An Introduction To Option Trading

by Vikas D. Stock Market Trader

What is options trading?

Options trading is still new for many stock traders. It is also very dangerous, as the old traders say. But not really. Once a trader understands options trading, he will realize that options trading can be just as profitable as stock trading.

An option is the right, but not the obligation to buy a specific share, currency, commodity or futures contract at the agreed price at a specific future date. For example, a trader can buy an option that gives him the right to buy shares of a company at a specific price (called the strike price) three months from now.

The benefits of options trading

It can cost a trader a few lakhs to buy 100 shares of a company. However, because the options are taken advantage of, it can buy an option at a very low price. This can be as low as 1% of the actual stock price.

But other than that, how will options trading benefit a stock trader compared to buying actual shares? This part is very simple. Suppose this trader has bought an option to buy 100 shares of a company for Rs. 10 in three months from now. He bought a three month options contract of 100 shares of the company for Rs. 10 x 100 shares = Rs. 1000.

Until then, if the share price rises to Rs 45, the trader will get the full benefit of the price movement. That means Rs 35 x 100 shares = Rs 3,500 - when you never actually own the stock. Remember, there is no obligation to use the option: the price of the option at the time of expiration will show an increase in the share price, so there will be a full profit.

Shares of the company may have closed below the strike price of Rs 10 for three months from now. Even if it falls to Rs 5, the options trader will not lose more than the amount initially paid for the option.

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Calls and Putts

The example we quoted above is of the so-called call option. Suppose they expect the underlying asset's value (shares, commodities, etc.) to rise between now and the expiration date. In that case, someone should buy one of these.

But the incredible flexibility of options trading also allows the trader to benefit when the underlying asset's value goes down. This is called the put option. Don't confuse it - it works like a call option; otherwise, the trader will benefit if the property price goes below the strike price.

As with the call option, when buying a put option, they cannot lose more than the initial price paid for it. This is called option premium.

Conclusion

Options trading may be more involved than the examples given above. Still, once the trader understands the basics, the learning curve is not so sharp. There are also options trading strategies to take advantage of a completely stagnant market, but more on that later.