Any newbie who wants to start their option trading journey, should go through this guide on Options Trading for Beginners.
Investment instruments are many and each of them work in an exclusive way. As Far as options Trading is concerned, you need to adopt the well learned way and then begin with trading, which is subject to their complexity.
This article has everything you need to know, i.e. the basics of Option Trading, to help you get started.
Whilst taking baby steps is necessary to begin with Options trading, as it lets you learn and depict every tiny detail, we provide you access to each of the bits.
How Options Trading really works?
Considering the emerging need for information, we have drawn out the essentials and basics of options concisely.
Determining the strategy to work with, trading style and other facets is secondary, while the primary objective remains the same – foundational knowledge right from the roots.
For a successful options trading journey, one has to be well read about a lot of items starting from the basics.
It is when the basics and the fundamentals of the concept are clear that trading will turn out to be successful. To lend a contributing hand, we have the major factors mentioned below.
Options Pricing Criteria
You concern here must be to understand process of contract valuation, followed by its price determination.
They comprise of two components here, i.e. the intrinsic value and the extrinsic value. Let us get started with the explanation of intrinsic value.
This concept is pretty simple and easy to understand. If traders have a profit to make from value of options by exercising the options, the profit is simple referred to as the intrinsic value.
Consider an example for better understanding.
The call option of an underlying security you wish to take will only have an intrinsic value if the strike price is Rs.20 and the security is trading at Rs.21 or more.
The profit you make shall be the intrinsic value. Contrarily, if the security is trading at Rs.20 or less, no intrinsic value will exist.
Extrinsic value on the other hand is obtained by deducting the intrinsic value from price. This value is however not straightforward, but a rather complex value than it might seem, i.e. it is based on factors apart from security’s price.
Other relatable aspects you must take notes of are buying and selling price, bid and ask price etc. Bid and ask price are two separate values of a security listed in exchanges, on contrary to a single security’s price.
Bid price is the amount at which a security can be sold, whereas Ask price is the buying price.
Exercising of Options
When a trader buys a contract, the rights to sell or either buy the underlying assets are as well owned, generally at a strike price.
Owning to the rights if you wish to take an action, you are exercising the option. Subject to exercising of contract, by the holder, a writer is deemed to carry on the said transaction.
The intervals at which an option can be exercised vary, depending upon the style. American styled contracts allow exercising at any point, however European styled can only be exercised upon expiry.
Exercising is however not a mandatory requirement, and in fact is rarely done. Traders can simply buy and sell contracts to earn profits.
Upon exercising, the writer of the contract has to undergo a brief process, to meet the holder’s take on contract. This process is denoted by the name settlement, which is done upon exercising or expiry when options are automatically settled.
This process can be done via cash or physical medium. Physical settlement is when the transfer takes place between two parties, and cash settlement is cash payment to the holder.
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Key Terms & Phrases in Options Trading
A vast number of elements together make up everything options trading has to offer. These elements must be known to the people planning to indulge themselves in options trading.
There elements comprise of both simple and complex key terms and phrases, which will walk everyone seamless through successful options investment.
Liquidity and volume
If a particular contract traded a lot of times in a trading day, it can be referred to have a high volume.
This has a substantial effect on the liquidity of the same contract and should be one of the prime factors traders must consider while selecting a particular contract to trade with.
This refers to the easily flow of transaction, i.e. if you choose a contract which is highly liquid, you will be able to easily sell and buy the same.
Bull markets and bear markets
Both the terms are frequently used by traders, investing in multiple financial products. Bull market has a basic trait of rising prices, where the prices are high or the traders expects the prices to rise.
Contrarily, bear market has the trait of falling prices, where the prices are low or expected to fall. Both the markets have a proportionate effect on any security’s profit earning capacity.
Fundamental analysis and technical analysis
These factors are used to determine the most suitable investment option by any trader. Fundamental analysis is generally determining the inherent value of a security by means of research.
Here traders basically check if the security is overpriced or under-priced, and also study its financial prospects.
On the other hand, technical analysis is when an investors checks out the historical performance of the security.
Traders generally take the past trends, or specific patterns into concern to predict the future price movement.
Contract size is not limited to a single unit of the security, as is perceived by a large number of individuals.
Rather, multiple units of an underlying security can be bought. This amount is generally 100 units and this also alters the amount you will be paying to trade.
This term signifies the relationship between the chosen strike price and the price at which the security is trading.
There are 3 states in which moneyness is categorized – in the money, at the money and of the money.
Perks of options trading is the provision of leverage. Leverage is basically the exceeded investment power you get, from the initial invested amount.
This exceeded investment power will in turn fetch higher profits. Options are designed in such a way that you can invest in large number of stocks by means of leverage.
Option tables and options chains
Both the mentioned names are used to denote the general table which has all the information of a security, including price.
Tables are used to convey the factors of the option, and hence the name is designated to it.
This term is simple and it refers to the diminishing intrinsic value of an options contract, when it comes closer to its expiry date.
This alters the return expectancy of an investment and hence, it must be taken into account. Investors must learn and understand the concept of time decay closely.
Options premium and symbols
Options premium has multiple meanings, and the most general one is the paid price of dealing in a contract.
It also refers to intrinsic value of the contract, of the amount the writer receives. Options symbols are options names. They are used to refer to or denote particular contracts.
The symbol is generally designed in a way, where first three characters represent the underlying security, fourth and the fifth characters are expiry month and strike price respectively.
Types of Options
Precision explanation would be – there are only 2 kinds of contracts, i.e. puts and call. Furthermore, for extensive understanding, options are also grouped on the basis of styles, i.e. American and European.
Such styles contracts are generally not distinguished on the basis of the geographical belonging rather than exercising basis.
Nevertheless, basis of distinguishing is not limited to style, as options are further classified on trading method, expiration cycle, and related underlying security.
Another medium of distinction is exotic options that exist.
Calls and Puts
Owners of call contract of a particular security have the right buy the same in future at a specific price.
Circumstance under which a call order is placed is when the underlying security is expected to rise in price. Such calls have a specified expiry data, following which traders buy them on or before the specified date.
Puts go on the opposite direction of call, where they give the right to sell the contract at a fixed amount. Similarly, you would by a put, if you perceive a security will fall in price.
Puts also have an expiry date, as similar to calls.
American style and European style
The names of contract do not signify their place of origin or markets they are traded in. They are rather used to refer to the specific fashioned terms of the contracts.
A common factor for both the styled contracts is that, owners of contracts can buy or sell an underlying contract, and each contract has an expiry date.
American styled contracts generally allow an owner of contract to exercise the contract before the expiry date.
Whereas, in the European style, such a flexibility is not offered, as owners can only buy or sell the contract on expiry.
Exchange traded options and over the counter options
Exchange traded options are the most common form of options as they are listed in the public exchanges. One can use a stock broker to get access to invest in stock exchange and trade in desirable contracts.
On the other hand, the OTC or over the counter options are less likely accessible for investment. It is because they are customized and have a huge set of terms and conditions, and are only traded in OTC markets.
Underlying security and expiration
Most frequently traded options are underlying securities of stock, and they are not all. There are a lot of contracts, comprising of underlying securities such as index, forex/currency, futures, commodity, basket and lots more.
Here, the options are classified as per the date and frequency of expiration tagged with them. Some have defined set of expiration cycle, while the other provide you the flexibility of choice.
Classification here is done as Regular options, weekly options, quarterly options, long term expiration anticipation securities.
Employee stock and cash settled option
Employee stock can be deemed as a bonus, remuneration or even incentives. These are the options types, where they are given additional contracts on the basis of company they work for.
As far as the cash settled option is of concern, there is not physical movement upon expiry or settlement. The party, who has incurred a profit, will be contrarily paid in cash by the other party.
Exotic options are the ones who contain pretty complex terms and conditions as a contract, and classified as non-standardized options.
Such contracts are exclusively available on in the OTC markets and are many in number. The popularity of such contracts is leading them nowadays to be listed in exchanges.
The further types of Exotic options are barrier options, binary options, chooser options, compound options, look back options.
Types of Options Orders
Since, we have a better understanding of the types of options, it is time we move ahead and discuss the types of orders options traders can usually place.
Well, the order placement is options is not as simple as buying and selling of options contracts. Traders can place multiple types of order, and this can get rather confusing at some point.
No matter how confusing it may get, obtaining precise and clear understanding will lead to ease in options trading.
Options dealing is not limited to two specific aspects like shares trading, rather multiple facets are responsible. This alters the way an order is placed, i.e. to deal in options contract.
As per your perception of opening a position or closing a positing, there are four types of orders you can place.
You must know that, if you buy a contract, it is referred to as going long, whereas if you wish to short sell the contract, it is referred to as going short.
Multiple other parameters which distinguish orders exist and they are how orders are filed, timing, etc.
Buy to Open
This order type is highly popular, and is placed when a trader wants to purchase a contract and opens a position and wishes to go long.
This order is placed when behavior of rising prices is witnessed or expected, or if the trader wishes to exercise the option.
Buy to Close
This is as well a purchase order but, is actually undertaken to close a previously opened position.
For a precise explanation, if a trader opens a short sell position, he/she may proceed to close it by placing a buy to close order.
Sell to open
A trader can short sell an option by opening a position, through sell to open order placement. This order is placed when the price of a specific option is expected to fall.
Sell to Close
On the scale of popularity, sell to close order stands on the second place. Through this order, a trader can close the position opened via buy to open order.
So, you may use the sell to close order to close a position after your security has risen up in price and has fetched you the desirable profits.
In order to trade in options, you have to consult brokers, who provide options investment services. They generally place options orders on your behalf.
Hence, there is an utmost necessity of telling them your choice of options order placement, and also convey the person who filled the order.
There are two ways in which you can file order, i.e. limit orders and market orders.
The order you wish to place also has a timing feasibility, where timing order is used.
You may use the following timing order, to convey to your broker, a specific set of timing instructions, relating to the filling or cancellation.
- Day order
These orders are used to close open position, when a set of criteria are met. Here, the feasibility is of minimizing losses or take profits without the need to monitor for a position.
It would turn out to be the greatest perk for traders with multiple open positions, making it difficult to monitor all the positions.
Generally and most often used Exit orders are – Stop orders, market stop, limit stop, trailing stop, contingent orders.
Simple and complex, both varieties of strategies comprise of combination orders. As the name itself signifies, it means placing an order which is a combination of different orders, to set straight, the entry or exist of multiple positions on options contracts. They are of two types – OTO, OCO.
Types of Options Spreads
Closer understanding will lead you to the perks of options spreads. It is absolutely feasible to trade in any market conditions and also earn profits.
This can be achieved by combining buying and selling calls. However, usage of options spreads only expands your horizons of making profits.
If an options traders take position in two or more options contracts based on same underlying security, then he/she is said to have created an options spread.
Purpose for deploying options spread is to minimize risk arising from investment or cut off upfront cost of taking a position to an extent.
Simple as well as complex options spread make up the types of options spread. Check out the major spreads you must have knowledge about.
Call and put
Spreads are classified on the basis of calls and put, in simple terms. There also exist certain spreads, where combination of calls and puts are used.
Spread which is made by deploying only calls is referred to as call spread, and contrarily, spreads made with puts, are referred to as put spreads.
Credit and Debit
Next distinction is based on the capital outlay factor, where possibilities are you may incur an upfront cost, or receive an upfront credit.
In cases when you incur an upfront cost, it is on account of spending more on buying contracts than you receive from writing contracts. It is generally known as debit spread.
In cases when you received an upfront credit, it in on account of spending less on buying contracts, than received from writing contracts. This case is referred to as a credit spread.
Vertical, Horizontal and Diagonal
Under then method of classifying options spreads, options are placed in certain places of an options chain.
In an options chain, the vertical stacked spread are the ones which involve buying and writing contracts of same type, expiry, and also same underlying security, rather at different strike prices.
Contrarily, the horizontal spreads are the ones which involve buying and writing contracts of different expiry dates, but, with same type, strike price and underlying security.
The diagonal spreads are the ones which involve buying and writing contracts with different strike prices and different expiry dates, but same type and underlying security.
In short, horizontal and diagonal spreads are part of calendar spreads. Here the options involved have different expiry dates.
This refers to a spread formed on account of sale and purchase of different amounts of options contract. This is unlikely the case where equal amount of options are bought and written.
Herein, the number of contracts written exceeds the number of contracts bought. There is also another way around, and varies as per the strategy used.
Types of Option Trader & Trading Styles
Risk and benefit should be in the process, which will actually get you started practically, rather than theoretically. Along the process, there are two general fashioned traders, i.e. the professionals and the retail investors.
Professionals generally cater for the financial institutions or provide investment solutions to traders. They are also a part of the market makers and fulfill a lot of responsibilities in the finance arena.
Retail investors on the other hand, follow their own set of strategies and plans to earn profits. Such people trade, both on part time and full time basis.
However, there are multiple trading styles investors can follow up with and they are provided below.
Day trading in Options
This style of trading is opted by professionals in general, but a lot of individual traders are as well drawn nowadays.
You may refer to it as a full time based trading as the concerned individual is supposed to constantly monitor the price fluctuation and place orders accordingly.
The orders placed must be winded up in a day, and hence the name Day Trading applies accordingly. This is a common style adopted in trading shares as well.
Part time traders rely on this trading style, as they have a short span of time they can cater for trading. This style is not exclusive to options, rather suitable for a lot of other instruments.
Beginners are as well indulged in this form of trading, which makes it quite a popular style. It includes identifying profitable deals through price swings, and place buy and sell orders accordingly.
This style is most probably connected with options and futures. Adopting this style, the risk is lowered, however not suitable for beginners.
The barriers are put on account of the dept knowledge requirement. One has to be well read about the possibilities and circumstances, and professionals tend to have such expertise.
They comprise of professionals essential for options exchanges. They are endorsed with certain responsibility and it includes maintaining dept and liquidity in market for the traders.
Such professionals’ trade in bulk and act as a player when corresponding buyer or seller is absent in market.
Basics of Options Trading – Conclusion
We have laid down the basics of options trading in this article for your reference. Readers can use this and gain in dept knowledge of Options trading.
Following all the mentioned items, you will understand the ways in which you can place profitable trades.
Post this article you can understand how options trading work and will learn a thing or two about strategies implementation.
All the mentioned aspects of the article can be effectively used for strategy formulation, which is the pathway of dodging risk to an extent and earning heavy returns.
Open a Demat Account Now! – Apply this Options Strategy
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