If you are new to the stock markets and ask more experienced investors whether you should partake in derivative trading, they will likely say “no.” If you are a complete beginner, they are not wrong, and you should gain some experience in the market before batting your eyes toward futures and options trading. However, many investors, including those with some experience, fail to understand the advantages of derivative trading. So, let us help you know whether you should trade options by understanding how options trading works.
How Do Options Contracts Work?
Options are financial contracts that state an agreement between two parties, an options buyer and an options seller. The value of an options contract is pegged to an underlying asset like an index or stock. The contract expires on a predetermined date, called the expiry date. On the expiry date, the options buyer has the choice to transact the underlying asset on that day at a predetermined price. Depending on the type of options contract, the options buyer may choose to buy or sell the underlying asset on the expiry of the contract. You can trade options using your stock market NSE BSE app or trading platform, similar to stocks.
Call Options & Put Options
Unlike other derivatives contracts like futures, in the case of options, there are two types of contracts: call options and put options. A trader purchases call options when they think the underlying asset’s value may appreciate before the expiry. In this case, the buyer can decide to buy the underlying asset on expiry at a price agreed upon earlier. On the other hand, if the trader thinks the value of the underlying asset will fall, they buy put options. In this case, on expiry, the buyer of the puts sells the underlying asset.
To buy both calls and puts, the buyer will pay the options seller a fee called a premium. Moreover, options, like futures, are traded in lots. The premium paid per unit is only a fraction of the underlying asset’s current value. For example, if you had to buy Nifty 17,000 calls, you would have to trade a minimum of one lot, which would have 50 units. Here 17,000 is the strike price, which is the price at which you would have to buy the Nifty on the expiry date if you choose to do so. In contrast, the premium per unit could be around ₹110-140. However, the premium is not stable and fluctuates based on various factors.
From the above, you must have understood that in options trading, traders purchase calls when they expect a rise in the underlying asset and puts when they foresee a fall. That way, the trader could get Nifty units at ₹17,000, even if the Nifty price on the expiry date is 18,000.
However, many options traders do not wait for the expiry to transact the underlying asset. Option premiums are volatile. Even a not-so-significant change in the underlying asset’s value can lead to drastic spikes and falls. A professional traders will take advantage of the leverage and square off their positions as soon as the premium spikes. It means that an options trader may pay a premium of ₹100 and square off as the premium hits ₹150. So, the trader profits, in this case, will be ₹50 multiplied by the lot size before tax and brokerage deductions.
In contrast, many seasoned investors use options to hedge their current investments. Hedging is a strategy whereby an investor could use options to choose to sell or buy shares at a predetermined price to protect themselves from future price fluctuations.
Should You Start Trading Options?
Trading options have several benefits and can help you generate plenty of wealth if traded diligently. As an options trader, you can use leverage to multiply your gains by paying only a fraction of the total share price. And as the buyer of an option, your profits are unlimited, while your loss is limited to the premium. However, it would be best to remember that the market does not always work in your favour. As an options trader, you must understand technical analysis and have trading experience in the equity segments. Hence, always cut short your losses before it is too late. You cannot afford a significant amount of the premium.
Suppose you trade four contracts and make a profit of ₹5,000. It would be pointless if you lost ₹1,500 on the other three. In short, options are high-risk, high-reward trades. To succeed in this field, you must thoroughly comprehend options trading and know how to manage risk. If you have a trading account with a broker like Kotak Securities, you refer to their daily trading strategies and can start trading options gradually using their stock trading NSE BSE App.