Options Trading: Exploring Strategies, Managing Risks and Assessing Suitability

Options Trading: Exploring Strategies, Managing Risks, and Assessing Suitability
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What is an options trading?

Options trading is a form of financial trading that involves buying and selling option contracts. Options are derivative securities that give the holder the right to buy or sell an underlying asset such as a stock, commodity or currency etc. at the strike price on or before the expiration date. Option trading does not impose any liability on the holder.

Simple example of Options trading:

Suppose you go to a car showroom to buy a car, there you like a car, Which you are getting after including tax in 8 lakhs and that car is needed in black color, that too within 15-20 days because you come to know that from next month GST will be applicable on the car is going to increase. But at that time black colored car is not available in the car showroom.

It will take 1 month for that black car to become available. In such a condition, the seller person tells you to make a black car booking of 20,000 and after 1 month will sell you the car at today’s time price, whether GST increases or losses. But after 1 month instead of increasing the GST decreased and the price of the car has increased to 7 lakhs including GST tax. Now you will come in the problem that the seller person has claimed to sell me the car according to that time. In such a condition, you will have a loss of 1 lakh.

What would you do in such a condition? In this situation you will not buy that car. Now you must be thinking that in such a situation your booking amount which was 20000 will be lost. But if you buy a car then you will have a loss of 1 lakh because earlier the price of the car was 8 lakhs and now it is 7 lakhs. In this case 20,000 would be less loss as compared to 1 lakh. So you will give up your booking amount and will not buy the car.

The booking amount In share market is the premium, in this you pay the premium to the option trader to get the right to buy the shares after 1 month. Suppose you want to buy shares of ABC TV channel company as it has entered into a bid with BCCI for live telecast of upcoming World Cup. In such a situation, if this deal is received by ABC tv channel Company, then the share price of ABC Company will increase.

So you pay a premium of ₹20 for the right to buy the share which is currently priced at ₹100. But now ABC TV channel Company did not get the deal and instead of increasing the share price has increased from ₹100 to ₹50, so in such a situation will you buy the shares? No, you will not buy that stock to cover your loss and give up your premium of ₹20 because a loss of ₹20 is less than a loss of ₹50.

How many types of options trading are there ?

There are two types of option trading:

Call Option:

It offers the holder the right to buy the underlying asset at a predetermined rate earlier than the expiration date.

Put Option:

It offers the holder the right to sell the underlying asset at a predetermined rate earlier than expiration date.

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Options Trading Strategies:

Following are four of the most commonly used options trading strategies:

Covered Call Strategy:

A covered call strategy involves both owning an underlying asset (such as a stock) as well as selling a call option on that asset. This strategy is used when the objective is to generate income from the premium received on the asset held but this is possible only when the potential risk is limited to missing out on large price gains.

Protective Put Strategy:

This is known by another name called “married put”. In this strategy, a put option is exercised on existing holdings of the underlying asset, which involves buying. Its strategic role is to act as an insurance policy against potential price declines. If the asset drops in value, the put option helps try to minimize those losses.

Long Straddle Strategy:

As per the strategy, a trader exercises two options on the same underlying asset, a call option and a put option, with the same strike price and expiry date. It buys both call and put options. It is used when the trader anticipates a significant price change in either direction but is unsure about the direction.

Vertical spread strategy:

It involves buying and selling two options of the same type, either call or put, on the same underlying asset, but with different strike prices and includes bull call spread and bear put spread. These strategies aim to profit from price movements within a specified range.

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Risk Factors Underlying Options Trading:

Options trading involves a number of risks that traders need to be aware of before engaging in options trading. The risks involved in option trading are as follows:

Leverage:

Options allow the trader to control a larger amount of the underlying asset with a premium. While this can increase profits, the trader may suffer losses if the trade goes against the trader.

Limited Time Horizon:

If the expected value does not change before the option expires, the investor may lose the entire premium paid i.e. he/she loses the premium.

Price Volatility:

Options are highly sensitive to changes in the price of the underlying asset as there is a possibility of unexpected losses if the price fluctuates rapidly.

Loss of premium:

The premium paid to buy an option is at risk. If the trade does not go as expected, that is, if the price of the stock goes down in the trade, then there is no benefit to the trader in buying the stock because he has lost it, so he has to pay his entire premium to keep his loss to a minimum.

Complexity:

Many times it happens that the options can be very complicated. Like options, there are many instruments with many factors affecting the value, such as time decay, implied volatility and changes in the price of the underlying asset, etc. There is a possibility of loss if these factors are not understood.

Implied Volatility Risk:

Implied volatility can affect option prices. As we know how much volatility is there in the stock market, even if the implied volatility in the stock market decreases, the value of the option is likely to decrease even if the price of the underlying asset remains relatively stable.

Market risk:

General market movements and economic events such as a downturn in the market or a boom or a financial loss of a company, etc. affect the value of both the underlying asset and the option.

For which investors options trading is suitable?

Options trading can be suitable for investors who have a high level of risk tolerance and good knowledge to understand the intricacies of options, which is why options trading is often preferred by experienced traders. Those who want to hedge the current position of the stock market, want to generate good income by using strategies like covered calls.

However, options trading carries the potential for profit and loss, so it is important that investors seek all concrete information regarding options before engaging in this type of trading. Options trading may not be suitable for conservative investors or newbies to the market as options trading is complex and takes time to understand, therefore it is advised to consult a financial advisor before venturing into options trading.

FAQs :

What are options in trading?

Options are derivative securities that give the holder the right to buy or sell an underlying asset at a predetermined price on or before a specific expiration date.

What is the premium in the option trading?

Premium is the price paid by the buyer to the seller of the option for the rights granted by the option contract.

What is Covered Call Strategy?

Covered call strategy involves owning an underlying asset and selling a call option on that asset. The objective of this strategy is to generate income from the premiums received, while limiting the risk of missing out on potentially large value gains.

What are some of the risks associated with options trading?

Options trading carries risks such as limited time horizon, leverage, price volatility, loss of premium, complexity, implied volatility risk and market risk. Understanding and managing these risks is critical to successful options trading.

What is vertical spread strategy?

Vertical spread strategy involves buying and selling two options (call or put) of the same type on the same underlying asset, but with different strike prices. Its goal is to profit from price movements within a specified range.

What is long straddle strategy?

The long straddle strategy involves buying both a call option and a put option on the same underlying asset with the same strike price and expiration date. It is used when there is a possibility of a significant price move in either direction, without being sure of the direction.

Who is option trading suitable for?

Option trading is suitable for Investors with high risk tolerance, Good knowledge of options Intricacies and experience in business. This can be useful for hedging, generating income, and other strategies. Conservative investors or newcomers may find options trading complex and should seek advice before participating.

Should I consult a financial advisor before starting options trading?

Yes, it is advisable to consult a financial advisor before venturing into options trading. They can provide personalized guidance, help you understand the intricacies and assess whether options trading aligns with your financial goals and risk tolerance.

Disclaimer:

The information provided in this blog is for general informational purposes only and should not be considered as professional financial or investment advice. Always conduct thorough research and seek advice from a qualified financial advisor before making any investment decisions. The blog author and publisher are not responsible for any actions taken based on the information provided in this blog. Any reliance on the content is at your own risk. Remember that the financial markets can be volatile, and past performance is not indicative of future results. The company mentioned in the blog may have undergone changes or developments that are not reflected here. Please verify the information with credible sources before making any financial decisions.

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