If as a trader you’ve experienced dealing with several derivatives, products like forex, commodities, indices, cryptocurrencies, bonds and others but willing to experiment for exponential growth in terms of revenue generation. Options trading is that opportunity wrapped in the diversification of portfolio. The risk and reward ratio is higher here. So, if traders back it with their strategies and understanding of the financial markets, profits follow.
As a beginner, you may find it slightly complex while starting. But as you grow into it, the profits start to follow and so does the interest. So, the narrative that only veterans should invest in it is a myth. Everyone can, but there’s a process to it. So, if that is followed precisely, you can produce gains.
What is options trading?
Options can be defined as conditional derivative contracts which gives liberty to the contract buyer vis-a-vis option holders to sell or buy a given security at a specific rate or price. For offering the right, a broker or a seller charges an amount called premium from the buyer.
Precisely, in trading, you trade instruments which allow you to sell and buy any security at a particular price and date. An options contract is always linked to an underlying asset. For example, commodities or other security.
In a standard contract of options, there are 100 shares of the underlying asset.
Moreover, depending on the market conditions, options contracts can be good for investors. They can keep them for as long as for years and as short as for a day. Here, you are not obligated to the assets. However, if someone decides to do that, that is known as exercising options.
As a DIY investor, a trader is in full control of the decision and management of the contract and the market. However, you are not alone.
There are plenty of communities that bring several people together to discuss the market, its outlook and trading strategies.
Additionally, if the market is not favourable to investors. They can let the contract expire worthless. It saves them from heavy losses than the premium.
On the other hand, option writers (sellers) are at a greater risk compared to buyers. That’s the reason they ask for the premium.
Options can be bifurcated into two types; call option and put option.
What is a call option?
Here, the contract buyer has the right to purchase the underlying asset in the days to come or future at a predetermined rate, which is called strike price or exercise price. Here, you buy an asset with a set expiration date. It can be a stock or other financial product.
You buy call options if you are sure about the price rise of an underlying asset prior to the date of expiration.
For instance, you purchase a call option for 200 shares of a random stock, after hoping they would see a surge.
Suppose your call option contract renders the right to purchase each share at USD 100. Meanwhile, the rate of stocks rises to USD 200 apiece. Now, you have a chance to use your call option and buy the share at a discounted price.
What is a put option?
Through a put option, a purchaser gets the right to let off the underlying asset at a predetermined price in the future. However, before buying a put option, one must consider a few things:-
- The time frame for investing in the option
- Amount of money that you should invest
- The price swing or trend of the asset’s price
Purchasing put options can be beneficial if someone anticipates the price of the underlying asset will be slipping ahead of the expiration date. Moreover, if you purchase put options at a strike price and the price of an asset dips, the investor has the chance to exercise the put option at the original or previous strike price.
For instance, if you purchase a put option for 200 shares of a stock, at USD 100 per share. And if the prices of the stock plunge to USD 50 per share, before the expiration date. Interestingly, you still have the opportunity to sell 200 shares at a rate higher than USD 100 using the option.
Why trade options?
Options trading comes with several advantages, including:-
- You get number of alternatives for building strategies
- Get increased cost-efficiency
- Lesser risky than equities
- The returns are higher for traders
So, any trader interested to get elevated benefits prefers options trading. Also, by trading through it, an investor receives chances to cover up investment goof ups.
Several trading strategies can be developed by traders to sell and buy complex to simple options. That may include several simultaneous option positions.
Options are leveraged instruments. Thus, by using them or taking some risk, traders can amplify their benefits in a quick time. People use call options for applying certain strategies and when they have something concrete that can work wonders for their returns.
When a trader is confident in an index, ETF or a stock for its bullish trend and desires to limit the risk while investing, he uses the option. Moreover, when he is looking forward to taking advantage of the rising prices, there can’t be anything better than the option.
Traders risk a smaller amount while trading it.
Risk and reward ratio with call option
The loss a trader can incur here is the premium. So, anyone can enter the market when the reward is bigger because the potential gain is unlimited. The payoff of the option surges with the increase in price of the underlying asset until the date of expiry. Moreover, even theoretically, one cannot chalk out how far or high it can touch.
The process of ‘put options’ is contrary to the calls. You gain profits here when the value of an underlying asset plunges. Moreover, even through short-selling, traders have the chance to earn money.
However, with the put option, if there’s an increase in price of an asset, that would lead to the option expiring worthless.
Risk and reward ratio with put option
Here as well, the potential losses are limited to the premium paid by an investor. So, anyone who does not have qualms can afford to have that and indulge in profit booking aggressively. However, unlike the call option, the maximum profit is capped because the price of the underlying asset cannot go beyond zero.
How to determine options pricing?
Traders or investors can use different models for determining the options pricing. However, at the core, they are primarily known through two ways, time value and intrinsic value.
The intrinsic value of an option indicates the profit potential. It is based on the distinction between the asset’s current price and the strike price. Time value is used to ascertain the impact of volatility on the underlying asset until the expiration date.
The expiration date, strike price and stock rate, all factors are important and affect option pricing. On the other side, the time value gets affected by expiration date while strike price and stock price affect intrinsic value.
What is a covered call?
In covered call strategy or planning, a trader buys 100 shares of an underlying stock and against those shares, a call option is sold against the shares. When the investor sells the call, the premium of options gets collected. It provides downside protection. It reduces the cost basis applied on the shares.
In return, the seller agrees to let off underlying asset’s shares at the strike price of the option. Thus, there’s a capping of upside potential.
Risk and Reward for covered call
If the share price goes beyond the price of strike ahead of the expiration, the trader can exercise the short call option. Here, traders would be delivering underlying asset’s shares at the option’s strike price even if it goes lower than the market price.
There’s a limited downside protection received by a trader in the premium’s form while selling the call option.
What is a protective put?
It is also known as long put. It gives downside protection while a trader is attempting to take advantage from a downside move. A protective put is purchased by traders who own shares considering a bullish run in the market following the sentiments. It is for a long run. However when the trader intends to protect funds from a short run, a protective put is applied.
If the rate of an underlying asset surges and during the maturity, it goes beyond the strike price of the put, the option expires worthless. Moreover, the trader has to bear the loss of the premium. However, he earns through the increased price of the underlying asset.
But if the underlying asset’s price plunges, the portfolio of the trader loses valuation. However, this loss gets covered largely by the position taken in the put option. Thus, the position works effectively as an insurance.
An investor has the chance to set the strike price beneath the current price to bring down the premium payment in lieu of decreasing downside protection.
It can be contemplated as deductible insurance.
Risk and reward ratio
If the rate of the underlying asset rises or stays the same, the potential loss will remain limited for the option premium. It is invested as insurance. However, if the rate of the underlying asset slips, the loss of funds will be offset by a surge in the option’s rates. It will be capped to the difference between the premium paid plus strike and the initial stock price.
Different options trading strategies
As a trader, you should use brokers that allow you to apply options strategies. Brokerage firms like PrimeFin, Brokereo, InvestLite, ETFinance and TradedWell can be helpful in doing that.
Here are some renowned options strategies that a trader can apply for better profits:-
The married strategy or planning involves buying an asset and then buying put options for a similar number of shares. This method is the indication of the downside shield or protection. It gives traders a chance to ward off at the strike price.
Protective collar strategy
This strategy limits both losses and gains. Its position is created by holding an underlying asset, warding off an out of the fund call option and purchasing out of the funds call option.
In this strategy, a trader buys both put and call options at the same time. It means, both options must have the same expiration date and strike price.
Here, traders purchase out-of-the-money put and call options at a similar time. However, they have different strike prices but the same expiration date. Moreover, the call strike price should be above the put strike price.
Bull call spread
In this strategy, a trader simultaneously purchases calls at a specific strike price. However, selling of a similar number of calls at higher rates also continues. Both calls have the same expiration date and an underlying asset.
When an investor goes bullish on an underlying asset, this vertical strategy is applied by him. The premium spend can be reduced here along with the upside limit.
Bear put spread
It is a vertical spread’s another form used by several investors. Here, a buyer purchases and sells specific put options simultaneously. Both options are bought for the same underlying asset. Moreover, the expiration date also remains the same.
Trading throughput and call options provide opportunities to traders that can offer great benefits. Moreover, the benefits get doubled and risks can be averted by applying proper strategies seeing the movement of the market. Brokers like PrimeFin, and others can be helpful to market players while indulging in these types of trading. Find is PrimeFin legit?
Also, trading with options is good if an investor can think out of the box to accommodate changing directions of the financial market.