Options Trading: Meaning and How Does it Work?

According to Bank of America, the average daily notional value of options on India's Nifty 50 index has risen to about $1.64 trillion as of June 2024, surpassing the S&P 500 index's average of $1.44 trillion. This statistic shows the growing popularity of options trading in India, with new traders diving into this segment. Given this trend, traders must understand the basics of options trading and how to navigate this market. Here is a comprehensive guide to get you started.

What is Options Trading?

Options are derivative instruments that derive value from an underlying asset, such as stocks, indexes, or other securities. Options trading involves buying or selling options contracts on these underlying assets at predetermined prices and expiration dates. 

These contracts grant the holder the right, but not the obligation, to buy or sell the underlying asset at the agreed prices. There are two main types of options, i.e., call options and put options. A call option gives the trader the right to buy the asset, while a put option gives the trader the right to sell the asset.

How Does Options Trading Work?

As mentioned above, options trading allows traders to buy and sell contracts on underlying assets in predetermined lots at predetermined prices. When a trader buys an options contract, they pay a premium, which is the cost of the option. A call option gives the trader the right to buy the asset at a specific price (strike price) before the contract expires, while a put option gives the trader the right to sell the asset at the strike price before expiration. 

Traders can also sell options, obligating them to sell (call option) or buy (put option) the asset if the buyer chooses to exercise the option. The goal is to predict the price movements of the underlying asset to make a profit. 

For instance, if a trader thinks a stock's price will rise, they might buy a call option to buy it at today's lower price. If they believe the price will fall, they might buy a put option to sell it at a higher price. However, options trading is complex and risky, so traders need to understand the market and have a strategy before starting.

Example of Options Trading

Let us consider the following options trading example to get more clarity on this type of trading.

Consider Ashish betting on an increase in the stock price of Infosys from Rs. 1700 for the coming month. The strategy for him will be to buy a call option. Here are a few more details.

Current Stock Price - Rs. 1700

Call Option Strike Price - Rs. 1800 (the price at which you can buy the stock)

Premium - Rs. 50 per share

Expiration Date - 1 month 

Scenario 1 - Stock Price Rises Above Rs. 1,800

Suppose the stock price rises to Rs. 2,000. Ashish can exercise the option to buy Infosys at Rs. 1,800, then sell it at the current market price of Rs. 2,000. The profit per share would be Rs. 2,000 - Rs. 1,800 - Rs. 50 (premium) = Rs. 150.

Scenario 2 - Stock Price Stays Below Rs. 1800

If the stock price stays below Rs. 1,800, Ashish will not exercise the option and will only lose Rs. 50 per share paid for the option.

Participants in Options Trading

Participants in options trading include various types of traders and investors, each with different strategies and goals. Here are the key participants,

• Options Buyers: Options buyers are traders who purchase options contracts to gain rights to buy or sell an underlying asset at a set price after paying a premium to profit from favourable price movements.

• Options Writers/Sellers of the Option: Options writers sell options contracts and receive a premium from buyers. However, they have the obligation to buy or sell the underlying asset if the buyer decides to exercise the option.

• Hedgers: These are traders or investors who use options to protect their existing investments from potential losses. 

• Speculators:  Speculators are traders aiming to profit from predicting underlying asset price movements.

• Market Makers:  Firms or individuals who provide liquidity in the options market by continuously offering to buy and sell options.

Strategies in Options Trading

Options trading strategies are systematic approaches to using buy and sell contracts or a combination of the two to make profitable trading opportunities and spread the risk through effective hedging. Some of the popular or common options trading strategies include,

• Long Call - Buying a call option to profit from an anticipated rise in the stock's price.

• Long Put - Buying a put option to profit from an anticipated decline in the stock's price.

• Covered Call - Selling a call option on a stock that one already owns to generate income from the premium.

• Protective Put - Buying a put option to hedge against potential losses in a stock one owns.

• Straddle - Buying a call and a put option at the same strike price and expiration date to profit from significant price movement in either direction.

• Iron Condor - Selling a call and put option at one strike price and buying a call and put option at higher and lower strike prices, respectively, to profit from low volatility.

• Butterfly Spread - Combining bull and bear spreads to limit risk while betting on minimal price movement.

Pros and Cons of Options Trading

Now that we have seen how to do options trading and other related basics let us focus on a few pros and cons of options trading to better understand this concept. 

Conclusion

Options trading can be quite tricky as traders need to navigate this complex world with many nuances like options trading strategies, options greeks, hedging against risks or speculative price movements and more. Therefore, traders need to understand options trading in depth, especially the risks involved before committing to this trading.