Options Trading Basics for Beginners

Option trading

Options are known to be the most popular instrument for traders because of its rapid price movement which helps you in making a lot of money in no time. Option strategies can vary from simple to complex along with different payoffs and odd names. Options have the power to enhance an individual’s portfolio. This is done through added income, leverage and protection. Depending on the situation, usually there is an option scenario appropriate to fulfill the investor’s goal. 

Before understanding the strategies related to options, let’s first understand the term option.

What is an Option?

An option is basically a contract which allows the buyer to buy or sell the underlying asset at a specific price on or before a particular date. It is a type of security just like a bond or a stock which constitutes a contract with defined terms and conditions. Regardless of the fact that they are complex, all the option strategies are based on two options types namely the call and the put. 

What is the need for option trading?

We will understand the need for option trading through an example. 

Suppose you are buying a stock worth Rs 3000 but your broker comes up with an exciting offer that you can buy stock for Rs 3000 or you can give a token money of Rs 30 to reserve it for next month purchase regardless of the increased stock value at that time. You realise that there are high chances that the stock price would cross Rs 3030. Since you have paid just Rs30 as a token money the rest can be used somewhere else for a month. So, you wait for a month to see if there is any change in stock price. Now, you have the option to purchase the stock through a broker or not depending on the stock price. Here is what we call it option trading.

Types of Options

• Call Options- When you buy a call, you have the right to buy a specific stock at a specific price within a particular time period. In simple words, you have the right to call the stock according to your needs. Whereas if you sell a call, you don’t have the right to sell the stock at a specific price within a particular time period. It can only be done when the call buyer decides to raise their right to purchase the stock at that price.
• Put Options-When you buy a put, it allows you to sell a specific stock at a specific price within a specific time period. In simple words, you have the right to put stock to somebody. Whereas, if you sell a put, you can’t buy the stock at a specific rate and within the specific time period. It can only be done if the put buyer decides to raise their right to sell the stock at that price.

There are different types of strategies comes under the option trading, let’s understand these four terms in detail-

1. Long call

In this type of strategy, the trader buys a call which can be referred as the long call. So, if the stock price exceeds the strike price by expiration, traders can earn many times of their initial investment. This is the reason long calls are considered as one of the popular ways to wager on a rising stock price. While the upside can get you make you reach heights, the downside can be a total loss of your investment. If the stock finishes below the strike price, the call will expire and you will be left empty handed.

The best time to use a long call option when you really expect the stock price to rise before the expiry of options. 

2. Covered call

It includes selling a call option where the trader sells a call but buys the stock also. The stock can turn out to be potentially risky trade into a safe trade to create income. Traders expect the stock price to be down when the strike price expires. If the stock finishes above the strike price, the trader must sell the stock to the call buyer. The upside of the covered call is limited to the premium you received even if the stock price rises. Traders can’t make more than that but can lose a lot. Whereas the downside gets you complete loss of the investment and the stock goes to zero.

The best time to use a covered call is when you already bought the stock and don’t have any expectation of a rise in stock price, you will generate good income.

3. Long put

In this, the trader buys a put and expects the price of stock to be below the strike price by expiration. Traders can experience increased value of option premium many times of the initial investment. The downside of a long put is that it is capped at the premium paid. If the stock finishes above the strike price, you will be left empty handed as the put expires. 

The best time to use it is when you are expecting the stock to fall before the expiry of the option. If the stock falls down just a little below the strike price, the option may be in the money and not get you the premium paid which in turn gets you a loss.

4. Short put

In this, the trader sells a put and expects the stock price to rise above the strike price before expiry. In Exchange to it, the trader gets a cash premium which is the best upside a short put can gain. The upside to it is that the short put will never be more than the premium received. The maximum return is what the seller receives upfront.

While options are generally known for high risk trading, traders have some strategies that have limited risk. Adopting these strategies even the risk averse traders can use options for enhanced returns. However, it is essential to understand the downside of these so that you know the situation well to understand the circumstances for losses and for profits.