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Saturday, February 23, 2013

Simple Guide to Options Trading!

Question: I am interested in trading in Stock and Nifty Options. Can you please guide on how to be profitable in Options Trading.

Options are a major trend in Indian Stock markets now, with turnover in Options category being significantly higher than that of Stocks, Index or Derivatives category. Just to take an example, on 22-Feb-13, turnover for Index Futures at NSE was 7,220 crores, turnover for Stock Futures was 16,574 crores and turnover for Index Options was a whooping 87,077 crores.

So options have become an instrument of choice for Traders – both Retail and Institutional traders – in Indian Stock Markets. As our Finance Minister remarked recently, Indian markets are primarily non-delivery based, meaning majority of trades do not result in deliveries and are cash settled. Options in Indian market are cash settled as well with no delivery taking place at the option expiry date.

Simply speaking, an option is a bet on direction of either the underlying Index e.g. Nifty or a given Stock. When a trader is taking a position in Options, he is either buying or selling an options contract, and is making a bet that either the underlying instrument will rise in price or fall in price before the monthly expiry date. Obviously, if the direction is predicted accurately, the trader stands to hold a profitable position, which he can close at or before the expiry date.

Options are basically of two types – Call Option and Put Option. A buyer for a Call option is taking a position that underlying instrument e.g. the Stock or Nifty Index, would rise in value before expiry date. A buyer of Put options is taking the opposite position that the underlying instrument e.g. the Stock or Nifty Index, would actually fall in value before expiry date.

However, there are few more things to keep in mind, before you jump in Options trading. One should be aware of the strike price and days remaining before expiry as well. Options decay in value as their price is dependent on variable known as Theta, which is also known as the rate of decay. Simply speaking, if you are an options buyer, your options will lose a little bit of value each day, even if the underlying instrument is not moving at all, due to time decay.

Due to this reason, professional traders or large institutions are biased towards options selling, rather than options buying, as they can benefit from this time decay if underlying instrument is not moving at all. However, option selling is akin to selling insurance and hence is detrimental to an individual retail trader as the potential liability can be significant if volatility increases overnight.

Another way to benefit from options is to take a combination trade in Options. A trader expecting the Stock or Index price to change dramatically in next few days can buy an Options Straddle. A long straddle involves purchasing both a call option and a put option on same stock or Index at the same strike price and expire date. For example, if Infosys is coming up with its quarterly results and investors are not sure whether it will be a positive result or not, one can buy a Call option and Put Option at same strike price, preferably closer to current stock price. If results are good, Call options would rise in price and would make up a profitable trade, else if results are less than expected Put Options would result in profits for the trader.

Another simple way to trade in options for a trader already holding a stock is to execute a Covered Call. This strategy has to be adopted in bearish markets for stocks which are not expected to rise in price. If a trader is holding a stock in cash segment, he can sell the corresponding Call options for the stock. When the stock declines in price as expected, the call options would be worthless and seller of Call options would get to keep the option premium which he received while selling the Call Options. If the stock goes up, since the trader is already holding the stock in cash market, he would get compensated with the price rise of his holdings. This is a useful strategy for slightly bearish markets.

This is a simple primer, however Options trading is a complicated subject and one needs to do significant research before jumping in Options trading. With the high Options volumes witnessed in Indian markets, Options trading is much more coveted than cash trading or Futures trading and here to stay for long.

1 comment:

  1. can you give me step by step process to do buying and selling in stock option with real exmples?


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