Option trading for beginners can be an exciting and volatile field. For example, you may buy an option on a stock at Rs.5 and it may end the day at Rs.10, implying a return of 100% in a single day. Since options trade abstract rights, such returns are quite normal. Before you venture into options trading strategies, here are a few things you need to be aware of. We have highlighted 8 things to know about options trading before you start off..
1. There are only 2 types of options
To that extent, options are very simple products. You can have a right to buy an asset at a specified price and that is referred to as a call option. Alternatively, you can have the right to sell an asset at a specified price and that is referred to as a put option. Traders typically buy a call option when they expect the price of a stock to go up. Alternatively, if they expect the stock price to go down, they will buy a put option.
2. Buying an option is a right with limited loss
Having understood the two types of options, let us also look at the two parties to an option. Just as there are buyers and sellers of shares, there are buyers and sellers of an option. An option buyer can buy a call option or a put option depending on their view of the stock price movement. The profits can be unlimited for the buyer of an option based on price movement but losses are limited to the premium paid.
3. Selling an option is an obligation with unlimited loss
When you get a right to buy an option, there must be someone who is willing to give you that right. That person is the seller of the option. Option sellers will sell call options if they do not expect prices to go above a level and sell put options if they do not expect prices to go below a certain level. For option sellers, the potential losses can be unlimited but gains are limited to the extent of premium received.
4. All options are time-bound and therefore they are wasting assets
All options have a defined expiry period. In India, the 1-month option expiring on the last Thursday of the month is the most active. You also have 2-month and 3-month options. There are also longer term options where you can take 1-year view on the market. Whatever, be the tenure of the option, the option is always a wasting asset! That means its time value will keep going down and approach zero as the option expires.
5. The option premium is also called the option price
When you trade options on your online trading terminal, you actually trade the option price. The option price is nothing but the premium that you pay for buying an option; that is getting the right without the obligation. When you trade options you actually trade in these rights without obligations. If the Reliance spot price is Rs.970 and the Reliance 1000 call option (May expiry) is available at Rs.5, then this is the price of the right to buy without the obligation.
6. Options can be American or European
For a long time, India had American and European options. While index options were European options, stock options were American options. European options could only be exercised on the expiry date but American options could be exercised on any day even prior to the expiry date. However, effective 2011, all stock options in India have also shifted to being European options.
7. Volatility benefits the buyer of the option
This is, perhaps, the most interesting and the most important facet of options. Whether it is a call option or a put option, the buyer of the option benefits from higher volatility! That is because positive volatility is beneficial and negative volatility is protected by the option premium. Therefore, volatility always favours the buyer of the option and represents a risk for the seller of the option.
8. Options are primarily for hedging and only then for trading
This is the basis on which the options product was created in the first place. What do we understand by hedging? If you are holding on to a stock then you can protect your downside risk by buying a put option. Similarly, you can reduce your cost of holding by selling higher call options that will expire worthless. As an options trader, you need to primarily recognize and appreciate that options are meant for hedging. They are not trading products, unlike equities and futures. As long as you use options as primarily a product to hedge your risk, your experience with options is likely to be quite favourable.