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Beginner’s Guide To Option Trading

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Options Trading

By: Tavaga Research

Options fall under the category of derivative instruments. To understand the inherent nature of options, it is important to understand what derivatives are.

Financial instruments that derive their value from an underlying asset are commonly known as derivatives. For example, an option being a derivative, the price of an option will depend on another underlying asset. Options may have stocks, commodities, currencies, or any other security as their underlying. 

An option contract gives the investor a right to participate in a trade. An option contract is not an obligation in that the option may or may not be exercised. Options contracts give the option buyer the right to either buy or sell an asset at a pre-specified price at or before the expiration date of the contract.

The right that the option provides comes at a premium, which is the cost paid upfront at the time of purchasing the derivative. In an option contract, the two parties involved are the option buyer (also known as an ‘option holder’) and the option seller (also known as an ‘option writer’).

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Option strategies, if designed carefully, can ideally suit any investment portfolio. Options provide the following benefits:

  • Income generation, through earning a premium for option writing
  • Hedging the risk in the portfolio by limiting the downside potential
  • Speculation about price direction of the underlying asset

Basic option concepts

What is a call option? 

A call option gives the option buyer a right, but no obligation, to buy the underlying asset at a pre-specified price within the expiration date.  Call options behave like fractional shares. As the price of the underlying share increases, the price of the option also increases.

What is a put option?

A put option is diametrically opposite to call options in that the put option gives the option buyer a right, but no an obligation, to sell an underlying asset at a pre-specified price within the expiration date. Put options limit the downside risk of the portfolio by providing a support level to the assets in the portfolio.

What is the strike price?

The strike price, also known as the exercise price, is the pre-specified price in an option contract. The pre-specified price in an option contract is the price at which the underlying asset will be bought or sold.  For call options, the strike price is the price at which the underlying asset will be bought. For put options, the strike price is the price at which the underlying asset will be sold.

What is the expiration date?

The expiration date of an option contract is the pre-specified date or the last day of the contract on which the option expires. If the contract is not exercised within the expiration date, the option expires worthless.

What is the option premium?

Option premium refers to the current market price of entering into an option contract. It is the cost that the option buyer has to incur and the income that the option writer generates from initiating the option contract.

The option premium is a factor of the intrinsic value and extrinsic value of the option. Intrinsic value is a close estimate of the difference between the exercise price and the market value of the underlying. The extrinsic value of the options depends on time to expiration (time value of the option) and implied volatility of the underlying asset. 

What is the moneyness of an option?

The moneyness of an option can be known by whether the option is ‘in-the-money’ (ITM) or ‘out-of-the-money’ (OTM).

An ITM option allows the option buyer to exercise the right provided by the option. For example, an ITM call option will give the option buyer the right to buy the underlying asset at a price lower than the prevailing market price. The premium for ITM options is predominantly attributed to intrinsic value. 

An OTM option means the option cannot be exercised, and ultimately lapse on expiry if such options do not become ITM. For example, a put option is OTM if the market value of the underlying is greater than the strike price. An investor can sell the asset at the market price, and let the option lapse. OTM option premiums are made up of the extrinsic value of the option contract. 

The moneyness of an option defines the behavior of option prices concerning variables such as sensitivity with the price of the underlying, time to expiration, and implied volatility. The moneyness also determines the payoff for the parties to the option contract. 

Option Trading Mechanics

Option contracts reflect a price opinion of the investor. An investor’s decision to buy a particular option is based on the likelihood of the future event materializing in the favor of the investor. An option likely to benefit the investor will demand a higher premium. This is precisely why options with a strike price at par with the market price of the underlying demand a higher premium. The probability of an option to fall in the money is higher in the case of such options. 

Similarly, option contracts with a longer time to expire come at a higher premium carrying a time value. Options suffer from time decay, that is, options become less valuable by each passing day. Therefore, 3-month options are more expensive than 1-month options, given more chances of a favorable price movement. 

The higher the implied volatility, the higher the option value. Volatility aids in large price movements that can be unfavorable or favorable. Again, such substantial price movements increase the chance of reaping profits from an options contract. 

Let’s say that Reliance Limited is trading at Rs 1,500 and an investor is of the view that owing to stellar performance and inflow of investments, the stock can go up to Rs 2,000. However, the investor is unsure of the effect that the pandemic may have in the short-term. The investor can buy a call option with a strike price of, say Rs 1,500. Now if the stock moves up to Rs 2,000 at the expiration date, the call option will be exercised. If the stock falls due to adverse economic conditions, the option will lapse and the investor will only lose the premium paid for the option. Call option buyers generally adopt a bullish view. 

Similarly, put options protect the downside risk for the put option holder by acting as a stop-loss in case of sudden adverse movements.

Option Trading Strategies

Covered Call Strategy

Covered call strategy is a slightly neutral strategy, instead of a purely bullish or bearish strategy. A covered call is a strategy of buying stocks of a company and simultaneously selling the call options on the stocks bought. The call option sold is ‘covered’ by the long position on the underlying, so if the option buyer exercises the call option when the share price increases, the option writer can deliver the shares already held by them.

Why covered call?

  • Income generation: If the stock held by the investor is not expected to move much in the near-term, the investor can write call options just to earn the premium without having to deliver the shares. 
  • Target selling price: The investor wants to offload the shares at a certain target price and will write call options with a strike price equal to the target price. Once the call option becomes ITM, the option will be exercised and the investor can sell the shares at the target price, earning profit as well as the premium. 

Drawback of the strategy

  • The investor caps the upside potential by writing the call. If the stock price dramatically increases in price, the investor will have to deliver the shares to the option buyer and will not be able to book profits on the shares held.
  • The downside risk is prevalent in the form of the share price tanking to zero

Protective Put Strategy

The protective put strategy involves simultaneously buying of shares and put options on an equivalent number of such shares. 

Why protective put?

  • The strategy provides insurance to the investor by acting as a stop-loss function. Limiting the downside risk of a long position in a stock, the strategy sets the strike price as the floor price for the stock. If the stock moves unfavorably, the shares will be sold as the put option simultaneously gets exercised. 

Drawback of the strategy

  • The strategy increases the effective cost of the holding asset, as buying an option means paying a premium which is added to the overall investment base.

Bullish Call Spread Strategy

Bullish Call Spread is a moderately bullish strategy. The strategy involves buying two call options on the same underlying with the same expiration date but different strike prices. The investor will buy a call option at a certain strike price and sell an equivalent number of call options at a higher strike price. 

Why bullish call spread strategy?

  • The investor reduces the net premium spent on the option trade, as writing the option will earn some income. 
  • The downside risk is limited by buying the call option – limited loss.

Drawback in the strategy

  • The upside for the strategy is also limited by writing the call option – limited gain.

Bearish Put Spread Strategy

Bearish Put Spread is a moderately bearish strategy. The strategy involved buying two put options on the same underlying with the same expiration date but different strike prices. The investor will buy a put option at a certain strike price and sell an equivalent number of put options at a lower strike price.

Why bear put spread strategy?

  • The investor reduces the net premium spent on the option trade, as writing the option will earn some income. 
  • The downside risk is limited by buying the put option – limited loss.

Drawback of the strategy

  • The upside for the strategy is also limited by writing the put option – limited gain.

Protective Collar Strategy

The protective collar strategy is only applicable to out-of-the-money call and put options with similar expiration date and underlying asset. The strategy involves buying an OTM put option and selling an OTM call option. 

Why Protective Collar strategy?

  • If a stock in an investment portfolio has experienced a substantial price increase and the investor wants to lock-in the potential selling price, the investor can set a floor and a cap using this strategy.
  • Limited downside risk to extent of the net premium paid

Drawback of the strategy

  • The investor has to forego any further price increases in the share beyond the strike price of the call option written – limited upside. 

Long Straddle Strategy

Long Straddle Strategy is a non-directional that involves simultaneously buying a call and a put option on the same underlying asset at the same strike price with the same expiration date. The strategy is employed when the investor is unsure of the direction of further price movements.

Why Long Straddle strategy?

  • The strategy yields a positive payoff for any price movements regardless of the direction
  • Unlimited profit potential

Drawback of the strategy

  • If the price of the underlying stays close or equal to the strike price, the investors will incur a loss to the extent of the combined premium paid for the call and put options.

Long Strangle Strategy

Long Strangle Strategy involves simultaneously buying an OTM call and an OTM put option on the same underlying asset with the same expiration and similar strike price. The strategy is executed when the investor expects very large price movements.

Why Long Straddle strategy?

  • Like the long strangle, the strategy is non-directional with positive payoffs for large price movements
  • Strangles are not as expensive at straddles because the options purchased are OTM
  • Unlimited profit potential

Drawback of the strategy

  • If the price of the underlying stays close or equal to the strike price, the investors will incur a loss to the extent of the combined premium paid for the call and put options.

Is option trading profitable?

Option strategies have to be carefully designed and tested to become aware of the possible risks inherent in the strategies. Option trading makes use of leverage. Investors can play with a larger capital pool aside from their original capital investment. Therefore, the returns on option strategies are enhanced. 

However, option trading comes with its share of disadvantages such as:

  • Insufficient liquidity for some stocks and no option markets for many stocks
  • Immense risk exists, especially in the case of option writing, if the investor does not protect the downside appropriately
  • The strategies are complicated if not implemented with clarity. Investors have to be firm regarding the price belief and the time frame

Option trading tips for beginners

  • An option buyer should choose the option with a longer time to expiry to increases chances of a positive payoff
  • An option writer should go for the shorter expiration dates to limit the probability of an unfavorable event
  • Implement strategies with a low level of implied volatility. Lower volatility implies lower profit potential but also limits the loss by committing less premium
  • Expiration dates and strike prices should be decided after considering upcoming key events for the underlying, such as an earnings update
  • Understanding of sectors that the underlying asset caters to can also be a crucial deciding factor. For example, drug approval can go either way for a pharmaceutical company. A suitable strategy, such as straddle or strangle, can be designed to reap the benefits of non-directional price belief
  • Practice the strategies on simulators that allow testing a strategy outcome without committing real money

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