Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T18:05:26+05:30
Listen icon

Introduction

Options are known for being derivatives contracts. Using options, buyers may purchase or make a sale of a security at a specific rate in the long run. These buyers must pay a certain fee known as a premium to the sellers to enjoy the liberty of this right. 

In case the market prices are not suitable for the option buyers, they can allow this right to be left unexercised. This helps affirm that the potential losses are at a better position than the premium. But if the rights become valuable due to the positive rise in the market moves, then the implications of this right are important. 

If you are learning options trading for beginners, you might not have understood this fully. That is why it will be a good practice to read more. 
 

What Is Options Trading?

The process of selling or purchasing a specific asset at a pre-determined rate and date is called options trading. This type of trading involves a thorough understanding of opening an options account, numerous advanced strategies, and mindful trading. It is equally significant to learn about how to trade options, as not being well-acquainted with it could bring you closer to incurring massive losses. 

Stock options trading is generally tougher than stock trading. This is because the purchase of stock merely requires you to decide upon the number of shares you wish for. However, there are tons of factors you must consider when trading options. It is also cardinal for you to learn the difference between both future and options put together. 

Generally, options are classified into two types of contracts- put and call. In a put option, the buyer has the liberty to make a sale of the underlying asset in the future at a pre-negotiated rate. On the contrary, with a call option, the contract buyer gets the opportunity to purchase the underlying asset in the long run at a pre-negotiated rate. This may also be known as the strike rate. This is why options trading for beginners is crucial to understand in detail. 

Options can help generate income when the market conditions are not suitable. It can also help safeguard against downsides. That is why if you learn about how to trade options, you could be inching closer to mindful profit-making. 
 

How are Trade Options Using Four Easy Steps?

Step 1- Open An Options Trading Account 

To start trading in options is not the endgame. Before you do that, it is crucial to have a trading account in your name. We have already talked about how options trading can be far more complex than the concept of trading in stocks. This is also because options trading may require significant amounts of capital.  

In this type of trading, brokers also prefer to learn holistically about those investors to make sure they are suitable for this type of trading. Once they affirm that, they might issue a permission slip to them at the earliest. So, options trading for beginners India may not be very easy. 

When the broker interviews you, it is necessary to provide them with the information they are looking for. Tell them about your investment objectives. You may have to tell them about your capital speculation or preservation, income growth, and even capital. Next, you may even be asked about your knowledge in the field of investments and options trading. 

At this point, you must answer accurately and smartly, as this will help them understand your trading experience. You can also talk about the most successful options strategy at this point. Also, do not forget to provide your personal financial details and the type of options you wish to choose as per your preference. 

Step 2- Pick The Options To Buy Or Sell 

We have already talked about the two types of options that you can choose from- Call and put. Now, it depends upon the direction in which you want the underlying stock to make movements which will help you analyze the form of options you wish to opt for. For this, here’s how to make a mindful decision- 

●    In case you are looking for the stock price to stabilize- you may sell either a call or a put option. 
●    In case you are hoping for the stock price to go high- sell a put but buy a call option. 
●    In case you are anticipating the stock price to go low- purchase a put but sell a call.

We will also recommend you take some options trading example to make the best choice. You can also seek the expert assistance of a financial advisor. These people may also be able to help you gain extensive knowledge in this field. As a result, you can inch closer to making a mindful choice. 

Step 3- Predict The Options Strike Price 

The purchase of an option is only relevant as long as the stock price closes the expiry period of an option. This must happen either below or above the strike price. It is significant for you to want to purchase an option with a strike price that represents the location of the prediction of your stock. 

Let us take an example- In case you assume that a specific company has a share price of Rs. 8,276 will increase to Rs. 9,931 by a predicted date, it is advisable to purchase a call option. Make sure that the call option you purchase has a strike price of less than Rs. 9,931. In case the stock rises above the strike price, your option is likely to be in the money. This is how you can learn more about options trading in India. 

In the same way, if you suspect that the share price of the company is falling to Rs. 6,621, it is best to purchase a put option with a strike price above this. In case of a strike price drop, your option is likely to be in the money. In this process, it will be useful to learn about numerous options trading strategies in need. 

Step 4- Analyse The Time Frame Of The Option 

There is an expiry date for every option contract out there. This implies the final day for one to use the option. Again, here the individual cannot simply pull out a date from nowhere. The choices are fairly restricted to the ones that are delivered. That is why it is significant to know more about futures and options trading for beginners. 

The expiry dates of Options may vary from weeks, months to even years. The riskiest is the daily and weekly options. These are generally booked for seasoned option traders. Those investors who have been in it for the long term prefer the monthly and annual options. When the expiration is long, it allows the stock to move with more time. That is why it is significant to learn about options trading strategies for beginners. 

Remember that although a longer expiration can be expensive, it can also be quite useful. This is because it may significantly help in retaining time value. This is irrespective of the stock trade being below the strike price. With the expiration closing in, the time value of options starts to decay. However, the option buyers cannot see their purchased options go down in value.
 

Advantages And Disadvantages Of Trading Options

Advantages- 

1. High Return Potential 

Although buying shares in cash can help you gain good returns, the ones with options trading provide higher returns. This is why with options, you can pay an equal profit just like the simple stock buying if the right strike is selected. With options on a lower margin and receiving the same profitability, you can expect a better return percentage.

2. Better Availability Of Strategies 

Options markets have a host of available strategies to implement. Each of the trades can be combined, which can help to form a strategic position. This will be achieved with the assistance of both put and call options of numerous strike prices and expiries. 

3. Cost-effective 

Options are available for many uses. But what is most enticing is the fact that both an investor and a trader can easily acquire the options position equivalent to a stock position at a fairly low margin. 

4. Low Risk 

Options can be a risky affair. In fact, they can be far more risky than owning equities. But we must also consider that they can help avoid risk in many ways too. If you learn about options trading for beginners, you will know more about the advantages that you can receive from this form of trading. 

Disadvantages

●    High commissions
●    Less liquidity 
●    Non-availability of stock options
●    Time decay
 

What Are The Levels Of Options Trading?

There are four major levels of options trading for beginners. Let us learn about each of them in detail. 

Level 1- Protective puts and covered calls. This is when an investor already has an underlying asset. 
Level 2- Both puts and calls are lengthy. This involves strangles and straddles. 
Level 3- This stage includes the purchase of one or multiple options. In this stage, selling one or multiple options of the same underlying asset also occurs at the same time. 
Level 4- This one includes naked options where there can be the possibility of incurring numerous losses. Options trading for beginners can thus be a risky affair to get into without prior knowledge of these four levels of trading. 
 

Conclusion

Today, the concept of options trading is available to all types of individual traders. Even if you are a beginner, options trading can be a good call. However, make sure you have an online broker to help you and a margin account ready. 

When your options trading is approved, the orders can be entered to trade these options. This can be done by leveraging the power of an option chain. This can help evaluate the expiry date, strike price, and more. Accordingly, you may decide to place limit orders or market orders for that specific option. 

As a beginner, you might also want to learn about certain options trading strategies. For starters, there are many kinds of strategies to learn about. Married put strategy, protective collar strategy, long strangle strategy and vertical spreads are the most common ones. All of these strategies are pretty straightforward and may be useful for both experienced and beginner-level investors. 

However, there may be many other questions relating to this type of trading that you might want to ask about. Let us help you receive answers to each of them one by one as we read. With this, you can start trading options more effectively than ever. 
 

Open Free Demat Account

Resend OTP
Please Enter OTP

By proceeding, you agree to the T&C.

More About Derivatives Trading Basics

Frequently Asked Questions

There are four easy steps to trading options using this app. 

Step 1- Find Out Your Objective 

There are many reasons you might desire to trade in options. This may range from hedging and speculations to arbitrage. Now, you need to identify one of these reasons and create a strong objective for why you wish to trade in options. 

Step 2- Risk-reward Payoff 

Come up with a suitable risk-reward payoff. This must entirely rely on your risk appetite. Remember, only bet as much as you can afford to risk. 

Step 3- Create A Strong Strategy 

We have already talked about the numerous options trading strategies you can choose from. Learn about each of them in detail and then create your strategy around them. 

Step 4- Flourish Parameters

Now, you must set the options parameter. This includes setting up option delta, expiration, and strike price. 
 

Options trading occurs in a very similar manner to that of equity trading. This type of trading can occur whenever during market hours. The market hours take place between Monday to Friday. The timings are 9.15 am IST to 3.30 pm IST. So, make sure you trade accordingly for minimal inconvenience. 

Generally, those options that are traded on exchanges are known as exchange-traded options. But you may want to know that a few private deals are also implemented that may be known as over-the-counter options. 

Yes, many brokers do provide commission-free trading both in ETF and stock options. However, some amount of fee is still involved in it. Generally, there is a fee-per-trade. Alongside, there is a commission per contract. 

Although most beginners think that options trading may be risky in their initial stages, it can be fairly convenient with sufficient knowledge for them in this field. In fact, it can be an important investment tool for all types of beginners who wish to know more about this field. 

There is no need to invest lump sum capital in options trading. You can start with an amount as small as Rs. 2 Lakhs. Remember, starting small can help you be a careful trader and allow you to incur fewer losses in the initial stages. 

Although there are many strategies for options trading to choose from, you must select the one that is most useful. Apparently, a straddle is the most effective options trading strategy.