A Beginner’s Guide on How to Trade Options in India: Options Trading has been quite popular in India in recent days. Because of the pandemic situation, many new and existing traders have been able to understand and learn this new craft of trading (Options Trading).
Nonetheless, schools and colleges don’t teach the skills and steps required to trade Options, and hence most beginners find it challenging to learn how to trade options in India. Therefore today, we will see the step by step process on how to trade options in India in the most straightforward possible words. Let’s get started.
Brief Overview of Options Trading
The most common concept that most of you must have heard about trading via options is the power to leverage.
Leveraging in terms of Options trading would simply mean the power to trade at a higher capacity than what the direct value of trade would allow. Let us understand this with the help of a simple scenario from day-to-day life.
Say, Ram has a wedding in his house two months down the line and for the wedding, he needs to get 100 grams of Gold. The current price of 10gms of Gold is Rs. 50,000. However, Ram is a little sceptical about the volatility in the market and wants to lock in the current price of Gold, to be bought two months down the line. Therefore, intending to freeze the price of gold, he visits the jewellery shop and puts forward his proposition of buying the gold at the current price, two months down the line.
But looking at the current volatility, the jewellery shop owner is a little skeptical of taking the risk of fixing the price of Gold. Therefore, to incentivise the jewellery shop, Ram pays him a certain token money (say, Rs. 2000 per 10 gm of Gold) to fix the Gold price. Therefore, the total money paid by Ram to enter the agreement with the jewellery shop owner is Rs. 20,000.
Let’s suppose, if upon expiry (i.e. after two months) if the price of gold goes above Rs 50,000 (per 10 gm), then Ram will exercise his right to buy the gold at Rs. 50,000. However, if the price of gold after two months remains unchanged or goes down, then Ram is not obligated to honour the agreement. He merely stands to lose the token money (Rs. 20000), which he paid to enter into the agreement. And that becomes the income of the Jewelry shop owner.
For example, if the price of Gold were to increase to Rs. 57,000 for 10 grams, then the overall benefit of Ram will be –
= Total gold * (Price after two months – Current price – Premium paid) = 10*10*(57,000-50,000-2,000) = Rs. 50,000.
Now, if I were to relate this example to options, then the Ram is the Option buyer, the Jewelry shop owner is the option seller, Gold is the underlying asset, the current price of gold is the Strike price and token money paid is the option premium.
A similar scenario is also applicable to the stock market. Here, if the option buyer believes that the price of a share may go higher in the future (through his analysis or study), he/she may pay a premium to the options seller to enter in a contract to buy the stocks at the pre-decided value. Further, the premium paid might be an expense, however, if the share price goes way above the pre-decided agreement price, then the option buyer will make profits.
Basic Options Trading Definition
To define in financial terms, Options are a derivative instrument that gives the right to option buyer to buy the underlying asset at a pre-decided price from the option seller, on or before expiry.
However, the option buyer is not obligated to honor the contract upon expiry. He has the right to buy the asset if he chooses to. However, if he does not wants to buy (in case the current price goes below the pre-decided value), he will simply lose the premium paid beforehand.
Nevertheless, the Option seller is obligated to honor the contract as he/she has taken a premium at the starting of the agreement. And the option seller is compensated in the form of this fee (or premium) to give up his right on underlying assets till the expiry of the contract.
Option Trading – Example
Assume a stock is trading at Rs 67 today. You are given a right today to buy the same one month later, at say Rs 75, but only if the share price on that day is more than Rs 75, would you buy it?
Obviously, you would as after 1-month even if the share is trading at Rs 85 you can still get to buy it at Rs 75!
In order to get this right, you are required to pay a small amount today, say Rs 5. If the share price moves above Rs 75 you can exercise your right and buy the shares at Rs 75.
If the share price stays at or below Rs 75 you do not exercise your right and you do not need to buy the shares. All you lose is Rs 5 in this case. An arrangement of this sort is called an option contract, a call option to be precise.
After you get into this agreement, there are only three possibilities that can occur. They are:
1. The stock price can go up, say Rs 85
2. The stock price can go down, say Rs 65
3. The stock price can stay at Rs 75
Case 1: If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs 75. The P&L would look like this:
Price at which the stock is bought: Rs 75Premium paid: Rs 5Expense incurred: Rs 80Current market price: Rs 85
Profit: Rs 85 – Rs 80 = Rs 5
Case 2: If the stock price falls to Rs 65 it does not make sense to buy it at Rs 75 as effectively you would be spending Rs 80 (75+5) for a stock that is available at Rs 65 in the open market.
Case 3: If the stock stays flat at Rs 75 it simply means you are spending Rs 80 to buy a stock which is available at Rs 75, hence you would not invoke your right to buy the stock at Rs 75.
Whenever you expect the price of a stock (or any asset for that matter) to increase, it always makes sense to buy a call option!
Options Trading: Understanding Call and Put
As we have seen, options are nothing but contract between two parties (buyers and sellers of options) to buy or sell shares at a fixed price on or before the pre-decided date.
Usually, the shares are bought and sold in predetermined umbers and it is called a ‘lot’. Eg : Reliance Industries has lot size if 1000. That means the buyer and seller should come to agreement to buy / sell minimum 1000 shares or in multiples of 1000 shares of Reliance Industries.
Options are basically of two types: Call Option and Put Option
A call option gives the holder the right to buy a stock at a certain price (known as a strike price) by a certain date (known as an expiration). A put gives the holder the right to sell the shares at a certain price by a certain date.
A Call Option gives the buyer the right, but not the obligation to buy the underlying security at the exercise price, at or within a specified time. A Put Option gives the buyer the right, but not the obligation to sell the underlying security at the exercise price, at or within a specified time.
Options Trading: Picking the Right Broker
There are many stock brokers across the country who offer options trading as a service. But not all are good for options trading. The following factors should be kept in mind before choosing a broker for options trading:
Brokerage: Ensure profits are not cut down because of the higher brokerage you pay. Some brokers charge on a per lot basis and some other fixed brokerage irrespective number of lots. The second category of brokers works well for options trading.
Leverage: Exposure / margin becomes are critical criteria when one is interested in selling options.
Trading Platforms: Having state of the art charting tools help in arriving at the strike price.
Mobile Apps: Evaluate the stock broker with a mobile app with suitable features.
Options Trading: Tips for Beginners
Beginners option trader in to make a lot of mistakes in becoming a good option trader in India. Some tips to remember:
- Never forget Time Decay
- You May Lose Your Entire Capital
- Choose a Discount Broker to Trade in Options
- Always Trade in Liquid Counters
Benefits of Options Trading
Options Trading if traded properly has a lot of advantages. If one can predict the direction of the underlying correctly, options can give huge profits with small downside risk.
Leverage: With Options, one can buy higher number of shares with lesser amount.
Hedging: Options are used for hedging purposes. eg : When one is long on Nifty Futures, one could also exercise the put option to avoid any blackswan event that may result in a huge gap down opening next day.
Covered Options Trade: If an investor hold securities for long term, he can sell out of the money call options and have regular extra income.
Tax Efficient: When compared to Futures, Options are tax efficient. Since the tax is paid only on premium and not on total traded value, total tax out go is lesser.
Options Trading – Myths
A pervasive belief exists that options trading is risky. Firstly, one must understand that options were introduced as a means of effectively managing risk. Correct application of options in the form of various strategies enables an individual to trade in a systematic manner with reduced risk, provided an individual understands options trading instruments. There is no reason to consider options as risky because at all times the risks and rewards of any given trade are known.
Options Trading In India – Conclusion
Options involve leverage which is a double-edged sword. if used properly one can make an enormous amount of money.
If you are entering with intention of making quick money chances of blowing up your account is also high with options trading.
Trading options in India picked up momentum during Corona lockdown period. Many newcomers got attracted to option selling watching the fancy lifestyles of options traders in social media.
Selling options require a huge margin and also adjusting the trade if it goes against you need further margins.
They suffered huge losses and it is all because they did not know how to trade options in India. Before starting trading in options first learn the basics of options. Once understood, start small since the chances of making mistakes are high at the beginning.
Once you gain confidence and become profitable consistently, you can increase your bet.