What is options trading?
An investor's portfolio consists of various financial instruments like stocks, exchange traded funds (ETFs), mutual funds and bonds. However, the Options are altogether different. Options are used in different ways depending upon investors' goals and how they plan to use them. Investors often use options to reduce the risk associated with the stock they have in their portfolio. Similarly, others may use options to earn additional income. Most importantly, options provide an opportunity to traders or investors to benefit from the price movement without paying the full price of a security or taking delivery.
In India, the National Stock Exchange (NSE) launched index options on 4 June 2001, and stock options were launched on 4 July 2001. In the year 2020, NSE also surpassed America's Chicago Mercantile Exchange to become the world's largest derivatives market exchange by volume.
What are options?
Options are defined as derivatives instruments that enable the buyer (holder or owner) of the instrument to buy or sell the underlying asset. The right to buy or sell is without any obligation. The seller of the option is, however, obligated to buy or sell, should the buyer exercise his or her right.
Simply put, option trading includes:
- A right to buy or sell, but not an obligation
- Buy or sell at predetermined price
- Buy or sell on or before predetermined date
Types of options
There are two types of options: Call and Put. A call option gives the buyer the right to “buy” the underlying security but not the obligation to do so at a predetermined price and date. A put option gives the buyer the right to “sell” the underlying security but not the obligation to do so at a predetermined price and date.
How does options trading work?
Before we come to the options trading guide, a beginner must understand the two essential derivatives concepts -- long and short. When a trader goes long on an index or a stock, it means he or she believes that the price of the underlying will increase. On the contrary, if the trader goes short on any index or a stock, it means he or she believes that the price of the underlying will fall.
Now, let’s put this in context with call and put.
When does a trader buy a call option?
A trader buys a “call” option when he or she believes that the price of the underlying asset (stock or an index) will rise. The buyer of the call option pays the price of the option, generally referred to as a premium, to buy the contract.
When does a trader buy a put option?
A trader buys a “put” option when he or she holds a bearish view and looks forward to profit from a potential decline in the price of the underlying asset. Like the buyer of a call option, the buyer of a put option also pays a premium to buy the contract.
When does a trader sell a call option?
A trader sells a “call” option when he or she believes that the price of the underlying asset (stock or an index) will decline or will remain around the same level. The seller of the call option receives the premium from the buyer.
When does a trader sell a put option?
A trader sells a “put” option when he or she has a view that the price of the underlying will rise or will remain around the same level. Just like the call writer, the seller of the put option also receives the premium from the buyer.
Let’s understand how does options pricing works
There are three components that have a strong and direct impact on option prices:
- Intrinsic value
- Time value
The intrinsic value (IV) measures the extent to which the option is “in-the-Money” or ITM. It is obtained by calculating the difference between the strike price and current price of the underlying security. The intrinsic value of an option can be either positive or zero. It can never be negative.
The intrinsic value of a call option will be positive when the strike price of an option is below the current price of the underlying security. If the strike price is above or equal to the current price of the underlying asset, then the call option's intrinsic value will be zero.
Intrinsic value of call option = current price – strike price
Similarly, the put option will have a positive intrinsic value when the strike price is above the current price of the underlying security. If the strike price is equal to or below the current price of the underlying security, the intrinsic value of that put option will be zero.
Intrinsic value of put option = strike price – current price
Time value is also referred to as the extrinsic value of an option. Unlike intrinsic value, which is a tangible portion of the option price, time value is intangible. The time value has nothing to do with the price of the underlying security. Instead, it only focuses on time till the expiration of the option contract. In options trading, the time value is also referred to as Theta or time decay.
Simply put, the longer it takes for the option to expire, the greater the time value and vice-versa. With the reduction of time till expiration, the probability of option premium moving in favour of the buyer reduces significantly. On the other hand, the time value is the element that option sellers or writers collect for taking the time risk.
Time value = option price - intrinsic value
Volatility is the rate at which the price of a security fluctuates. It is neither impacted by nor impacts the direction of price movement. Instead, it is only indicative of the magnitude of fluctuation in the price of an asset. Volatility is a vital concept as it measures the element of "risk" involved in options trading. Higher the volatility, higher the risk involved and vice-versa.
There are two types of volatility: historical and implied. Historical volatility is based on past fluctuation of the price of an underlying security. On the other hand, the Implied volatility (IV), as the name suggests, is a measure of future volatility. The IV is reflected through the time value of the option price. If the implied volatility of an option strike is higher, then the option’s time value and premium will be higher. Similarly, if the IV of an option strike is lower, then the time value and the premium of that option will be lower.
Option trading example
Let’s use a simple example to understand how to trade options.
Let’s suppose that the Nifty50 spot is currently trading at 16,261. Mr. Hardik is of the view that the Nifty50 will rise to 16,500 in a month’s time. Mr. Krunal, on the other hand, believes that NIfty50 is overvalued and expects it to trade sideways or decline below 16,100. With their respective views, both of them decide to trade in the Nifty50 using call options.
Mr. Hardik buys one lot of Nifty50’s call option of 16,300 strike price (monthly expiry) by paying the premium of ₹100. At the opposite end of this trade, Mr. Krunal sells the 16,300 call option and receives the premium of ₹100 from Mr. Hardik. The lot size of Nifty50 contact is 50. In case you missed it, read our Index Futures blog to understand the concept of lot size. The breakeven point for this trade would be strike price + premium paid i.e. (16,300 + 100) = 16,400. Hence, Mr. Hardik will only make profit when the Nifty50 moves above 16,400.
Now, let's come back to the basics of options trading and understand how the options trade between Mr Hardik and Mr Krunal panned out.
Scenario 1: Nifty50 rises and closed at 16,500
Since it is a zero-sum game, only one of them will make a profit and the other will pay the loss. Assuming that the Nifty50 rises to 16,500, Mr. Hardik, the buyer of the call option, will exercise the right to buy the Nifty50 at a predetermined price of 16,300
Profit = (current price – strike price – premium paid) * lot size = (16,500 – 16,300 – 100) * 50 = ₹5,000
Mr. Krunal being the seller of call option will suffer the loss of ₹5,000.
Loss = (strike price – current price + premium received) * lot size = (16,300 – 16,500 + 100) * lot size = - ₹5,000
Scenario 2: Nifty50 declines and closed at 16,100
Mr. Hardik will choose not to exercise the call option as he can buy the Nifty50’s contact from the open market at a cheaper price compared to the predetermined price of ₹16,300. In this case, Mr. Hardik will let the call option expire and forfeit the premium of ₹100, which would be his loss.
Loss = net premium paid * lot size = 100 * 50 = -₹5,000
However, Mr. Krunal the seller, will retain the premium of ₹100 as the buyer, Mr. Hardik has not exercised the call option.
Profit = net premium received * lot size = 100 * 50 = ₹5,000
Benefits of options trading
Let's understand how options differ from the other financial instruments and how a trader can use them effectively to minimise risks and maximise profits.
- Cost-efficient -The transaction cost of trading options is cheaper than buying stocks or even taking futures positions which involves paying upfront SPAN and exposure margins. To buy an option, a trader only pays an option premium at a fraction of the cost compared to the above alternatives. Being low cost also enables options traders to design and execute complex payoff strategies while generating higher than expected average returns.
- High return potential - Options contracts can be owned by paying a small premium. Thus, enabling traders to make a higher return on investment (ROI) by deploying a small capital. Simply put, a trader can trade an option contract by paying just the premium amount, as against a futures contract, where the initial investment is much higher on account of SPAN and exposure margin. Options offer the highest amount of leverage, even more than futures. Thus, making them ideal instruments for successful trading and generating higher profits.
- Instrument of Hedging - The low transaction and ownership cost helps in hedging the long-term portfolio in an efficient manner. Also, the selling of options contracts to build or preserve a portfolio is a standard practice adopted by investors and fund managers.
- Deploying options strategies: For a trader, effective use of options strategies and changing them as per the market condition is an effective way of making higher returns. Options offer a perfect mix of strategies to take advantage of both long and short-term trends at limited risk exposure.