Basics Of Options Trading Explained

Basics Of Options Trading Explained

By Nitin Thapar

I have been trading for some time now and I still remember how I started off with limited resources and high spirits. But soon it was all gone, maybe it was due to lack of required skills and the inheritance of tendencies from my poker playing days. I was doing really well, playing poker, as a semi-professional but then got introduced to the concept of investing in share markets and I immediately got a hook of it. Within days I did some basic research and got myself signed up on a popular trading platform. The first few months were good where I invested in some stocks with decent returns, mostly it was intraday but as a typical poker player I started losing patience, I wanted quick returns but instead lost all in multiple attempts of revenge trading i.e. by trying to recover my initial losses.

Like most of us, the reality check made me go back to the basics again. That’s when I got to learn about Options Trading. It was a perfect fit for my kind of trading which involved quick results (monthly and weekly expiration) with limited investments for higher returns. This short course will help you to get a quick glimpse if you are a novice in this segment of trading instruments and I will also try and cover all the important characteristics that can help you get started.

In this post, I will try and cover what I have learnt about Options Trading in the due course. Once you are done with this article you can refer some of the most commonly used and easy to execute Option trading strategies that I have covered in my previous blogs.

What are Options?

Options are instruments that belong to the derivatives family, which means its price is derived from something else. The price of an Option is intrinsically linked to the price of underlying stock.

Here is a text book definition:

A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

Here is how I define Option:

Options are trading instrument for people who don’t like to invest heavily in stocks. It is basically an agreement between two parties to sell or purchase the right to an underlying stock. For e.g. The buyer of an Option pays a premium to the seller with a hope or speculation that the stock price may move up before the expiration of the agreement or vice versa.

With Options you have an opportunity to practice a wide range of strategies with limited/unlimited risk/profit potential, create hedging and speculative trading opportunities for yourself.

How are Options different from Stocks?

  • The Option contract has an expiration date unlike stocks. The expiration can vary from weeks, months to years depending upon the regulations and the type of Option that you are practicing. Stocks on the other hand do not have an expiration date.
  • Unlike Stocks, Options derive their value from something else and that’s why they fall under the derivatives category
  • Options are not definite by numbers like Stocks
  • You can profit from a drop in the price of an underlying stock. In fact, you can profit in all directions depending upon the type of position or strategy you are holding unlike stocks where you make a loss when the stock price goes downwards
  • Option owners have no right (voting or dividend) in a company unlike Stock owners

Characteristics of Options

It is quite often that some people find the Option’s concept difficult to understand though they have been already following it in their other transactions for e.g. a car insurance or mortgages.  In this part I will take you through some of the most important aspects of Option trading.

Type of Options

In true sense there are only two type of Options i.e Call & Put Options rest all are the combination of strategies based on these prime categories.

A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of buying a Call Option you pay a certain amount of premium to the seller which grants you the right to but the underlying stock at a specified price (strike price).

Whereas, a Put Option is an option to sell an underlying Stock on or before its expiration date. Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down. In order for you to make profit the price of the stock should go down from the strike price of the Put Option that you have purchased before or at the time of its expiration.

What is Strike Price in Options Trading?

The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. It is often referred as exercise.

In options trading the Strike Price for a Call Option indicates the price at which the Stock can be bought (on or before its expiration) and for Put Option it refers to the price at which the seller can exercise its right to sell the underlying stocks (on or before its expiration)

Premium

Since the Options themselves don’t have an underlying value, the Option premium is the price that you have to pay in order to purchase an Option. The premium is determined by multiple factors including the underlying stock price, volatility in the market and the days until the Option’s expiration.

Underlying Asset

Underlying asset can be stocks, futures, index, commodity or currency. The price of Option is derived from its underlying asset and since we are specifically talking about Stock Options, we will consider the underlying asset as the stock.

The Option of a stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.

Option Style

Since I have repeated multiple times regarding the expiration of Options I am sure by now you already know that Stock Options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading the expiration of Options can vary from week to months to years depending upon the market and the regulations.

There are two major types of Options that are practised in most of the markets. The American Options which can be exercised anytime before its expiration date and the European Options which can only be exercised on the day of its expiration.

What is Moneyness (ITM, OTM & ATM) in Options Trading?

It is very important to understand the Option Moneyness before you start trading in Stock Options. Lot of strategies are played around the Moneyness of an Option. It basically defines the relationship between the strike price of an Option and the current price of the underlying Stocks.

When is an Option in-the-money?

Call Option – when the underlying stock price is higher than the strike price

Put Option – when the underlying stock price is lower than the strike price

When is an Option out-of-the-money?

Call Option – when the underlying stock price is lower than the strike price

Put Option – when the underlying stock price is higher than the strike price

What is at-the-money?

When the underlying stock price is equal to the strike price

Why is Options Trading attractive?

Options are attractive instruments to trade in because of the higher returns and fewer risks involved. An option gives the right to the holder to do something, with the ‘option’ of not to exercise that right. This way, the holder can restrict his losses and multiply his returns. However in reality, options are very complex instrument to trade. That is because options pricing models are quite mathematical and complex.

Conclusion

Before you start with Stock Options it is important to understand the key determinants since Options Trading carries a risk of unlimited loss. Once you understand how Options Trading works you can leverage the unlimited profit part of it.  You can start with paper trading some basic strategies of Options to get an idea about how well you can perform in the live market.

Next Step

Now that you know the basics of Options trading it’s time to start with a simple to implement Option trading strategy. Dispersion Trading Using Options is one such strategy for Options Trading lovers which is easy to start and implement if you know the basics of Python programming. In this project work by one of the EPAT alumni you will be able to learn the complete set of steps to execute this strategy.