Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T11:06:58+05:30

Introduction

Over the last decade, there has been tremendous growth in the financial markets. Consequently, there are various financial instruments and products available to investors. These choices often confuse investors. The primary factor to consider while choosing a product is the investment purpose which ranges from periodic returns, capital protection, wealth appreciation, and tax benefit to risk mitigation.  

Investors either trade or invest in the financial markets. Typically, the time horizon for trading is short-term and ranges from a couple of days to a year. Investing in instruments is long-term, and the time horizon ranges from one to five years. 

The investment avenues include equity instruments, fixed income securities, real estate, foreign exchange, or commodities such as gold, silver, crude oil, rice, and wheat. There is one choice that investors are relatively unaware of, i.e., derivatives.  As the name suggests, derivatives obtain their value from the underlying asset. Derivatives include futures and options. This article will discuss options' characteristics, benefits, risks, and options trading.  

Best Stocks for Options Trading

Options are a type of derivative contract that confers the right, but not an obligation, to purchase or sell the underlying security at a predetermined price on or before the expiry of a future date. The buyer of the options contracts pays a premium and holds it till expiry. The seller of an option contract earns the premium in exchange for delivery on the expiration date if the buyer exercises the option. In India, option trading is limited to equity stock and extends to indices (NIFTY, SENSEX), exchange-traded funds and commodities. 

An investor must understand the below characteristics of option contracts to select the best stock for trading – 

Strike price – Strike price refers to the predetermined future price of the underlying asset agreed on before entering into the contract. 
Spot price – Spot price refers to the current market price of the underlying asset. 
Expiration date – The expiration date is when the option matures or ceases to exist. An option contract may have three maturity dates – Near month (maturing after a month), middle month (maturing after two months) and far month (maturing after three months). 
Lot size – Lot size is the minimum quantity of the underlying asset in an options contract. For example, the lot size of RIL is 250 shares. The lot size for each security and asset class varies. The exchange revises the lot size regularly. 

Options trading is lucrative and allows investors to earn maximum profits with minimum capital investment. Options are easier, safer, and more cost-efficient to trade than other investments such as bonds, real estate, etc. However, the risk associated with options trading is relatively high. Options trading is a derivative trading platform for institutional and retail investors. Therefore, it is imperative to choose the best stocks for options trading. 

Investors require expertise and knowledge to trade options and effectively make them a profit tool. Thorough technical and fundamental research of the underlying asset is a prerequisite to option trading. The research includes analyzing financials, past price trends, trading volumes, industry research and competition analysis. 

Factors to Consider Before Choosing Stocks for Options Trading

Time Horizon

One of the most important factors to consider while choosing a stock for option trading is the investment period. The options market is complex and extensive. A wide range of trading instruments is available in the spot market itself. These include complex contracts such as short saddles, iron condors and calendar spread. Therefore, it is relatively seamless to identify a contract that meets your requirement. 


Volatility

Volatility measures the degree of stock value appreciation or depreciation over some time. Investors compare a stock's price movements with its average price to calculate volatility. Options trading involves a high level of volatility compared to traditional stock trading. Some experts opine that profit potential is maximum for stocks with high volatility.

High volatility stocks are ideal for aggressive investors. Aggressive investors can take advantage of events such as geopolitical incidents or economic fluctuations that cause unexpected price movements before expiry. 

Intrinsic Value

The intrinsic value of an option refers to the value of the option if exercised in real time. The intrinsic value of an option is the difference between the option's strike price and the underlying asset's spot price. Traders analyze intrinsic value while purchasing or selling an option. 

The intrinsic value of a financial instrument is not an indicator of the underlying asset's market price. Intrinsic value and market price are independent concepts. 


Time Value 

Time value means that a sum of money is worth more now than the same sum of money in the future since money can grow over time through investing. In options trading, time value is the degree of increase in an option's value over the contract's tenor. The intrinsic value of an option includes the time value of money. 

The time value of a call option is more than a put option since the buyer of a call option has more time to exercise the right to buy the underlying asset at the strike price. Ultimately, a call option buyer has more time to profit from exercising the option before expiry. 


Risk Appetite

Option trading is relatively unexplored in India. It is appropriate for investors with a high-risk appetite. Furthermore, options trading involves short and medium-term instruments. The reduced time horizon increases the uncertainty associated with options trading. The profit and loss potential for options trading is significantly high. 
Options trading does not entail any guarantees or obligations. An options trader is individually responsible for any losses incurred during trading. 

Trading objective

Investors trade in options with specific objectives. These include:

  • Hedging – Hedging refers to mitigating or reducing the risk associated with a financial instrument. The purpose of hedging is not to benefit from price movement but to reduce risk from a trade. For example, an investor with a substantial investment in blue-chip stocks may purchase NIFTY puts to offset any potential loss from the price reduction. 
  • Speculation – The primary objective for traders to indulge in options trading for price speculation. Speculation refers to betting on price movements for gains. Speculation is short-term and highly risky. 

The trading objective enables the investors to choose an appropriate strategy for trading.

Call options

Consider a call option similar to the down payment for purchasing a car. You decide to purchase a car and make a down payment when signing the contract. With the down payment, you have the right but not the obligation to purchase the car. However, the seller of the car will not wait indefinitely for the balance payment. You have a fixed period to purchase the car. If not, the seller forfeits the down payment.    

A call option provides the buyer with a right, but not an obligation, to purchase the underlying asset at a predetermined future price on or before the expiry date. The buyer of a call option is bullish and expects an increase in the underlying asset's price. The buyer pays the seller an upfront premium while entering the contract. 

Suppose the underlying asset's price (spot price) is higher than the strike price (predetermined price), then the buyer exercises the option. The buyer can purchase the underlying asset at a price lower than its market price. Contrarily, if the spot price is lower than the strike price, the option expires worthless. The buyer will prefer to purchase the underlying asset from the open market rather than exercise the option. In both cases, the premium is a cost for the buyer. For the buyer of a call option, there is no limit to the maximum profit potential. The maximum loss for the buyer of a call option is the premium paid.

A call option is in-the-money if the spot price of the underlying asset is greater than the option's strike price. The buyer profits from the trade if it is in the money. If the strike price of the option is lower than the spot price of the underlying, then the option is out-of-the-money, and the buyer suffers a loss. When the spot price equals the strike price, the option is at the money.

Within call options, there are two types – naked and covered call options. Naked call options involve selling the call option without owning the underlying asset. The potential for loss from a naked call is unlimited since there is no limit on the possibility of a price rise. Thus, naked call options are risky instruments.

Investors with a lower risk appetite prefer covered call options. The covered call option is ideal for an investor holding some stock who wants to profit from any price increase. If the price rises, the investor may realize gains without selling the underlying asset. A covered call is a conservative strategy and may not be suitable for a bear market, especially if the spot price moves above the strike price.

Put options

In the above example, for a down payment to purchase the car, suppose you purchase a brand-new car. Now, you may purchase an insurance cover for the car to safeguard yourself from huge expenses in case of an accident. Similarly, traders purchase put options to mitigate the risk associated with falling prices. 

Put options are opposite call options. They provide the right, but not an obligation, to the buyer to sell the underlying asset at a predetermined future price on or before the expiry of the contract. The buyer of a put option has a bearish outlook and expects the underlying asset's price to fall. The buyer of a put contract pays a premium to the seller. 

For example, you hold 100 shares of HDFC Bank Ltd and expect the price to fall short. To benefit from the price fall, you purchase put options of HDFC Bank Ltd at Rs. 1400 per share. The current market price is Rs. 1500 per share. You pay a premium of Rs. 100 per share to purchase the put option. 

On expiry, the spot price of HDFC Bank Ltd is Rs. 1200 per share. The strike price of the put option is Rs. 1400 per share. Therefore, you may exercise the right to sell the underlying shares at Rs. 1400 rather than selling the shares in the open market for Rs. 1200. The difference between the strike and spot price is the profit from the put option. In this case, you gain Rs. 200 (Rs. 1400 – Rs. 1200) per share. Premium paid is adjusted against the profit. The net profit from the transaction is Rs. 100 (Rs. 200 – Rs. 100). 

Suppose the spot price for HDFC Bank Ltd is Rs. 1450 on expiry. You can sell the shares in the open market for Rs. 1450 instead of exercising the put option and selling the underlying at Rs. 1400. The put option expires worthless. Premium paid on purchasing the put option is a cost for the buyer. The maximum profit potential is if the underlying asset's price is zero. The maximum loss potential from put options is the amount of premium paid.

A put option is in-the-money if the underlying spot price is greater than the option's strike price. If the spot price exceeds the strike price, the put is out-of-the-money, and the buyer is disadvantaged. A put option is at-the-money if the spot is equal to the strike price. 

Often, traders use put options as a hedging tool since it allows the buyer to benefit from falling prices. Simultaneously, put options let the buyer benefit from any dividend, voting rights or other benefits that the company may declare since the buyer need not sell the underlying asset. Traders refer to this type of option as a 'married put'. 

Risk appetite

A trader's risk appetite is important when deciding on an investment avenue. Generally, the risk involved in futures and options transactions is relatively high. Among options, some trades are safer than others. 

For example, using an option to hedge risk is safer than speculating with options. Similarly, deep out-of-the-money options with low premiums tend to be extremely risky. Naked call options are also risky since the potential for loss is significant. Similarly, writing or selling a call or put option involves a higher risk than purchasing an option. 

Thus, you must assess your risk appetite and understand the risk associated with each trade before execution. 

Conclusion

Options trading is rewarding for traders willing to test unchartered waters. Options allow traders to use leverage and maximize profits. The USP of options trading is no limit to the profit potential. The maximum loss is the premium paid. Also, options trading is a zero-sum game. There is no win-win situation. If you win, then someone else loses and vice-versa. 

Purchasing options is relatively safer than investing in stocks or futures. The downside to purchasing shares is unlimited if the share prices go into a freefall. The same applies to future contracts as well. Unlike options, futures do not provide an exit if the price movement is contrary to expectation. 

The primary disadvantage of options is that they are complex and difficult to understand. Traders consider options to be advanced investment avenues suitable for experienced traders. Another downside to options is that traders do not own the company. Unlike shares, options traders do not have dividends, voting or any other type of rights. Options are purely speculative if you bet on prices falling or rising.

However, the shortcoming of options trading is quite insignificant as compared to its advantages. Understanding the framework of options trading for beginners is time-consuming. You may track and analyze the most active options to gauge what's popular with investors. Learning and understanding option trading strategies are also helpful. Study the impact of political and economic factors on stock prices. Lastly, practice your skills in a simulated environment before diving into the markets. 

It is pertinent to note that writing or selling options are extremely risky. Option writing has the capacity for outsized losses, and investors must understand the implications before writing options. Failing to do so may lead to devastating losses. 

FAQs:

Q1. Is Buying options a good idea?
Ans. The maximum potential for loss in buying an option is the premium paid. Therefore, the risk associated with buying options is low, whereas the potential for reward is high. Hence, buying options is a good idea. 

Q2. Are options safer than stocks?
Ans. The capital commitment required to buy options is much lower than purchasing stocks. Also, the downside for options is limited as compared to stocks. Many traders believe that options are safer than stocks.

Q3. How do you trade options for beginners?
Before entering a trade, beginners must fully understand the potential ramifications of options trading. Traders must conveniently identify and understand the underlying asset, its strike price, expiration and premium. 

Most brokers offer options trading along with margin accounts. Traders may trade online or through the broker. 

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