What is options trading?

Options are trading instruments that give you the option to buy or sell specific security on a specific date at a specific price. It is always linked to an underlying asset – may be a stock or another type of security. The time horizon associated with an option can be as short as a day or as long as a couple of hours. While there are various options trading strategies, the most popular ones include Covered Call, Married Put, and the Bull/Bear Spread. It is imperative to  have a good understanding of these strategies first before delving into putting them into practice (An options trading course for beginners is a good starting point for understanding the world of options)

Another interesting detail about options is how they are priced. It is often done using the Black-Scholes or Binomial pricing models and getting an understanding of the same will aid in one’s trading journey especially as it will give a holistic understanding of where an option derives its value from.  An option has two primary parts: intrinsic value and time value. The Time value component is the one that is also affected by volatility.

There are two stakeholders involved in trading options: the buyer and the seller. When a market participant sells an option, they in essence create new security altogether. That is called option writing and is the only way they come into existence.  (Think about it this way, an option is issued neither by the underlying company nor the stock exchange).

Why should you trade options?

The biggest advantage of trading options is that they provide both flexibility and liquidity. One can trade in options with a much smaller amount of capital compared to some other instruments. (due to the low margin requirements in options trading).  A successful options trader earns substantial returns while keeping their portfolio diversified.

There are some advantages (and disadvantages of course) to trading in options versus taking similar trades in the cash market. The latter also gives you small ownership of the company.

Trading in the cash market works mostly only during a bull market – as one can exploit the increasing prices to book profits. It’s almost impossible (especially for a retail investor in India) to make money in a bearish or sideways market. Contrary to that, options trading can be done in all market conditions.

So what it boils down to is psychology. Trading options is a much harder mental game than most other securities. To be able to control one’s emotions, think quickly and maintain discipline are key characteristics that separate a successful trader from a novice.

Advantages / Pitfalls of Options Trading

One should keep in mind that trading options are a zero-sum game – for someone to earn money, someone else has to lose the same amount. An option buyer’s gain is the option seller’s loss (and vice-versa).

No wonder that trading options are often compared to a matchstick. If done well, it will bring light into your life. But it holds the power to burn as well.

Many traders have felt the wrath of options. The most common reason they lose money is that they hold the option too close to expiry while the more lucrative thing to do is exit the option (i.e book profits) when there is still time value left. Sometimes they lose money because they hold it in anticipation of key events. For example, if you had bought an OTM (Out of the money) call on Reliance in expectation of a good financial result and it disappoints then your call option is going to be pretty much worthless.

At the same time, some traders have made a fortune (to say the least!) trading these options.

Learn option trading the correct way!

Option trading can be an extremely lucrative opportunity – one that is filled with an immense amount of potential. However, it is important to acknowledge that it is very different from stocks, and will take a whole lot of extra time, dedication, and effort to mastering this security. Getting a firm grasp of the essentials and building a strong foundation should be the top priority of any beginners in the industry. Post that one can tailor each trade to match their risk appetite and desired reward.

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Raushan Kumar
A Cook, Software analyst & Blogger.

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