Options trading can seem difficult at first, but it’s a powerful way to take control of your financial investments. This guide is designed to break down the fundamentals of options trading, making it easy for you to understand key concepts and strategies, so you can start trading with confidence
Introduction
Options trading involves buying and selling contracts that give you the right, but not the obligation, to buy or sell an underlying asset, such as stocks, at a predetermined price (strike price) before a certain date (expiration date). Options are valuable because they offer the potential for high returns and can help protect your investments against market risks.
3 Important Things to Know
1. Time Decay (Theta)
Time decay refers to the decrease in value of an options contract as it approaches its expiration date. Its value diminishes as time passes. As an option gets closer to expiration, its value decreases even if the underlying stock's price remains the same.
Tip: Time decay is your friend if you are an option seller.
You purchase an option for ₹1,000 with one month left until expiration. After two weeks, due to time decay, the option's value might drop to ₹600.
2. Volatility (Vega)
Explanation: Volatility measures how much the price of the underlying asset fluctuates. High volatility typically increases the value of options because there’s a greater chance that the option could become profitable.
If a stock’s price is usually stable, an option might cost ₹200. However, if there's news expected to cause significant price movement, the same option could increase to ₹500.
3. Risk-Reward Ratio
Explanation: This ratio compares the potential profit of a trade to the potential loss. A favorable ratio means the potential profit outweighs the risk involved.
If you risk ₹500 on an option and stand to earn ₹2,000, your risk-reward ratio is 1:4, indicating a good trading opportunity.
Strike Price and Expiration
- Strike Price: The price at which you can buy or sell the asset if you exercise the option. If you have a call option with a strike price of ₹500 and the stock rises to ₹600, you can buy the stock at ₹500, potentially earning ₹100 per share.
- Expiration Date: The last day on which you can exercise the option. After this date, the option becomes worthless. If your option expires on September 30th and you haven’t used it, you lose the premium paid for the option.
Call Options and Put Options
Call Options
A call option gives the buyer the right to buy an underlying asset at the strike price before the expiration date. This is a bullish strategy, suitable for traders who believe the underlying asset's price will increase.
- You expect a stock to rise from ₹300 to ₹400. You buy a call option with a strike price of ₹350. If the stock reaches ₹400, you can exercise the option and buy the stock at ₹350, then sell it in the market for ₹400, making a profit of ₹50 per share.
- Profit Potential: Unlimited.
- Risk: Limited to the premium paid for the option.
Put Options
A put option gives the buyer the right to sell an underlying asset at the strike price before the expiration date. This is a bearish strategy, suitable for traders who believe the underlying asset's price will decrease.
- You expect a stock to fall from ₹200 to ₹100. You buy a put option with a strike price of ₹180. If the stock falls to ₹100, you can exercise the option and sell the stock at ₹180, even though the market price is only ₹100, making a profit of ₹80 per share.
- Profit Potential: Limited to the strike price minus the premium paid.
- Risk: Limited to the premium paid for the option.
.webp)
.png)
.png)
