Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T11:00:50+05:30

Introduction

Derivatives are a type of financial instrument that derives their value from their underlying assets or group of assets, such as stocks, bonds, and commodities, among others. It can trade on an exchange or over-the-counter. Investors consider derivative trading to increase market efficiency.

There are typically four types of derivatives trading: forwards, futures, options, and swaps. In this article, you will learn how to trade options in detail.

What is options trading?

Options are derivative contracts that provide the buyer with the right to buy/sell the underlying at a predefined price at a specific date in the future. Option buyers pay a premium to avail the right of buying/selling to the option sellers.

If the market price is unfavourable to the option holder, the option will expire and become worthless. Conversely, if the market moves in the direction of making that right more valuable, the investor will exercise it.

Typically, options are of two types: Call and Put. Call options give the contract buyers the right to buy the underlying asset and put options allow the contract buyers the right to sell them at a pre-defined price. The pre-defined price in an options contract is known as the strike price or exercise price. 

For example, you estimate Company XYZ's stock price to touch INR 90 within the next month. You check the premium and find the premium to buy an option contract for this company is INR 4.50 with a strike price of INR 75 per share. That means you’ll pay INR 450 for your options contract (INR 4.50 x 100 shares).

Later, the stock price begins to rise as per your expectation and stabilizes at INR 100. Before the expiry date on the options contract, you execute the call option and buy all 100 shares of Company XYZ at INR 75 (the strike price) for INR 7,500.

Since it’s worth INR 100 a share, you can then sell your new stock on the market for INR 10,000. Your profit would be INR 2,050, since you’d need to take the original INR 450 options contract into account (INR 10,000 - INR 7,500 - INR 450 = INR 2,050).

How to trade options in four steps?

Options trading provides flexibility to traders and investors. If executed properly with complex strategies like spread and combinations, there’s a potential profit in every market scenario. Below is a simple four processes on how to start options trading:

1. Determine your objective

Having an investment objective is non-negotiable in any type of investment. Options trading is no different; it is important to answer why are you trading options in the first place. Are you looking to hedge an existing position or are you speculating on the bullish or bearish nature of the underlying asset? Or are you looking to earn a premium by selling an options contract?

Options trading can be used for either of these reasons:

  • Speculation: All transactions are based on investor anticipations. Markets only work if someone is willing to sell and someone on the other side is willing to buy. The speculation involves significant risk of loss. The main reason for speculation is the potential for big profits.
  • Hedging: Hedging is an advanced strategy that seeks to limit the risk of financial assets. Some of the common hedging techniques include offsetting derivative positions that match existing positions.  Other types of hedges can be constructed through other means such as diversification. An example is investing in both cyclical and anti-cyclical stocks.
  • Arbitrage: Arbitrage is the act of buying and selling assets simultaneously in different markets to take advantage of price discrepancies. These opportunities arise due to market inefficiencies. It is a common practice in forex trading and stocks listed on multiple exchanges, and are typically short-lived. However, it’s uncommon to find such an opportunity.

 

2. Risk-reward payoff

After you formulate your investment objective, analyze the risk-reward payoff based on your risk tolerance or appetite. Risk is the degree of uncertainty and potential loss inherent in an investment decision and not the loss itself. A risk-reward analysis helps you in managing the risk of losing money or trades. 

If you consider yourself a conservative investor or trader, aggressive strategies like writing puts or buying large amounts of deep out-of-the-money (OTM) options may not be the ideal option. Not all options strategies have a well-defined risk and reward profile, so make sure you fully understand them.

 

3. Devise a strategy

Strategizing your options trading is crucial. First research the volatility of the underlying asset and other contributing factors and events that can potentially affect the prices in either direction. Knowing all of the above can help you strategize a better options trading strategy.

For example, let's say you're a conservative investor with a sizeable stock portfolio and want to capture premium income before companies start reporting quarterly earnings in a few months. Therefore, you can choose a covered call writing strategy to write calls on some or all stocks in your portfolio.

You can combine multiple options to devise a strategy to realize a profit. Some examples of the options strategy include:

  • Covered Call: In this strategy, you hold the underlying asset and sell a call option. This is a very popular strategy as it generates income from the premium and reduces the risk of being long on the stock alone. The trade-off is that you must be willing to sell your shares at a set price—the short strike price.
  • Protective Put: They are often used when an investor is going long or buying stocks or other assets that they want to keep in their portfolio.
  • Bull Call Spread: In the bull call spread strategy, an investor buys calls at a given strike at the same time and sells the same number of calls at a higher strike at the same time. Both call options have the same expiration and underlying.
  • Bear Put Spread: In a bear put strategy, an investor simultaneously buys put options at a specified strike price and sells the same number of put options at a lower strike price.
  • Protective Collar: A protective collar strategy is executed by buying an out-of-the-money (OTM) put option and simultaneously writing an OTM call option (with the same expiry date) when you already own the underlying asset.
  • Long Straddle: This happens when you simultaneously move ahead with a long call and put option on the same underlying asset with the same strike price and expiration date.
  • Long Strangle: Here, the investor purchases a call and a put option with a different strike price: an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset with the same expiration date.
  • Long Call Butterfly Spread: This is more complex for an investor who will combine both a bull spread strategy and a bear spread strategy. They will also use three different strike prices. All options are for the same underlying asset and expiration date.
  • Iron Condor: This strategy is devised by writing an out-of-the-money (OTM) put and purchasing an OTM put of a lower strike–a bull put spread–and selling one OTM call and buying one OTM call of a higher strike–a bear call spread.
  • Iron Butterfly: In this strategy, an investor writes an at-the-money (ATM) put and buys an OTM put. Simultaneously, they will also sell an ATM call and buy an OTM call.

 

4. Establish parameters

Now that you have identified the specific option strategy you want to implement, all that remains is to set the option parameters such as expiration, strike price, and option delta. For example, you may want to buy a call with the longest possible maturity but the lowest possible cost. In this case, an out-of-the-money call may be appropriate. Conversely, if you want a higher delta call, you can also choose the in-the-money option. 

Why trade options?

Once you are well-versed with the option strategies, there is potential to generate massive returns with limited downside, if traded mindfully. It offers a low-cost way to buy and sell in the markets with limited downside risk. Options also offer traders and investors more flexible and complex strategies such as spreads and combinations that can potentially be profitable in any market scenario.

Some of the major advantages of trading an option include:

  • Cost Efficient: An investor can have an option position similar to a stock position with the benefit of huge cost savings. For example, to buy 100 shares of an INR 80 stock, an investor must pay out INR 8,000. However, if the investor were to purchase one INR 20 call, the total outlay would be only INR 2,000 (1 contract x 100 shares/contract x INR 20 market price). The investor would then have an additional INR 6,000 to use at their discretion.
  • Lesser Risk: It is not as easy as it sounds and there are situations in which buying options is riskier than owning equities, but at times, it can help in reducing risk. It all depends on how you trade options.
  • Potentially High Returns: If you can get nearly the same return for less, you get a higher percentage return. Once they have paid off, the options are usually presented to the investor. Keeping a risk-reward ratio in check is necessary here.
  • More Strategic Alternatives: Lastly, they offer more investment choices. Options are a very flexible tool. There are many ways to replicate other positions using options, called synthetic options.

For example, a covered call, i.e., selling call options while holding the underlying stock, can help you benefit in the sideways market. Most covered calls are sold out of money (OTM), generating an immediate income. If the stock falls slightly, goes sideways, or rises slightly, the options will expire worthless with no further obligation. If the stock rises and reaches above the strike price on the expiry date, the stock will be called away at a profit in addition to the income gained from the options premium. The most important thing to keep in mind is how you trade options.

What’s the premium?

A premium is a price you pay an option seller or "writer" to enter into an option contract. A premium is paid to the broker, which is passed to the exchange, and from there to the writer. The premium is a percentage of the underlying asset and is determined by various factors including the intrinsic value of the option contract. The premium will always change depending on whether the option is in-the-money or out-of-the-money.
 

  • In-the-money: An option contract is in-the-money if it would be profitable if sold at the current time.
  • Out of the Money: This situation occurs when the option contract cannot make a profit when sold at the moment.
  • Strike Price: The price at which the option contract ends.
  • Expiration Date: Option contracts have a fixed duration. It may take 1, 2, or 3 months.
  • Underlying Asset: These can be stocks, indices, or commodities. The option price is determined by the price of the underlying asset.

Bullish or Bearish?

With options trading, you are betting on the price movement of the underlying asset. Therefore, choosing an option depends on whether you expect the price to rise or fall.

There are two types of options: calls and puts. A call option gives you the right, but not the obligation, to buy a specific stock at a specific price. A put option gives the right to sell the stock. If you expect the stock price to rise, you should choose the call option. A put option is better if the price is falling.

FAQs:

Q.1: How can I start trading options?
Ans: Trading options can be risky if not done with utmost care and knowledge. You can start gathering knowledge of the same and decide on which underlying asset you would want to buy or sell in an options contract.

Q.2: When do options trade during the day?
Ans: Just like equity trading, you can trade options anytime during the market hours from Monday to Friday. The market hours are 9.15 am IST to 3.30 pm IST.

Q.3: How a beginner can trade in options?
Ans: Trading in options is an advanced investment bet. For a beginner to start trading in options require a little practice and knowledge of the market to begin. It’s more advisable to learn it via mock trials under a supervisor.

Q.4: Where do options trade?
Ans: Typically, options traded on exchanges are called exchange-traded options. However, some private deals are executed that are known as over-the-counter (OTC) options.

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