Are you a beginner? Know how to trade in options!

Are You A Beginner Know How To Trade In Options Are you a beginner? Know how to trade in options!

Options are simple products if you don’t complicate it too much. Let us look at a quick tutorial at how a beginner should go about trading in options. The learning process is the most important aspect here. Most investors tend to be wary of options as they consider them to be high risk products. As a beginner in options you need to understand the concept and appreciate that options are very useful when it comes to managing risk and for capitalizing on market volatility. Here is how to go about it.

Get the basics of options right at the start

Remember, that options are the right to buy or sell an asset without the obligation. Since it is a right without an obligation, you are required to pay a premium to the seller of the option. That is because the seller gives the buyer the right without the obligation. A right to buy is called a call option while a right to sell is called a put option. When options trade in the market, the price of the option is nothing but the value of this “right without obligation”.

The second very important thing to understand before venturing into options trading is the concept of ITM, OTM and ATM options. An option is in-the-money when the price of the stock is above the strike price in case off call options. If the price of SBI is Rs.320, then the Rs.300 call option will be ITM. Similarly, the Rs.340 call option will be OTM. In case of put options it is exactly the opposite as prices below the strike price will be ITM.

The third thing you need to learn is the concept of time value and intrinsic value of an option. Time value is not a consideration in futures but only in option. To understand time value you need to go back to ITM and OTM that we saw in the previous point. An ITM option has intrinsic value and time value. An OTM option only has time value. If the price of SBI is Rs.320 and the Rs.310 strike call option is trading at Rs.15, then Rs.10 (320 – 310) will be the intrinsic value and the balance of Rs.5 will be the time value. In case OTM call and put options, the entire premium will be time value and there is no intrinsic value at all.

Now, let us move to when to buy and sell options

Having understood the three main aspects of options, the next step is to focus on when to buy options and when to sell options. The decision to buy calls and puts will depend on your outlook. If you expect the stock price to go up, you can buy a call option and if you expect the price to go down you can buy a put option. In both cases, risk is limited to the premium paid but profits can be unlimited when prices moves in your favour. An important point to remember is not to be enticed by deep ITM options just because they have low premiums. That is what they are worth and the chances of making money are very small.

Having seen when to buy options, let us also look at when to sell options. Remember, that when you sell options your inflow is limited to the premium but losses can be unlimited. Unlike an options buyer who has an affirmative view on the stock, the seller of the options has a non-affirmative view on the stock. For example, a call option seller believes that prices will not go above a certain level and a put option seller believes that prices will not go below a certain level.

When to use options; to trade or to hedge?

You can use options to trade or to hedge risk or to create hybrids. Normally, the best use of options is for the second and third uses, not for the first. If you have bought an option, you can sell it in the market and book the profit or loss. Liquidity is not an issue in most of the index and stock options. However, to use options to just trade is to under utilize its potential.

More than for trading, options should be actually used for protecting against risk. If you have bought Tata Motors at Rs.180 in the cash market, you can protect by buying an Rs.175 put option at Rs.3. Your total cost goes to Rs.183 (180+3), but then your total risk is limited to just Rs.8 {180-175) + 3}. At no point will your loss cross this figure. Another smart way to use options is to reduce cost of holding.

The moral of the story is that options work best when used as a hedge or as a cost reducer.

OPEN online trading ACCOUNT BUTTON Copy2 Are you a beginner? Know how to trade in options!

2 Comments

Add a Comment

Your email address will not be published.