What is Option Trading
Options are derivative contracts that grant the buyer the right, but not the obligation, to either buy or sell a sum of some underlying asset at or before the contract expires at a fixed price. Options can be acquired with brokers through online trading accounts as with any other asset group.
Options are important since they can help an investor hedge their risk or increase leverage for a smaller initial investment. To limit downside risks, a common example would be to use options as an efficient hedge against a weakening stock market. Often, options can be used to produce recurring revenues. Additionally, they are commonly used for speculative purposes, such as wagering on stock direction.
What is Option Trading?
One can buy or sell stocks, ETFs etc. at a fixed price over a certain period by online trading options. This method of online trading also gives buyers the flexibility not to purchase the security at the defined price or date.
Although options trading is a little more complex than stock trading, options can result in great upside potential with low downside risk, which is only limited to the premium you pay while buying the option. Similarly, selling options will reduce your losses if the security price goes down, which is called hedging.
Call and Put Options
A call option gives the owner the right to purchase an asset at a predetermined price, and a put option gives the owner the right to sell the same.
Options Trading Example
Let us try to understand the mechanics of options with the help of an example.
Suppose, you purchase a long call option for 100 shares of Company X at ₹110 per share for December 1. You’d be entitled to purchase 100 shares at ₹110 per share regardless of the actual price of the share is on December 1. On that day, if the shares of Company X are trading at a price higher than ₹110, you have the right to purchase them at a lower price, and hence, make profits. If, on the other hand, the shares are trading at a price lower than ₹110, you can simply choose not to exercise the option. The only loss you would have incurred would be the premium you paid while purchasing the call option.
Related Terms
1. Premium
It is the price you pay to the seller of the option for entering into the contract. You pay the broker the fee which is passed to the writer on the exchange and thereon. Premium is a percentage of the underlying, which is calculated by several factors, including the intrinsic value of the contract options. Premiums continue to adjust, depending on whether the option is in-the-money or out-of-money
2. American and European Options
‘American options' are options that can be exercised on or before their expiry date at any time. 'European options' are options that can be exercised only on the expiry date.
3. Open Interest
It applies to the cumulative number of available positions on an options contract at any given point in time among all market participants. Open Interest becomes zero for a given contract after the expiration date.
Conclusion
Options may seem like complicated derivative instruments, but they can prove to be quite useful financial instruments, providing you with the risk mitigation or the leverage that you need, while also protecting any downside risk. If you're well-versed in online trading options, there are sophisticated trading strategies in India such as a straddle, strangle, butterfly and collar that can be used to optimise returns.