In capital markets, money can be made in two ways: by investing in the cash market and trading in the derivatives market. Investing in the cash market entails purchasing financial assets such as stocks and betting on their potential for profit. Buying derivatives of stocks, such as futures and options, is an alternative to buying stocks directly. These are financial contracts between a buyer and a seller whose value is derived from underlying assets such as stocks. It is important to note that derivative contracts can be entered into for assets such as stocks, commodities, indices such as the Nifty, Bank Nifty, and so on.
Another unique aspect of a derivatives contract is that it only requires a fraction of the payment to purchase the underlying asset when compared to purchasing the asset in the cash market. For example, if one were to purchase 1000 shares of a publicly traded company in the cash market at INR 50 per share, a total payment of INR 50,000 would be required.
Instead, if one were to purchase a derivative of this stock, a fraction of INR 50,000, known as the margin, would be required. Assume the margin is 20% in this case. Thus, the total payment would be only INR 5000. This is also referred to as “leverage”.
Those who use options to make money are known as traders. Traders are unlike investors. A typical trader attempts to profit from daily market fluctuations. On the other hand, a long-term investor invests in the fundamental growth of the economy and the company in which he has invested.
What are Options?
Options, a type of derivative, are financial contracts whose value is contingent upon the value of an underlying instrument. The underlying instrument may be a stock, index, currency, commodity, or any other type of security.
Buyer and Seller of an Option: The buyer of an option has the right but not the obligation to buy or sell the underlying asset. If the buyer exercises their right, the option seller must honor the contract. The right to buy an asset is known as “Call”, while the right to sell is called “Put”. When a call option is purchased, the buyer anticipates that the underlying asset’s price will rise. Similarly, a put option is purchased when the buyer expects the underlying asset’s price to fall.
The seller of the option is also known as the “writer” of the option. The writer’s expectation differs from the buyer’s. When the option writer expects the price to fall, he writes a call option. He writes put options if the price is expected to rise.
It’s worth noting that the writer of an option has a much higher chance of making money than the option’s buyer.
Why Options?
The primary function of options is to assist investors in mitigating the portfolio risk caused by market volatility and uncertainty, known as hedging. Hedging is one of the strategies deployed by professional fund managers.
Besides hedging, traders use options to increase leverage for smaller initial investments. Interestingly, a large part of the trading volumes in options arises out of speculative trades to make quick gains arising out of market uncertainty and resulting volatility.
Since options trading is mainly focused on short-term price fluctuations, traders should have practical knowledge of technical analysis to understand the charts that depict price and volume data meaningfully. Apart from knowledge of reading and interpreting charts and other data, traders must adhere to strict stop loss. Trading is a game of discipline; emotions must be kept out of decision making.
Option Trading Terminologies: Meaning And Definitions
Premium: The price the option buyer pays the option seller to enter the contract. The option premium can be broken down into two components – intrinsic value and time value.
Intrinsic Value: The difference between the cash market spot price and the strike price of an option is the intrinsic value. It can be positive, zero or negative.
Time Value: Remember, options have an expiry date; therefore, time is of the essence in the options contract. Time value puts a premium on the time left to exercise an options contract. For example, if the time left between the current date and the expiry date of Contract A is longer than that of Contract B, Contract A has a higher time value.
Strike price: The Price at which the buyer and the seller of the option agree to enter the option contract. The strike price is fixed and does not change during the entire period of the contract’s validity.
Spot Price: The price of an option is based on some underlying asset or index. Spot price refers to the current market value of an underlying asset or index. The decision to buy or sell a call or put option is based on the expected future direction of the spot price.
Expiry date: Because options are derivative contracts, they have a fixed expiry date. The contract is valid until the expiration date. Because of this date, options traders have a limited window of opportunity to make money, making options trading a race against the clock in many ways. Most options contracts in India expire on the last Thursday of the month.
Lot Size: The minimum number or quantity of units that must be bought or sold under a contract. Lot sizes will differ from one contract to another.
Open Interest: Open Interest refers to the total number of outstanding positions on a particular options contract across all market participants at any time. Open Interest becomes zero post the contract expiry date
Moneyness of an option contract: whether an option is making money or not can be inferred from the term used to describe the moneyness of the option.
- In-the-money: One can make money by exercising the option. A Call option is ‘In-the-money’ when the underlying asset’s spot price is higher than the strike price. A Put Option is ‘In-the-money’ when the underlying asset’s spot price is lower than the strike price.
- Out-of-the-money: No money is to be made by exercising the option.
- At-the-money: A no-profit, no-loss scenario if one decides to exercise the option.
Best Option Trading Strategies Every Trader Should Know
Options Strategies: There are several hundreds of strategies an option trader can create to make money. Popular trading strategies such as a straddle, strangle, butterfly, iron condor, bull call spread, and bear put spread are used to optimize returns.
Option Greeks: Knowledge of options Greek is essential to making informed trading decisions. Option Greeks are the variables that measure the change in volatility, time to expiry and price fluctuations of the underlying asset, which impacts the value of options. They help traders identify new opportunities and emerging trends. Vega, Delta, Gamma, Theta and Rho are the main options Greek.
1. Vega – Volatility is the key driver of options price. Vega measures the sensitivity of option premium to changes in the underlying asset’s volatility. The higher the volatility, the greater the chance of changes in premium and vice versa. For the at-the-money option Vega is the highest because any change in volatility thereon will sharply move the premium up or down. It starts to taper when the option keeps getting in-to-money or out-of-money.
2. Delta – Delta is by far the most important and, thus, widely used Greek option. It quantifies the sensitivity of option prices to changes in underlying asset prices. A call option, for example, has a delta of 0.70. If the underlying asset’s price rises by one rupee, the option price rises by 0.70 rupees. A higher delta indicates greater sensitivity to changes in the value of the underlying asset. The delta of call options ranges between 0 and 1. Put options have a negative delta ranging from 0 to -1.
3. Gamma – Among the least used options Greek to formulate options strategies, Gamma shows how the Delta of an option will change for a one-point move in the underlying asset. At-the-money options have a higher Gamma, while it is lower for in and out-of-the-money options.
4. Theta – Because options have an expiration date, time is essential when making money through options. The premium has a built-in time value. The value of the option premium decreases with each passing day or week. As the expiry date approaches, the rate of decay accelerates. This is referred to as time decay and is quantified by the option Greek -Theta. Theta is highest for at-the-money options and lowest for deep-in-the-money options. Since it represents time, it is denoted in the negative.
5. Rho – Rho measures the rate at which the price of an option will change in response to a change in interest rate. For example, if a call option has a Rho of 1.0, a 1% increase in interest rate will increase the option price by 1%.
Advantages of Trading Options
- Options enable traders to make gains from rising and falling prices. All the trader needs is an anticipated significant price change, regardless of the trajectory of the price movement. Major economic events like monetary policy reviews, corporate results, mergers and acquisitions announcements, top management changes, etc., create uncertainty. By combining different types of options, traders can develop a strategy that generates profits regardless of the underlying asset’s price direction.
- Options are an effective tool for investors and traders. Using options strategies, investors can hedge their current investments against negative news or development. Traders, too, can virtually eliminate any risk associated with any trade by combining different types of options.
- Options require traders to pay a fraction of the contract value, known as the margin, compared to a transaction in the cash market which requires full payment. This means the trader can take larger positions with a given amount of money he has. Thus, he is in a position to make higher returns on the capital invested. It goes without saying that the risk taken also rises commensurately. While options were meant for hedging the portfolio, traders mainly use them for speculative gains.
- From the buyers’ standpoint, Options are less risky than futures or cash markets as the premium paid represents the maximum loss from purchasing options. Conversely, options writing is riskier as the trader carries unlimited risk.
Bottom Line
On the face of it, Options may seem like complicated derivative instruments with distinct terminology and esoteric strategies. However, once understood, they can be worthwhile financial instruments, providing risk mitigation, hedging and leverage. Since time is of the essence, traders must be on their toes, keeping a close eye on the underlying asset’s price movement and the information flow that impacts it. Quick decision making, maintaining strict discipline, and adhering to stop losses religiously is the key to success.
