Options Trading: A Beginner’s Guide to Trading Options

Options trading allows investors to make speculative bets on the future direction of the broader stock market or specific assets, such as stocks or bonds. These contracts provide the flexibility to buy or sell an underlying asset at a predetermined price on a specified date.

What Are Options?

Options are tradeable contracts that enable investors to speculate on whether the price of an asset will rise or fall on a future date, without the obligation to purchase the underlying asset itself.

Nifty 50 options, for instance, enable traders to speculate on the future direction of the benchmark stock index, which is commonly used as a proxy for the entire Indian stock market.

Options may initially appear complex, but they are more straightforward than they seem. To grasp options, you only need to understand a few key terms:

  1. Derivative: Options are a type of derivative, meaning their value is derived from another asset. For example, the price of a stock option is influenced by the price of the underlying stock.
  2. Call Option and Put Option: A call option grants the right to purchase a security at a predetermined price by a specified date, while a put option allows the sale of a security at a future date and price.
  3. Strike Price and Expiration Date: The predetermined price mentioned earlier is the strike price. Traders have until the option contract’s expiration date to execute it at the strike price.
  4. Premium: The cost to acquire an option is called the premium, determined by the underlying security’s price and other factors.
  5. Intrinsic Value and Extrinsic Value: Intrinsic value is the difference between the option contract’s strike price and the current price of the underlying asset. Extrinsic value encompasses other factors affecting the premium, such as the option’s time remaining.
  6. In-the-Money and Out-of-the-Money: An option is considered in-the-money (profitable) or out-of-the-money (unprofitable) based on the underlying security’s price and remaining time until expiration.

How Options Pricing Works: Let’s clarify these terms with an example. Suppose a stock currently trades at INR 100 per share. Here’s how the premiums, or prices, function for various options based on the strike price.

When engaging in options trading, an upfront premium payment grants you the choice to either purchase the hypothetical stock (through call options) or sell the stock (via put options) at the specified strike price by the expiration date.

A lower strike price holds greater intrinsic value for call options, as it allows you to buy the stock at a lower price than its current market value. If the stock remains at INR 100, your call options become ‘in-the-money,’ enabling you to purchase the stock at a discounted rate.

On the flip side, a higher strike price carries more intrinsic value for put options, as it permits you to sell the stock at a price higher than its current market value. In the scenario where the stock stays at INR 100, your options are ‘in-the-money,’ granting you the right to sell it at a higher strike price, such as INR 110.

How Options Trading Works:

Options trading encompasses a wide range of strategies, from straightforward to intricate. In essence, trading call options is a way to bet on rising prices, while trading put options is a means to speculate on falling prices.

Options contracts grant investors the right to buy or sell a minimum of 100 shares of stock or other assets, with no obligation to execute the trade if it’s unprofitable. This flexibility makes options trading a cost-effective method to speculate across various asset classes.

You can use options trading to speculate on:

  1. The direction (up or down) of an asset’s price from its current level.
  2. The magnitude of an asset’s price change.
  3. The timeframe within which these price changes will occur.

To break even with call and put options, the underlying asset’s price needs to move in the desired direction by an amount equal to the premium paid plus the strike price. Profits are achieved as follows:

  • Call options: When the underlying asset’s price surpasses the break-even level, you can sell the call option to realize the difference between the premium paid and the current premium. Alternatively, you can exercise the option to buy the underlying asset at the predetermined strike price.
  • Put options: If the asset’s price falls below the break-even level, you can sell the options contract to collect the difference between the premium paid and the current premium. Alternatively, you can exercise the option to sell the underlying asset at the agreed-upon strike price.

In cases where the asset’s price moves unfavorably for either a call or put option, you can allow the contract to expire, limiting your losses to the option’s initial cost, including the premium and associated trading fees.

Options Trading Pros:

Options trading offers a combination of specificity and flexibility. Traders must select a specific strike price and expiration date, locking in their price expectations for a specified time frame. However, they retain the flexibility to assess market conditions and choose whether or not to execute the trade.

Due to the expiration date, which can range from days to months, options trading suits those who wish to limit their exposure to an asset for a shorter period. Traders must actively monitor the underlying asset’s price to determine their in-the-money status and exercise options when favorable.

Options trading also serves as a hedge. For example, if you own shares of a company, you can purchase put options to mitigate potential losses if the stock’s price declines. This hedging feature is why options on market benchmarks like the Nifty 50 are used to safeguard against short-term market declines.

Overall, options trading provides a cost-effective way to make speculative bets with reduced risk, high return potential, and a strategic investment approach.

Options Trading Cons:

Options trading may not suit everyone, especially those who prefer hands-off investing. It involves making three crucial decisions (direction, price, and time), adding complexity to the investment process.

Unlike stock trading, options trading requires broker approval through an options trading agreement, assessing your understanding of associated risks.

To profit from options trading, you must set price alerts and closely monitor the market. Additionally, be aware of trading fees, which can accumulate with various options strategies, as they still exist despite the elimination of stock trading fees by many brokers.

Options trades typically result in short-term capital gains, taxed as ordinary income in India for investments held less than a year, compared to lower long-term capital gains rates for investments held longer.

Just like any other form of investment, it’s crucial to educate yourself extensively before diving in. Utilize online simulators to gain a practical understanding of options trading before venturing into live trading.

When you decide to commence options trading, it’s wise to start with small steps. You can explore more aggressive options and strategies as you gain experience. Initially, concentrate on assets you are familiar with and only invest an amount you are willing to risk.

Options Trading Brokers

The number of option trading brokers can vary depending on your location and the specific financial market you want to trade options in. In major financial markets like the United States, there are numerous well-established options trading brokers, including:

  1. Charles Schwab
  2. TD Ameritrade (now part of Charles Schwab)
  3. E*TRADE (now part of Morgan Stanley)
  4. Interactive Brokers
  5. Fidelity
  6. OptionsXpress (owned by Charles Schwab)
  7. Ally Invest

However, the availability of brokers can differ by region and country, and there may be local or specialized brokers that cater to specific markets. It’s essential to conduct thorough research to find a reputable and suitable options trading broker that meets your specific needs, trading preferences, and regulatory requirements. Additionally, the number of brokers may change over time due to mergers, acquisitions, and new entrants to the market.


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