The world of investing offers an endless array of strategies and instruments to participate in financial markets. While stocks provide equity ownership, options add a new dimension of versatility and risk management for active traders and investors. The strategic use of calls, puts, spreads, and other option tactics can boost portfolio performance. Read on to learn more.
An option is a contract that grants the holder the right to purchase or sell a security at a predetermined price for a specified duration. An options contract can be purchased and sold at any point prior to its expiration. Ownership of an option does not automatically grant the holder ownership of the underlying security, nor does it grant the holder any dividend payments.
You should trade options primarily because they allow you to magnify returns while limiting risk. When you buy an option contract, your loss is limited to the premium paid, while your potential upside is much higher. This asymmetric risk-reward profile allows options traders to generate outsized returns with defined and contained risk. Options enable income generation as well. Writing covered calls or cash secured puts help you collect premium income from your holdings. Options offer recurring cash flows not available from simply buying and holding stock.
The main elements of options are the underlying asset, strike price, expiration date, and premium. The underlying can be stocks, indices, commodities etc. The strike price is the price at which you can buy or sell the underlying if you exercise the option. Expiration date is the last day the option is valid. Premium is the price of the options contract.
A call option gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price known as the strike price, on or before the expiration date.
For example, let's say Reliance Industries (RIL) share is trading at Rs 2,000. You buy a 1-month RIL call option with a strike price of Rs 2,050 by paying a premium of Rs 100 per share. One call option contract controls 100 shares.
Now if RIL share price rises to Rs 2,200 by expiry, you can exercise your call option to buy 100 shares of RIL at Rs 2,050 per share, even though the market price is Rs 2,200. Your profit is Rs 2,200 - Rs 2,050 - Rs 100 = Rs 50 per share. Since 1 contract controls 100 shares, your total profit is 100 x Rs 50 = Rs 5,000.
However, if RIL share price falls to Rs 1,900, you won't exercise the call option since you can buy shares cheaper in the open market. Your maximum loss is limited to the Rs 10,000 premium paid (Rs 100 premium x 100 shares).
A put option gives the holder the right, but not the obligation, to sell the underlying asset at a predetermined price known as the strike price, on or before the expiration date.
For example, let's say Tata Motors share is trading at Rs 400. You buy a 1-month put option on Tata Motors with a strike price of Rs 380 by paying a premium of Rs 15 per share.
If Tata Motors share price falls to Rs 350 by expiry, you can exercise your put option to sell 100 shares of Tata Motors at Rs 380 per share, even though the market price is only Rs 350. Your profit is Rs 380 - Rs 350 - Rs 15 = Rs 15 per share. For the full contract of 100 shares, the total profit is 100 x Rs 15 = Rs 1,500. However, if Tata Motors share price rises to Rs 450, you won't exercise the put option since you can sell the shares at a higher price in the open market. Your maximum loss is limited to the Rs 1,500 premium paid (Rs 15 premium x 100 shares).
Below are some advanced concepts in options trading:
The Greeks measure the sensitivity of an option's price to various factors like time decay, volatility, underlying price, etc. Key Greeks are delta, gamma, theta, vega. Delta measures sensitivity to underlying price, gamma measures rate of delta change, theta captures time decay, and vega measures volatility sensitivity.
Volatility skew refers to the difference in implied volatility between out of the money options versus at the money options. Skew measures the relative demand for options with different strike prices and affects options pricing.
American style options allow early exercise before expiry. Early exercise may be optimal for deep in the money options trading at parity or for capturing upcoming dividends.
Spreads combine multiple legs like a call and a put to limit risk. Bull call spreads involve long call - short higher strike call. Bear put spreads are long put - short lower strike put. Ratio spreads use unequal legs.
An iron condor combines a bull put credit spread and a bear call credit spread. It aims to profit from low volatility by shorting high premium options out of the money on both sides.
The most basic option pricing model is the Black-Scholes model, developed in 1973. It calculates the fair value of an option based on the stock price, strike price, volatility, risk-free rate, and time to expiry. Key assumptions are no arbitrage, lognormal stock distribution, and the ability to short sell. The binomial options pricing model improves on Black-Scholes by allowing discrete price movements. The Monte Carlo simulation is even more flexible, modeling thousands of random stock price paths. Other variants, like the Merton jump diffusion model, incorporate discontinuous jumps.
Successful options trading relies heavily on effective market analysis and timing. Technical analysis techniques like chart patterns, indicators, and candlesticks allow traders to identify high probability trading opportunities. Fundamental analysis is also key to gauge market sentiment and major events like earnings that will impact volatility and prices. Trader psychology, seasonality trends, and market cycles also influence timing of entries and exits. Avoiding emotional decisions and maintaining disciplined risk management is critical.
With proper education, analysis and risk management, options can enhance portfolio returns. There are multiple platforms that you as an investor can utilise to trade options. Opt for one that provides tools and support needed to effectively begin trading. So, open your Demat account today and start your options trading journey.