Last Updated on May 25, 2023 by Harshit Singh
With the option to buy or sell underlying assets at a predetermined price, options trading has captured the attention of both seasoned investors and newcomers. However, navigating through these options requires caution, as they are considered among the riskiest trading instruments.
In this blog, we will explore options trading in detail, emphasising the types, benefits, participants, strategies, and risk factors.
Table of Contents
What is Options Trading?
An “option” is a contractual agreement that gives an investor a choice, but not the obligation, to buy or sell securities, ETFs, or index funds at a predetermined price within a specific timeframe.
Types of Options Trading
There are two types of options trading modules –
- Call Option: An option granting the holder the right, but not the obligation, to purchase an asset at a predetermined price before a specified date.
- Put Option: An option granting the holder the right, but not the obligation, to sell an asset at a predetermined price before a specified date.
Participants in Options Trading
Buying and selling options take place in the options market, which consists of mainly two players –
- Buyer of an Option: The individual who pays the premium to acquire the right to exercise the option from the seller/writer.
- Writer/Seller of an Option: The party receiving the premium for the option becomes obligated to sell/buy the asset if the option buyer exercises it.
Benefits of Options Trading
Although options trading is often associated with risk, the potential advantages outweigh the inherent uncertainties. Here are some of the underlying benefits of options trading –
- Lower initial expense: Buying options is cheaper than acquiring stocks as the cost of obtaining an option (premium and trading fee) is significantly lower.
- Price freezing: Options trading allows investors to fix the stock price at a specified amount for a specific period, ensuring the ability to trade at that rate until the options contract expires.
- Portfolio enhancement: Options trading offers additional income, leverage, and protection. It can act as a hedge against a declining stock market and generate recurring income.
- Flexibility: Traders can employ various strategic moves before the options contract expires, including buying shares, selling them for profit, or selling the contract at a higher rate to another investor.
Options Trading strategies
Options are categorised into call options and put options. Call options are used in bullish markets, while put options are used in bearish markets. Options trading strategies are further divided into bullish and bearish strategies, depending on the market trend.
Bullish Options strategies
When investors perceive a bullish market during options trading, they employ the subsequent bullish strategies to maximise profits and minimise potential losses:
- Bull call spread: A Bull-Call Spread involves purchasing an At-The-Money call option and selling an Out-Of-The-Money call option with different strike prices, creating a range. It becomes profitable if the underlying asset’s price rises, with limited profit (spread minus net debit) and potential loss if the stock price declines.
- Bull put spread: Similar to the Bull-Call spread, a Bull-Put spread involves using two put options with different strike prices and the same expiration date to create a range. By buying an Out-Of-The-Money put option and selling an In-The-Money put option, investors can profit if the underlying asset’s price increases. This strategy is implemented for a net credit, but losses occur if the asset’s price falls below the strike price of the long put option.
- Call ratio back spread: This strategy involves buying two Out-Of-The-Money call options and selling one In-The-Money call option. It offers unlimited profit potential but incurs losses if the underlying asset’s price remains within a specific range.
- Synthetic call: Investors employ a synthetic call when they hold a bullish long-term view of the asset but are concerned about downside risks. This involves buying put options for the same asset, providing unlimited profit potential if stock prices rise, with limited loss potential limited to the premium paid.
Bearish Options strategies
The market may enter a bearish trend in a dynamic financial market, influenced by external factors and prone to volatility. In such scenarios, options investors employ the following bearish options trading strategies to navigate the market:
- Bear call spread: In this strategy, investors purchase one Out-Of-The-Money call option with a higher strike price and sell one In-The-Money call option with a lower strike price, aiming for a net credit. Profit is earned if the underlying asset’s price decreases, with losses limited to the spread difference minus the net credit.
- Bear put Spread: Similar to a bear call spread, this strategy is used when investors expect a moderate decrease in the underlying asset’s price. It involves buying one In-The-Money put option and selling one Out-Of-The-Money put option. The profit potential is limited to the spread minus the net debit, which is the difference between the premiums paid and received.
- Strip: The Strip is a bearish to neutral three-legged strategy where investors purchase one At-The-Money call option, and two At-The-Money put options with the same underlying asset, strike price, and expiry date. It yields unlimited profit potential if the underlying asset’s price drops significantly by expiration, with the loss potential limited to the premium amount.
- Synthetic put: Investors in a bearish market employ the synthetic put strategy when they anticipate a decline in the underlying asset’s value. It allows them to profit from price drops, offering unlimited profit potential similar to a long put, while the difference between the short sale price and the long call strike price determines the loss potential.
Is options trading safe?
Options trading is very often considered to be risky. This is because it requires an accurate prediction of whether a stock will rise or fall and an accurate projection of when it will do so. For example, you may be accurate in believing that a particular company is growing, but if your option expires before it, you will not be paid with a return for your premium.
Options trading, like any other type of trading, has costs. For example, you must not only pay a premium for your options, but you must also pay a brokerage to your broker. As a result, before acquiring an options contract, it is always prudent to assess expected costs against possible earnings (and losses) before acquiring options contracts.
Some options methods are only effective when many trades are made simultaneously. Unfortunately, since options markets are not always as fluid as the stock market, those concurrent trades don’t always work precisely – and this might increase the danger that your approach won’t perform as well as you planned.
In contrast to an option buyer (or holder), an option seller (writer) can sustain losses well over the contract price. When an investor writes a put or call option, they are compelled to purchase or sell shares at a set price within the contract’s given timeframe, even though the price is unfavourable. And then, of course, there is no limit to how high a stock price may increase.
Conclusion
Options allow traders to trade market fluctuations through set prices and time. Though the chance of making money is enormous, it is extremely risky. Only trade options if you have enough knowledge of all market nuances. You may need to have a good hand in technical analysis as well. Do your research and only then indulge in any trading.
FAQs
How options trading work?
When traders or investors buy or sell options, they gain the right to exercise the option at any time before its expiration date. However, exercising the option at the time of expiration is not mandatory. This characteristic of options, where their value is derived from an underlying asset, classifies them as derivative securities.
Is option trading superior to stock trading?
No single investment method is inherently superior or more favourable than another. For example, long-term investors typically favour stocks that offer consistent growth over time, whereas option traders seek to capitalise on risk and volatility to achieve profitable returns. Each approach has merits and aligns with different investment objectives and risk tolerances.
Which type of options trading is considered to be safer?
Covered calls are considered to be a secure approach to options trading. This strategy involves selling a call option while owning the underlying stock, which helps minimise risks and maximise potential returns for traders.
As an investment fanatic, I’ve dabbled in early-stage startups, mutual funds, gold, stocks, smallcases, and real estate to identify which assets generate the highest ROI. At Tickertape, I’m dedicated to presenting my learning and providing insightful suggestions to help my readers make sound investment decision.
