An option is a type of contract or agreement between two parties, out of which one is a seller, and the other is a buyer. The agreement is valid for a certain period of time in which we have an underlying asset that holds the agreement together.
We’ve all heard stories about people making big in the Stock Market from nothing and sometimes losing everything they had. But how did these extreme occurrences come to pass? These stories of excessive profits and losses are a result of the lack of knowledge on the subject.
There has long been a saying that risk and reward in the stock market are interrelated.
The higher the return, the higher is the risk involved. People instinctively know that the stock market is an ocean of possibilities to make money. Still, they entirely neglect the reality that they need to learn before they can actually earn.
One such segment that offers enormous potential for wealth generation in the stock market is Options Trading. This article will help you understand how it works and how you could avoid those extreme situations with proper knowledge.
- Options Trading for Beginners
- What is call option and put option?
- Features of Option Contract
- How to Trade Options in Alice Blue
- Option Trading Strategies
Options Trading for Beginners
An option is a type of contract or agreement between two parties, out of which one is a seller and the other is a buyer. The agreement is valid for a certain period of time in which we have an underlying asset that holds the agreement together.
The underlying asset can be stocks, real estate, precious metals, or anything that can be considered as an investment and has the ability to multiply your invested money.
In options, the buyer pays a token or premium amount to lock in the underlying asset for that particular time mentioned in the agreement, which the buyer might buy after the agreement matures.
After the agreed-upon period has expired, the buyer evaluates their situation, determining whether they are in profit or loss, and then decides whether to proceed with the agreement.
In options, buyers have to pay a non-refundable premium amount to the seller and have the right to buy the asset as per the terms and conditions decided in the agreement. Now buyers can walk out of the agreement if they feel they are in a loss-making situation, but the sellers are obligated to comply with the agreement and cannot walk out of the agreement from their end.
Options Trading can be a little tricky, and trust me, it takes time to understand the technicalities. Hence, we suggest you read everything carefully and repeatedly for better understanding.
Wait, did you read our article on futures trading? If not, then click here to read about futures trading and understand this concept in a clearer way.
Coming back to the concept, let’s try to master it with an example.
Assume two friends, Nushrat and Kriti. Nushrat is actively looking to buy a piece of land that Kriti owns near the Highway, valued at ₹ 10 Lakh. Nushrat is optimistic about the land because a new airport along the highway is expected to be developed over the next six months. If this is accurate, the price of the land may easily reach 20 lakh. However, if the news is false, the land price could fall to as low as 5 lakh.
Since the information is not confirmed, the outcomes can be both positive and negative. And buying the land just on speculations would be a big gamble. So Nushrat comes up with an agreement where it’s a win-win for both Nushrat and Kriti.
- Nushrat pays a non-negotiable and non-refundable premium amount of ₹ 1 Lakh to Kriti and locks in the land for six months. After six months, Nushrat shall pay ₹ 9 Lakhs for the land to Kriti if deemed profitable. Or maybe not if the deal makes a loss for Nushrat, as she is the buyer here. In any case, Kriti cannot walk out of the agreement as she is the seller here.
- If the airport news is true, after six months, the land prices will increase to ₹ 20 Lakh, but Nushrat has to pay only ₹ 10 Lakh. In this case, Nushrat would be making a profit of ₹ 10 Lakhs [₹ 20 Lakh – (₹ 9 Lakh + ₹ 1 Lakh)], but Kriti, on the other hand, loses ₹ 10 Lakh.
- If the airport news is false, after six months, the land prices will decrease to ₹ 5 Lakh. Similar to the previous situation, Nushrat has to pay ₹ 10 Lakh for that piece of land. Now she has already paid ₹ 1 Lakh to Kriti as the token amount, which is non-refundable. Nushrat can either face a loss of ₹ 1 Lakh token amount and walk out of the agreement or buy the land for ₹ 10 Lakh and bear a loss.
- You might assume what Nushrat would have done. She clearly walked out of the contract with a ₹ 1 Lakh loss, and Kriti got to keep the land and the token amount paid by Nushrat.
This is a classic example of an options contract. Nushrat here is in a high-profit high-loss situation, but she made some intelligent deals and minimized her loss to only ₹ 1 Lakh when she could have lost around ₹ 10 Lakhs.
We hope the concept of options trading is clear to you, but we’d suggest you read this section again to be on the safer side.
Now, this was indeed an example, but similar theories of options and hedging the risks are used in stock market trading as well.
There is one more thing that you need to know about before moving forward. Click here to learn about what is hedging in the stock market.
Let’s move on to the types of options contracts and get into the technicalities.
Generally, options trading is of two types
- Call Option
- Put Option
Keep reading ahead to know about these options.
What is call option and put option?
- Call Option: The call option is a type of options contract which gives the buyer the right, but not the obligation to exercise the option / buy the security at the strike price before the contract gets expired.
- Put Option: The put option is a type of options contract which gives the buyer the right, but not the obligation to sell the security at the strike price before the contract gets expired. Since we get a right to buy/sell without any obligations to do so, we have to pay a premium to the option seller.
To get a comparative better understanding, why don’t you read the blog on Difference between Futures Trading and Options Trading.
Features of Option Contract
Until now, you understood about options contracts with the example of Nushrat and Kriti, but you should also know about the technical jargon used in the stock market. We will try to explain everything with the help of the same examples.
Strike price is nothing but the agreed price of the underlying asset price by both parties at the time of agreement.
Option Premium in Options Contract refers to the price paid by the buyer to the seller to initiate the agreement and lock in the underlying asset for the time mentioned in the contract. If we look into the above example, Option Premium is the ₹ 1 lakh paid by Nushrat to enter in the contract.
At any given time, a contract has multiple buyers and multiple sellers with multiple strike prices. Open Interest lets you know how many options contracts are currently open in the market.
In options, the expiration date refers to the final day on which the contract will expire. In the example above, you say the contract was valid for one week. Generally, to make sure there isn’t any confusion or ambiguity among traders, the Indian stock exchange has a set expiration date for the FnO market on the last Thursday of every month.
A stock’s implied volatility shows how volatile it will be over the life of an option. As people’s expectations change, option prices move with them. Implied volatility is directly affected by how many options are available and how the market thinks the share price will move. In our example, the stock price was supposed to move from ₹ 10 lakhs to beyond ₹ 20 lakhs which makes it a very volatile stock.
It is the difference between the current price of an asset and the strike price that is considered intrinsic value in options trading.
Moneyness of options
Moneyness is a measure of an option’s current intrinsic value. With put and call options, the term “moneyness” is used to indicate whether the option would generate money if it were instantly executed.
In the money options
Let’s understand this in terms of a call option. “In-The-Money Options” or ITM Options signify that the current market value of the stock is higher than the strike price of the stock.
Out of the money options
Similarly, an “Out of the Money Option” of an OTM option signifies that the contract has no intrinsic value and the strike price of the stock is higher than the current market value of the stock.
At the money options
These are the options whose strike price and the current market price are at equal levels or very near to each other.
How to Trade Options in Alice Blue
The obvious step after learning and understanding about options trading is to know how to trade in Options at Alice Blue. The very first step you need to take is, Open an Account with Alice Blue.
If you’re confused between a Demat and a Trading account, read our blog on Demat Vs Trading Account.
So, moving on to the account opening process, if your Mobile no. is linked with Aadhar, you can open the Trading & Demat Account online.
Follow the simple process given below:
- First, visit our website and click on Open an Account.
- Fill in your Name, Email, Mobile Number, and State, and click on Open an Account.
- Upload account opening documents.
- Provide an IPV (In-person verification) by showing your PAN towards the camera along with your face.
- E-sign the documents by verifying your Aadhaar with your Mobile Number.
- Your account will be activated within 24 hours.
Documents Required To Open An Account:
- Identity Proof (PAN Card Mandatory)
- Address Proof (Aadhar, Voter ID, Passport, etc)
- Income Proof (Latest six month’s bank statement, Latest ITR copy, Three month’s salary slip)
Once you open your account, we will provide you a Trading Platform. Using this trading platform, you can do anything related to Trading and Investment.
Option Trading Strategies
We understand this article has been a little lengthy, so to keep it simple we will be only giving a list of options trading strategies used in the stock market. You can read about them all in detail in this article.
Since options trading can be a little tricky, there are options trading strategies to your rescue. These strategies can help you gain an advantage over other investors when it comes to establishing a position in these options.
We have divided the strategies into 4 categories, which we will elaborate on in the coming articles.
1. Option buying strategies
- Long Call Option Strategy
- Short Put Option Strategy
- Bull Call Spread Option Strategy
- Bull Put Spread Option Strategy
2. Option Selling strategies
- Short Call Option Strategy
- Long Put Option Strategy
- Bear Call Spread Option Strategy
- Bear Put Spread Option Strategy
3. Neutral Trading Strategies
- Long Strangle Option Strategy
- Short Strangle Option Strategy
- Long Straddle Option Strategy
- Short Straddle Option Strategy
- Butterfly Option Strategy
4. Options Hedging Strategies
- Iron Condor Option Strategy
- Collar Option Strategy
- Butterfly Option Strategy
- Long Calendar Spread With Calls Option Strategy
- Long Calendar Spread With Puts Option Strategy
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know: