: Option trading enables control of large positions with relatively small capital.
- Flexibility: Multiple strategies to suit different market conditions.
- Hedging: Protect existing investments from adverse price movements.
- Income generation: Generate income through premium collection.
Risks associated with options trading
- Time decay (Theta): Options may lose value as expiry approaches, especially if the underlying doesn’t move favorably.
- Volatility risk (Vega): Sudden drops in volatility may erode premiums even if direction is suitable.
- Unlimited loss for sellers: Selling naked calls theoretically has unlimited risk if prices surge.
- Leverage amplifies losses: Small premiums control large positions, potentially magnifying both gains and losses.
- Liquidity risk: Some strikes/options may have wide bid-ask spreads or low volume.
Profitability scenario in options
For an options buyer, profitability generally arises when the option’s value increases by more than the premium paid. For example:
- A call option buyer may benefit if the price of the underlying asset rises above the strike price and exceeds the cost of the premium.
- A put option buyer may benefit if the price of the underlying asset falls below the strike price by an amount greater than the premium paid.
For an options seller (writer), profitability is typically limited to the premium received. However, the potential losses may be considerably higher if the market moves unfavourably.
A few factors that influence profitability include:
- Direction and magnitude of price movements
- Changes in market volatility
- Time decay as the contract approaches expiry
- Transaction costs and taxes
- The chosen options strategy
How to start options trading
- Open a trading + demat account with a SEBI-registered broker offering F&O segment.
- Complete KYC and risk profiling
- Activate F&O segment (typically requires net worth proof, experience declaration).
- You may learn basics via paper trading or demo accounts.
- You are advised to start small with strategies like covered calls or protective puts; use stop-losses.
- It is recommended to monitor margins (SPAN + exposure) and understand expiry/assignment rules.
Conclusion
Options trading can be a versatile and powerful tool for investors. While it offers significant potential rewards, it also carries risks that require careful management.
FAQs:
How to do options trading?
To start option trading, open a brokerage account in any of the stock trading platforms, understand the basics of options, and choose suitable option trading strategies.
What are call and put options?
A call option gives the buyer the right to buy the underlying asset at the strike price, while a put option gives the buyer the right to sell the underlying asset at the strike price. Traders use them based on their view of future price movements.
What is the risk involved in options trading?
Option trading involves significant risk. For buyers, the loss is generally limited to the premium paid. However, sellers may face substantial losses, and in some cases theoretically unlimited losses, especially when writing uncovered call options. Time decay, volatility changes, and market movements can also affect option prices.
How can options trading reduce investment risk?
Options trading can help reduce investment risk through hedging. For example, investors may buy put options to cushion losses while holding stocks, sell covered calls to earn income on stocks they already hold, or use strategies such as collars and spreads to limit potential downside.
What is the difference between American and European options?
The key difference lies in when the option can be exercised. American options can be exercised at any time before the expiry date, while European options can be exercised only on the expiry date. This affects how traders evaluate flexibility, pricing, and strategy while trading options.
Is options trading better than stock trading?
Neither is inherently ‘better’; options typically offer leverage/hedging but higher complexity/risk. Stocks may suit buy-and-hold; options may suit directional/time/volatility bets. However, options trading tends to carry higher risks than buy-and-hold strategies. Some investors also consider stock options strading.
Can beginners trade options safely?
Options trading is not safe or without risks. However, with education, small positions, and risk-defined strategies (long options/spreads), beginners may potentially mitigate risks.
What is option premium?
The price paid/received for the option contract, determined by intrinsic value + time value + volatility. It represents the cost of the right to buy/sell.
Is options trading legal in India?
Yes, options trading is legal in India when conducted through recognised stock exchanges regulated by Securities and Exchange Board of India and applicable exchange rules.
