Everything you need to know about Options trading.

Ever wished you could have a sneak peek into the future of the stock market, like you're holding a crystal ball? That's where options trading comes in – it's like making bets on where you think the prices of stocks or other cool stuff are headed.

Interesting right? Let’s learn more about options trading.

We’ll look into :-

• The types of options trading,

• Terminologies used in options trading,

• Effective strategies,

• Most asked questions about options trading

What are Options?

Options are financial instruments that give traders the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) within a specified time frame. The underlying asset could be stocks, commodities, indices, or even other financial instruments.

Types of Options

1. Call Options:

• Think of call options as your "I believe it's going up" move. When you buy a call option, you're essentially making a bet that the price of something, let's say a stock or a cool gadget, is going to rise.

• Here's the deal: You pay a small fee (we call it the premium) for the right to buy that thing at a fixed price, known as the strike price, before or on the expiration date of the option.

• If your prediction is spot-on and the actual price goes higher than the strike price, you can use your call option to buy at the agreed lower price. You make a profit. But if things don't go as expected, you're not obligated to buy, you simply lose the premium you paid for the option.

2. Put Options:

• Now, think of put options as your "I smell a drop coming" move. When you buy a put option, you're predicting that the price of something is going to fall.

• Similar to calls, you pay a premium for the right to sell that thing at a fixed strike price before or on the expiration date.

• If your prediction is correct and the actual price drops below the strike price, you can use your put option to sell at the agreed higher price, making a profit. If the price doesn't drop, you're not forced to sell, and you lose the premium.

Let’s understand options trading and its types with an example:-

Imagine you're eyeing a cool new gadget that's not yet released, let's call it the "TechWonder." You believe it's going to be a hit, and right now, it's not officially on the market. So, you decide to use options to get in on the action.

Call Option (Betting it Goes Up):

You buy a call option for the TechWonder at a certain price (let's say $100) with an expiration date a few months from now.

Now, here's the deal: You're paying a small fee (let's call it $5) for the right to buy the TechWonder at $100, no matter how high its price goes.

If, by the expiration date, the TechWonder is selling for $120, awesome! You use your call option and buy it at the agreed $100, even though everyone else is paying $120. You make a profit!

But, if the TechWonder is only worth $90 or you changed your mind, no worries. You're not obligated to buy it. You just lose the $5 fee you paid for the option.

Put Option (Betting it Goes Down):

Now, let's say you're a bit skeptical about another gadget, the "TechDud." You think its value is going to drop.

So, you buy a put option for the TechDud at $50 with the same expiration date. Again, you pay a fee (let's stick with $5).

If, by the expiration date, the TechDud's value plunges to $40, great! You use your put option to sell it at the agreed $50, even though everyone else is only getting $40. You make a profit again!

But, if the TechDud surprises you by going up to $60, no problem. You're not forced to sell at $50. You just lose the $5 fee.

Think of options as a way to make these cool bets on the future prices of things, without actually owning them. You're basically paying for the right to make a move in the future, and it's up to you whether you use that right or not.

Terminologies used in options trading

Before diving deep into options trading it’s crucial to understand the key terminologies which are used in options trading. Let’s have a look:-

Option:

The financial contract that gives the holder the right (but not the obligation) to buy or sell an underlying asset at a specified price within a set timeframe.

Call Option:

An option that gives the holder the right to buy the underlying asset at a predetermined price (strike price) before or on the expiration date.

Put Option:

An option that gives the holder the right to sell the underlying asset at a predetermined price (strike price) before or on the expiration date.

Strike Price:

The fixed price at which the holder of an option can buy or sell the underlying asset.

Premium:

The price paid by the option buyer to the option seller for the right to buy or sell the underlying asset. It represents the cost of the option.

Expiration Date:

The date on which the option contract expires. After this date, the option is no longer valid.

Underlying Asset:

The financial instrument (e.g., stocks, commodities) on which the option contract is based.

In-the-Money (ITM):

For a call option, when the current price of the underlying asset is higher than the strike price. For a put option, when the current price is lower than the strike price.

Out-of-the-Money (OTM):

For a call option, when the current price of the underlying asset is lower than the strike price. For a put option, when the current price is higher than the strike price.

At-the-Money (ATM):

When the current price of the underlying asset is equal to the strike price.

Assignment:

The process where the option seller (writer) is obligated to fulfill the terms of the option contract if the option buyer decides to exercise it.

Option Chain:

A list of all available options contracts for a particular underlying asset, showing strike prices, expiration dates, and prices.

Covered Call:

A strategy where an investor sells a call option on an asset they already own. This can act as a form of income.

Protective Put:

A strategy where an investor buys a put option to protect against potential losses in a stock they own.

Straddle:

A strategy where an investor buys both a call and a put option with the same strike price and expiration date, anticipating a significant price movement.

Now, as you have understood the terminologies used in options trading, it’s time to understand some effective strategies in options trading.

Effective strategies in options trading

Options trading offers various strategies that traders can employ and get benefitted from, here I am mentioning some effective strategies used in options trading.

Covered Call:

Objective: Generate income while holding a long position in the underlying asset.

How it works: If you own shares of a stock, you sell (write) a call option against those shares. You receive a premium from the call option buyer. If the option is exercised, you sell your shares at the strike price, but you keep the premium regardless.

Protective Put:

Objective: Hedge against potential losses in a long position.

How it works: You own the underlying asset (e.g., stocks) and buy a put option with a strike price that acts as a floor for potential losses. If the asset's value drops, the put option allows you to sell it at the higher strike price, limiting your losses.

Straddle:

Objective: Profit from significant price movements (up or down).

How it works: Buy both a call and a put option with the same strike price and expiration date. If the price moves significantly, one of the options should become profitable enough to offset the cost of the other. Effective when expecting a big price swing but uncertain about the direction.

The Strangle:

Objective: Similar to the straddle, profit from volatility, but with a slightly lower cost.

How it works: Buy an out-of-the-money call and an out-of-the-money put option. This strategy benefits from a substantial price move, but the underlying asset doesn't have to move as much as with a straddle. More cost-effective but requires a larger price move to be profitable.

The Iron Condor:

Objective: Generate income while limiting potential losses.

How it works: Sell both an out-of-the-money call and an out-of-the-money put option, while also buying a further out-of-the-money call and put for protection. This creates a range, known as the "wing," where you profit. Losses are limited if the price moves beyond the wings.

Butterfly Spread:

Objective: Profit from low volatility while limiting losses.

How it works: Involves using three strike prices. You buy one in-the-money option, sell two at-the-money options, and buy one out-of-the-money option. This creates a profit zone with limited risk, typically used when you expect low price volatility.

Collar Strategy:

Objective: Protect profits while limiting downside risk.

How it works: Involves buying a protective put and selling a covered call against an existing long position. The cost of the put is partially offset by the premium received from selling the call. This strategy provides a downside protection "collar" around the existing position.

As we have understood options trading in detail, it’s a high time to shed light on the most asked questions on options trading.

FAQ’s [Frequently asked questions] on Options trading]

1.How do call options work?

• Call options give the buyer the right to buy an underlying asset at a specified price (strike price) before or on the expiration date. Traders often buy call options when they anticipate the price of the asset will rise.

What are put options?

• Put options give the buyer the right to sell an underlying asset at a specified price (strike price) before or on the expiration date. Traders typically buy put options when they expect the price of the asset to fall.

3. What is the premium in options trading?

• The premium is the price paid by the option buyer to the option seller for the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. It represents the cost of the option.

4. What is the expiration date of an option?

• The expiration date is the date on which the option contract expires. After this date, the option is no longer valid, and the right to buy or sell the underlying asset lapses.

5. Can I lose more than the premium I paid?

• No, as an option buyer, your maximum loss is limited to the premium paid for the option. However, as an option seller, potential losses can be unlimited.

6. What is the difference between in-the-money, at-the-money, and out-of-the-money options?

• In-the-money (ITM) options have a strike price favorable to the current market price. At-the-money (ATM) options have a strike price equal to the current market price. Out-of-the-money (OTM) options have a strike price unfavorable to the current market price.

7. Can I exercise an option before the expiration date?

• In most cases, options can be exercised before the expiration date, but it's up to the option holder to decide. American options can be exercised at any time, while European options can only be exercised at expiration.

8. What are some common options trading strategies?

• Common strategies include covered calls, protective puts, straddles, strangles, iron condors, butterfly spreads, and collar strategies. Each strategy has its own risk-reward profile and is used in different market conditions.

9.Is options trading risky?

Yes, options trading can be risky. While it offers the potential for significant returns, it also involves the risk of losing the premium paid for the options. It's important for traders to understand the market, underlying assets, and the specific strategies they are using before engaging in options trading.