What is Options Trading & How Does it Work?

Understand the fundamentals of options trading, so you can make informed trading decisions about buying and selling these derivatives.
11 Dec, 2023 06:57am
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The financial market sees different kinds of securities and assets being traded between retail and institutional investors daily. Of these assets, equity shares are perhaps the most commonly known. However, beyond the equity segment, various other assets are traded in the markets. Options or options contracts are one such category of assets that experienced traders buy and sell over the stock or commodity exchanges. 

 

What are Options?

Options are essentially contracts that can be bought and sold over exchanges in the financial market. They represent the right to buy or sell an underlying asset — which can be a stock, currency or commodity. This is why we have equity options, currency options and commodity options. 

 

Depending on the right offered, options can be one of two types: 

  • Call options
  • Put options

 

When you buy a call option, it gives you the right to buy the underlying asset at a specified price on or before a specified date. However, when you buy a put option, it gives you the right to sell the underlying asset at a specified price on or before a specified date. The specified price is known as the strike price, and the specified date is known as the expiration date. 

 

That said, both call and put option contracts do not have any value themselves. Their value is only derived from the value of the underlying asset. Hence, they are also known as derivatives. When you buy an option contract, you will have to pay a premium to the options seller. The premium depends on the strike price of the option, the market value of the underlying asset and the expiration date. 

 

What is Options Trading?

Options trading is the process of buying and selling options contracts in the financial market. This is typically done through stock exchanges (for equity and currency options) and commodity exchanges (for commodity options). To understand how options trading works, it is essential to have more clarity about how options are priced. 

 

Take a look at the example tabulated below, for an options contract with an equity share as the underlying security. The share is currently trading in the market at Rs. 300. 

 

Strike Price of the Option

Profit/Loss if You Execute a Call Option

 

(Market Price — Strike Price)

Profit/Loss if You Execute a Put Option

 

(Market Price — Strike Price)

Rs. 150

Rs. 150

(Rs. 150)

Rs. 200

Rs. 100

(Rs. 100)

Rs. 300

Nil

Nil

Rs. 400

(Rs. 100)

Rs. 100

Rs. 450

(Rs. 150)

Rs. 150

 

Note: The above table does not take into account the options premium, brokerage charges and other charges associated with trading. Only the gross/absolute gains or losses have been computed for the purpose of the example. 

 

As the table above shows, a call option is profitable if its strike price is below the market price, but leads to losses if the strike price is above the market price. So, the lower the strike price of a call option, the more valuable it is, leading to higher premiums in the profitable range. 

 

In the case of put options, however, the converse is true. The higher the strike price of a put option is, the more valuable and profitable it is, leading to higher premiums in that range. 

 

Now that you know how the premiums for options change as the market price of the underlying asset changes, you can use that information to buy and sell options contracts. 

 

How Does Options Trading Work?

Options trading works quite like stock trading, where you research and assess the behaviour of the market, make reasonable assumptions and execute trades based on these speculations. Typically, there are three aspects or assumptions that influence options trading, namely:

  • Whether or not the price of the underlying asset will fall or rise in the future
  • By how much the price of the underlying asset could fall or rise
  • By when (i.e. what date) would the speculated price rise or fall occur

 

Depending on these factors, you can buy or sell call or put options and earn returns thereon, if the market moves as you expected it to. 

 

Let’s take a closer look at an example to understand how this works. This is a very simplified overview of how options trading works. In the financial markets, each option contract gives you the right to buy or sell the underlying asset in predetermined lots. 

 

Say you paid a premium of Rs. 50 to purchase a call option with a strike price of Rs. 400. The market price of the underlying asset is, say Rs. 600. So, if you execute your call option now, you can essentially purchase the underlying asset in the market for Rs. 400, which is less than the market price by Rs. 200. This means you essentially gain Rs. 200. When net off with the premium paid, your net gains amount to Rs. 150. 

 

Popular Options Trading Strategies 

Now that you know how options trading works, you may want to know if there are specific strategies that you can rely on to use market movements to your advantage. Depending on whether the market is bullish or bearish, and based on how volatile price movements are, different options trading strategies can be employed. 

 

Here is a list of some such common options trading strategies and a brief overview of each of them. 

 

Neutral Options Trading Strategies

A neutral market is not actively trending either upward or downward. This may lead to a degree of uncertainty about how the prices may move shortly, calling for neutral options trading strategies such as the following:

 

Long Straddle

This strategy involves buying a call option and a put option that have the same strike price, same expiration date and same underlying asset.

 

Short Straddle

This strategy involves selling a call option and a put option that have the same strike price, same expiration date and same underlying asset.

 

Long Strangle

In a long strangle, you buy a call option with a higher strike price and a put option with a lower strike price. This strategy is suitable in highly volatile markets. 

 

Short Strangle

In a short strangle, you sell a call option with a higher strike price and a put option with a lower strike price. This strategy also works best when you expect a fair bit of volatility in the market. 

 

Bullish Options Trading Strategies

These options trading strategies are better suited for bullish market conditions, where the prices of the underlying assets are on an increasing trend. Some such strategies include:

 

Bull Call Spread

A bull call spread strategy is about buying a call option with a lower strike price and selling a call option with a higher strike price. The options sold and bought both have the same strike prices and expiration dates. 

 

Bull Put Spread

A bull put spread strategy involves buying a put option with a lower strike price and selling a put option with a higher strike price. The options sold and bought both have the same strike prices and expiration dates. 

 

Long Call Butterfly 

This is an options trading strategy with three parts: buying a call option at a lower strike price, selling two call options at a higher strike price, and buying a third call option with an even higher strike price. 

 

Long Iron Condor

In this options trading strategy, there are four orders involved: selling a put option with its strike price below the current market price (CMP), buying a put option with its strike price closer to the CMP, buying a call option with its strike price above the CMP and selling a call option with its strike price further higher than the CMP. 

 

Bearish Options Trading Strategies

These options trading strategies are better suited for bearish market conditions, where the prices of the underlying assets are on a decreasing trajectory. Some such strategies include:

 

Bear Call Spread

A bear call spread strategy is about selling a call option with a lower strike price and buying a call option with a higher strike price. Both options have the same strike prices and expiration dates. 

 

Bear Put Spread

A bear put spread strategy is about selling a put option with a lower strike price and buying a put option with a higher strike price. Both options have the same strike prices and expiration dates. 

 

Short Call

A short call is a simple options trading strategy where you sell a call option. You do this because you expect the market to trend downward, thereby making the call option worthless by expiry. 

 

Things to Keep in Mind Before Trading Options 

Before you get into options trading, there are a few things that you need to be mindful of. Here is a closer look at some such important considerations. 

 

  • Understand the basics of options trading and how it works.
  • Educate yourself about different option strategies and their risk profiles.
  • Trade only with money you can afford to lose because options can be highly speculative.
  • Establish clear trading goals and stick to a well-defined plan.
  • Conduct thorough research on the underlying asset and market conditions.
  • Practice paper trading or trade in a simulated environment before risking real money.
  • Be mindful of implied volatility and its impact on option prices.
  • Stay updated on company earnings announcements and other events that may affect the underlying asset.
  • Set stop-loss orders to manage potential losses and prevent emotional decision-making.
  • Continuously monitor your positions and adjust your strategy as needed.

 

Conclusion 

Now that you know what options trading is, you can better appreciate how this market segment comes with both profit potential and risks. Keep in mind that the value of options depends on the asset's price, strike price and expiration date, and choose options trading strategies that align with the prevailing market conditions. 

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