A Beginners Guide To Options Trading

02 May, 2022

7 min read

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Understand what options trading is and the strategies it commonly employs.

Options Trading 101

For the uninitiated, options serve as a kind of derivative contract that provides the purchasers of said contracts (i.e., the option holders) with the right – but not the obligation – to buy or sell a security at a price of their choice in the future. Sellers of options charge buyers of these contracts an amount called a premium that provides them with this right. In the event that market prices are unfavourable for options holders, they have the right to let the option expire at a worthless value and can choose not to exercise this right. By doing this they can ensure that the potential losses they could incur don’t exceed the premium they paid. On the flip side, in the event that the market moves in a favourable direction such that exercising this right is a valuable decision, options holders can exercise their right.

Options are ordinarily split into “put” and “call” contracts. The former entitles the buyer to sell the underlying asset at some point in time in the future at the previously agreed-upon price. In contrast, call options see the buyer of the option availing the right to purchase the underlying asset in the future keeping in mind the agreed-upon price. This agreed-upon price is called the strike price or exercise price.

Popular Strategies

When looking at F&O trading for beginners, as far as call and put options are concerned, investors can utilise the following strategies such that their risks can be limited.

Buying Calls

If you wish to place a directional bet in the market, you will find that there exist certain advantages as far as trading options go. In case you feel that the price of an asset is likely to rise, you can purchase a call option with the aid of less capital than the asset itself. During this time, in case the price of the asset falls instead, your losses will remain limited to the premium you paid to purchase the options and not extend beyond them. This is particularly useful if you happen to be a trader who is bullish about an ETF, a certain stock or an index fund and wishes to restrict the risk you expose yourself to. It is also ideal for those who wish to employ leverage in order to benefit from rising prices.

Buying Puts

While a call option provides the holder with the right to buy the underlying asset at a set price prior to the contract expiring, a put option provides the holder with the right to sell the underlying asset at a set price. This is particularly useful if you happen to be a trader who is bearish about an ETF, a certain stock or an index fund and wish to expose yourself to less risk than what a short-selling strategy might expose you to. It is also ideal for those who wish to employ leverage in order to benefit from falling prices.

Covered Calls

Operating far differently from the previous two strategies, a covered call involves the contract being overlaid atop a pre-existing long position relating to the underlying asset. It can be understood to be an upside call that is sold for an amount that would help offset the existing position size. This manner allows the covered call writer to collect the option premium as an income while limiting the upside potential of the underlying position. If you as a trader anticipate no change or modest increase in the underlying asset’s price and collect the full option premium this is ideal for you. It is also suitable for traders that are amenable to limiting the upside potential in lieu of some downside protection.

Protective Puts

Here, you must purchase a downside put for an amount that is enough to cover the existing position of the underlying asset. This essentially means that you create a lower floor below which you can’t lose more money. That being said you are obligated to pay the premium applicable to the option. This method basically serves as an insurance policy against losses. Traders that own the underlying asset and wish to procure downside protection gravitate towards this strategy.

Married Put Strategy

This strategy functions in a similar manner to the previous one (i.e., protective puts) and requires you to purchase an at-the-money (or ATM) put option at an amount that covers the existing long position in the stock.

Protective Collar Strategy

Here, investors that own long positions in the underlying assets purchase downside or out-of-the-money put options while simultaneously writing an upside or out-of-the-money call option for the same stock.

Assessing the Levels of Options Trading

It isn’t uncommon for brokers to assign different levels of options trading approval keeping in mind the risk and complexity associated with them.

  • Ordinarily, Level 1 is associated with covered calls and protective puts wherein the investor already holds ownership of the underlying asset
  • Level 2 features long calls and puts along with straddles and strangles
  • Level 3 features options spreads wherein the trader must purchase one or more options while simultaneously selling one or more different options relating to the same underlying asset
  • Level 4 involves selling naked options that are unhedged. This means that the trader exposes himself to unlimited losses here owing to which this is the most complex level

Wrapping Up

Options trading is a possibility online and requires you to ordinarily apply for options trading, gain approval and then begin your trading journey. Visit the Angel One website today such that you can understand more.

 

Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.

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