We have seen a rapid growth in trading activities of option segment in Indian Derivatives market in last couple of years. Daily turnover at National Stock Exchange (NSE) F&O segment is surpassing 4 Lakh Cr. and out of which more than 80% is being contributed by index option activities. The same turnover surpasses to 10 Lakh Cr. on Bank Nifty weekly and Nifty monthly expiry days.
Option segment has become more popular now a day because of its own profile and that sounds exactly similar to the popularity of IPL T-20 matches as compared to 50 Overs or Test series matches. Trading activities is rapidly rising in this segment because its offers opportunity to get the benefit of all kind of market sentiment whether it’s Bullish, Bearish, Range Bound or Highly Volatile.
Let’s first understand, what is option all about which makes everyone to get a dip dive in it? Apart from cash market where shares are bought or sold, the exchange have segment where future and options of these stocks or indices can be bought or sold. A futures contract is an agreement to buy or sell an underlying stock or index at a predetermined price at a specified time in the future while an option is a contract that gives the buyers the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before certain date.
Let’s assume that I have bought 1 lot (75 Quantity) of Nifty June future at 10700 at the beginning of June series and now I will be at profit or loss as per its movement. If it goes down to 10400 that means I am at loss of Rs. 300. In the second scenario I have bought 1 lot of 10700 Call at Rs. 100 (that is the premium of 10700 Call). Now if Nifty goes down than my risk is limited to premium of Rs. 100 which I have paid, while if it goes up than I will get profit to extend of the market movement less the premium of Rs. 100 which I paid to get this right of benefit.
Option buyers has to pay the premium so they get the right but not the obligation, so risk is limited whatever be the market decline while reward is unlimited if market moves higher. Option sellers receive this premium so their risk is unlimited while profit is limited to only premium price which they get for this option contract.
Advantage of option trading which make it more lucrative and also reasons of rising trading volumes
Option Buyers point of view:
- Option buyers needs to pay the premium only so investment to get a contract is much lower compared to the future contract
- Risk is limited and maximum to the premium amount whatever be the unfavourable market conditions
- Hedging of long only delivery portfolio can be done by taking protective Puts
Option Sellers point of view:
- They take the advantage of range bound market movement as if it remains in a range then the premium declines as per the property of option contract
- Benefit of premium eating as deep out of the money option strikes are quoting at some premium and there is high probability that these premium will head towards zero
- Reducing the cost of position which is already taken in portfolio or future contract by selling out of the money Calls
Myth and Reality of options and options trading
Options are too risky: Options are risky only if we don’t understand how to use them. Risk for buyer is only up to the premium amount while only high risk in option when you are naked seller. So it requires a proper market judgement or hedging strategy which is in fact reduces risk and it’s a beauty of option segment. Risk is a part of the life and trading, and one has to understand how to hedge at the time of risk by using its own instrument and customised strategies.
Options are difficult to understand: Options by themselves are not difficult to understand. Basically, you have the right to buy or sell an underlying stock at a specified price. Even better, there are only two options - Call and Put, and you can either buy or sell. The difficult part is that options can be used in extremely complex strategies with sexy sounding names. If you’re a beginner, it’s best to stick with relatively simple strategies rather than going to Collar, Ladder Spread, Iron Condor, Strip, Strap, Butterfly, Calendar Spread, Box, etc.
Selling options is like receiving free money: Nothing is free in this world especially when you talk about trading. There is an incorrect belief that selling options is nearly risk free. Although selling options to collect cash looks safe while selling naked or uncovered options is a risky strategy because there is unlimited risk. Option sellers can win most of the time; the occasional losses can be devastating when inexperienced investors don’t manage risk properly with discipline.
Only options sellers make money: The fact is that both option buyers and sellers can make profit from option trading. If only sellers make money then there would be no buyers, with no buyers there would be no market. Sometimes option buying does have an edge in many cases especially at the scenario of high volatility, trending or directional market. We have seen many times that premiums have gone to multi fold especially in Bank Nifty weekly expiries too.
Trading options is a zero sum game: Derivatives is a Zero sum game but the truth is that options may be used as an insurance policies. It can be used as risk management tools, not only for trading vehicles always.
It’s easy to make money with options: Making money in market means you have to be smarter than other because it’s a zero sum game and one has to lose if other has to win. So it’s not as easy as it seems. How to trade and invest successfully requires a lifetime of work, dedication and focus. The key to finding and maintaining a high level of success in the markets is to trade and invest according to your own risk tolerance, time horizon, investment goals with proper management of risk - reward with discipline approach.
There is a general misconception that option trading is very risky. Options can be risky, but they don’t have to be. Options can be less risky or more risky, depending on risk tolerance. It can be used for speculation, but also for hedging, protection and leverage. There is more than one way to make money with option and we believe such beauty of options and customised option strategy is even going to boost the trading activities in Indian Derivatives market.