10 things you need to know while buying options
The most crucial element of any investment is knowing when to buy and sell securities based on your goals. The pointers listed in this blog will help you make the right decisions while buying options.
As a trader, you might have often thought about purchasing options and maximise your benefits. However, before you venture into it, there are a few critical things for you to know. The most crucial element of any investment is timeliness. Knowing when to buy and sell securities based on your goals will determine the returns you get. Whether your target is to augment your income in the short run or generate wealth in the long term, you will need to understand the basics, as well as the slightly trickier things that are associated with options trading, especially while buying. This blog will get you going in the right direction.
What are Options?
Options are financial derivative contracts. The holder of the said contract gains the right to either purchase or sell an underlying asset at a specified price without any obligation. The specified price is also known as the strike price at which the asset is transacted on before or on a predetermined expiration date.
In India, options trading takes place within the regulatory framework set by the Securities and Exchange Board of India (SEBI). Options are mainly traded on two stock exchanges: the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). The most commonly traded options are stock options and index options.
10 things you need to know while buying options:
As with most market endeavours, the act of buying options is inherently risky. You need to be doubly careful of things and market elements before venturing into it. We recommend taking the time out to study and acquire knowledge before you take the plunge.
And that’s not all. The timing of buying an option depends on your trading goals, market outlook and risk tolerance. Here are some common scenarios and strategies that will sort you out when you consider buying an option:
- Bullish outlook (call options): When you expect the underlying asset's price to rise: If you believe that the price of the underlying asset (e.g., a stock) will increase in the future, you may consider buying a call option. Call options give you the right to purchase the underlying asset at a specified price without any obligation. The specified price is also known as the strike price at which the asset is purchased on before or on a predetermined expiration date.
- Bearish outlook (put options): When you expect the underlying asset's price to fall: If you anticipate that the price of the underlying asset will decrease, you may consider buying a put option. Put options give you the right to sell the underlying asset at a specified price without any obligation. The specified price is also known as the strike price at which the asset is sold on before or on a predetermined expiration date.
- Speculative trading: When you have a short-term speculative view: Traders often buy options when they have a short-term market outlook or expect a significant price movement. Options can provide leverage, allowing you to potentially amplify your gains (or losses) compared to trading the underlying asset directly.
- Earnings announcements and events: Some traders buy options before earnings reports, product launches or other events that can lead to price volatility.
- Hedging: If you own the underlying asset and want to protect yourself against a potential price decline, you can buy put options as a form of insurance (protective put). Similarly, you can buy call options to hedge against a potential price decline if you are short the underlying asset.
- Volatility expectations: Options can become more valuable when market volatility rises. If you anticipate increased volatility due to upcoming news or events, you might consider buying options to benefit from potential price swings.
- Diversification: Some investors use options as part of a diversified investment strategy. They may buy options to complement their overall portfolio and manage risk.
- Timing and analysis: Based on technical and fundamental analysis: Traders often use technical and fundamental analysis to identify entry points for option purchases. They may look for chart patterns, support and resistance levels, or specific catalysts that could drive price movements.
- Directional bets: When you have a strong conviction about the future direction of an asset's price, buying options can be a way to capitalize on that conviction with a defined risk.
- Capital constraints: Options can provide exposure to assets that might be too expensive to buy outright. For example, instead of purchasing 100 shares of a high-priced stock, you can buy a call option with a lower upfront cost.
In conclusion, it's essential for you to conduct thorough research, have a clear trading plan and manage risks when buying options. As stated already, Options trading carries risks, including the potential loss of the entire premium paid for the option. So, it's crucial for you to understand the mechanics of options and consider your financial situation and risk tolerance before entering into options trades. The pointers listed here will help you make the right options buying decisions.