Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T11:02:11+05:30
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Derivatives trading is a great way to leverage your active trading experience and earn money more efficiently. One of the common derivatives trading that offers high returns with limited downside risk is options trading. Other derivatives include forwards, futures, and swaps. In this article, you will get to know options trading tips for active traders.

Options Should Be Thought of As an Extension of Stocks

As a trader, how many times have you been in a situation where you were confused to decide on holding or selling security? These are similar instances where options trading comes to your rescue. It provides flexibility at times of trade setbacks.

Stock trading alone is restricted to initiating bullish exposure by buying stocks and bearish exposure by shorting stocks. Successful trading depends on your ability to correctly guess the direction of a stock. Options allow you to bet long or short with less overall risk and capital expenditure. 

These additional benefits are just a fraction of what you get with options trading. Options are just additional tools that traders have in their toolboxes to express their investment ideas.

Options Can Put the Odds in Your Favor

If executed properly, you can turn the odds in your favour using options strategies. With options strategies, you can execute trades with a 50% plus profit probability. These are not trades that add extra risk compared to just trading stocks. They can reduce your risk. With these types of setups, options only trade stocks. 

When you take long positions in a stock, you have to increase them to make a profit. When you short a stock, you want the stock to go down to make a profit. These two trades represent a 50% result. Basically, no real gain. Consider that you are bullish on stocks and can make money if the stock rises, stands still or falls slightly. This is where options can become critical to portfolio success. 

Most people would agree that Warren Buffett weighs the odds in his favour when making investment decisions. What you may not know is that he is one of the largest option users in the world. When used correctly, options offer many opportunities to gain an advantage in trading. 

Fear and Greed Can Mean Big Profits for Options Traders

There are times when a stock's outlook is bad enough that the risk/reward trade-off looks good to an options trader. Trades that go against consensus can often skew the odds in your favour. We've all seen stocks bounce based on news, market noise, etc., only to eventually return to their earlier prices.

Exercising options on such events can provide attractive trade setups where greed and fear present opportunities for savvy investors. When these opportunities present themselves, it is beneficial to calculate the outcome of all possible scenarios from scratch. If things are right, it's time to act.

The willingness to take advantage of market volatility is an asset that patient investors know how to exploit. You may not always be on the winning side of a trade, but if you, the investor, are continuously looking for scenarios with the most profitable position, you can be ahead in the long run. Investing is a long game, so shifting your focus from "players" to "houses" will give you the edge you need to succeed.

Options Can Enhance Portfolios Like No Other Tool Available

Improving your portfolio does not necessarily mean adding more risk. Instead, it may mean using options to reduce risk and add income to your portfolio which is not possible by trading stocks alone. It may or may not need improvement. 

The key is to pay attention to the right settings that will benefit your portfolio in the long run. Whether your goals are steady growth, income-oriented, or short-term, making the right bets in your favour will set you up for success.

Consistency is the goal you want when deciding to expand your portfolio. Options traders have good times when their portfolio is expanding and portfolio is under pressure. Perceiving these times with a clear head is paramount. Just like an auto mechanic is as good as his tools, options traders need to use the right tools at the right time to improve their portfolios. 

There is some effective improvement strategy for all options traders, especially beginners. Options trading rarely needs to be complicated to have an impact on your portfolio.

Patience Is the Options Trader’s Route to Profit

Trades can be good, bad, winning, and losing. Some good deals you lose and some bad deals you win. The key is to realize that your best chance of success is with good, solid, solid deals.
One area where stock and options traders can struggle is patience. They feel the need to trade aggressively all the time. A patient options trader to a batter waiting for his pitch-perfect in the box. Those are where you swing because it's the right time and the odds of success are high.

Patience in options trading is no exception. Acting recklessly without a game plan can result in a strike. But if the perfect setup is waiting to come along with the right stock, it's the Sloths.

Knowing the difference between a good and a bad deal is the biggest part of this struggle. Focus on trading smarter and your batting average will go up. 

Plan Your Exit in Advance

Planning your exit is not just about minimizing your losses if something goes wrong. Even if the deal goes your way, you still need to have an exit plan and a time frame. Uphill and downhill exits must be pre-selected.

But it's important to remember that for options you need more than just the price target above and below. Also, you should plan a time frame for each exit. 

The expiration accelerates as it approaches. Therefore, if you are long a call or put and the expected move does not occur within the expected timeframe, exit, and move on to the next trade. 

However, the passage of time is not always painful. Time decay works when you sell without owning the option. In other words, if time decay hurts the price of an option, you are successful and can sell it and maintain the premium you received. Note that is of maximum benefit. The downside is that you may face significant risk if the trade goes wrong. 

The bottom line is that you should have a plan for getting out of every trade, regardless of what strategy you are using and whether you are a winner or a loser. Don't let greed hold you back from making profitable trades or hang around among the losers for too long in the hope that the trade will turn back in your favour. 

What if I leave early and leave something on the table? 

This is a typical trader concern and is often used as a justification for not sticking to the original plan. The best counterarguments are: What if you could make more consistent profits, lose less, and sleep better at night? 
Trade with a plan to establish more successful trading patterns and keep your worries at bay. While trading is exciting, it's not a one-hit wonder. Plan ahead and then stick to it like glue.

Try not to trade just to recover the losses

When faced with a trading scenario that does the exact opposite of your expectations, it is often tempting to break all sorts of personal rules and keep trading the same options you started with. As such, it may be tempting to buy more shares and lower the net cost base of the transaction. But be careful. 

Everything doesn’t need to provide value in the stock market. Then how you can trade better? Options are derivatives. That is, its price does not move in the same way as the underlying asset and does not have the same characteristics. 

Doubling can lower the cost-per-contract base for the entire position, but generally only increases risk. When a deal goes wrong and you're thinking about a previously unthinkable situation, take a step back and ask yourself: Then don't do it. Close trades, cut your losses and find another meaningful opportunity. Options offer great leverage for relatively little capital but dig deeper and they can explode quickly. It is much wiser to accept the loss now than prepare for a bigger disaster later.

How can you trade smarter?

Keeping the above options tips in mind can help you make better investment decisions, especially while trading options. It is also wise to use various options strategies instead of getting into naked contracts. Some commonly used options strategies include:

Covered Call: Here, you can hold the security and sell a call option, to take advantage of a minor increase or decrease in the underlying stock price for the life of the written call option.
Protective Put: A protective put offers unlimited profit potential because the put buyer also owns the underlying stock.
Bull Call Spread: This strategy can be implemented when your expectation about the security price is moderate and very aggressive.
Bull Put Spread: You can execute a bull put strategy when your market view is moderately bullish.
Bear Call Ladder: Bear call strategies are executed when you are confidently bullish on security.


Q.1: What is the most profitable way to trade options?
Ans: The most profitable options strategy is to sell out-of-the-money put and call options. This trading strategy allows you to accumulate large amounts of option premiums while reducing risk. Traders who execute this strategy can earn returns of around 40% per year.

Q.2: What should you not do in options trading?
Ans: As much as it is important to have an entry plan, you should not forget about the exit plan. Research the trade, position size, volatility, and affecting events carefully before diving into it.

Q.3: Which time frame is best for options trading?
Ans: The appropriate time frame for options trading depends on your purpose and research of the trade. However, a range of 30-90 days can be a good time frame for most trades.

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