Definition of Trade Options
Options are derivative instruments and they provide the buyer of the options contract an option, but not an obligation, to buy or sell the underlying security at a pre-determined rate known as the strike rate on or before the expiry date. There is no actual delivery of the underlying security and the buyer of the option has an option to either exercise the option and realize the net profit or loss on account of price differences or to not exercise the option in which case the contract will lapse.
How to Trade Options?
If you wish to try your hands in options trading, then these are some things that you would need to follow:
- Step 1: Decide the type of options contract to trade: There are two types of options trades namely call option and put option. A call option allows the buyer of an option to buy the underlying security at the pre-agreed price i.e. strike price on or before the expiry date and the put option allows an options seller to sell the underlying security at the strike price on or before the expiry date. If you speculate that the price of the underlying security is expected to move upwards as against the current price then you would consider buying the call option and if you expect that the price will move downwards then you can consider buying the put option.
- Step 2: Predict the magnitude of price movements: If you want to make profits in the options contract you would buy an options contract that is “in the money” i.e. ITM. An options contract is said to be ITM when the underlying stock’s price remains above the strike price in case of a call option and when the underlying stock’s price remains below the strike price in case of a put option. An investor must speculate how much the price is expected to move so that the strike price can be selected accordingly.
- Step 3: Selection of the strike price: The selection of the strike price should be based on what extent the prices of the stock are expected to change. This means that when buying a call option, you would choose a strike price less than the expected price, and similarly, for a put option, you would choose a strike price that is more than the expected price. Also, make sure you consider the premium payable on such strike prices since it adds to your costs.
- Step 4: Selection of the expiry period: The expiration date is the last day by which you can excise an options contract. For example, the options contracts can be for 1 month, 3 months, and so on. If you are an experienced trader you can go for daily or weekly expiration dates as well but selecting a longer expiration term gives you the flexibility to monitor the price movements.
- Step-5: Action at the contract expiry: An options buyer gets the right to execute the contract at the strike price irrespective of the prevailing prices of the underlying security. A call options buyer will exercise the option only when the current price is more than the strike price and realize the resultant gains. Similarly, a put options buyer will exercise the option only when the current price is less than the strike price and realize the resultant gains. If the situation is reversed, then the buyer of the option will not exercise the option and the contract shall lapse. Also, an options seller is under the obligation to accept the decision of the buyer of the option.
Example of Trade Options
To understand how options trading works, let us take an example.
Example: Suppose, an investor decides to buy an options contract on an underlying stock of ABC Ltd. The current price of the stock is $50 and the lot size is 100 stocks. Based on the current market position and the available information, the investor speculates that the price of the stock is expected to move upwards to $56 in 3 months. How the investor shall proceed for trading options contract in this case.
Solution: The investor can follow the following course of action in this case:
- Step 1: Decide the type of options contract to trade: Here the price of the underlying stock is expected to move upwards as against the current stock price. Accordingly, the investor shall buy the call option.
- Step 2:Predict the magnitude of price movements: The investor speculates that the price can move upwards up to $56 and hence the magnitude is speculated by the investor. The investor would select a strike price based on this speculation.
- Step 3: Selection of the strike price: The investor should select a strike price below $56 since the price is expected to move upwards up to 3 months. Let us assume that the investor selects the strike price as $54.
- Step-4: Selection of the expiry period: Since the investor has speculated the price movements over a period of 3 months, it would be better to consider the expiry period of 3 months.
- Step 5: Action at the contract expiry: Once the contract has been executed and the expiry date has also arrived, the options buyer can decide whether to execute the contract or not based on the prevailing stock price. In this case, the buyer of the option will exercise the contract if the current price falls above $54 which is the strike price, or else the buyer will let the contract lapse, and the losses, in that case, would be limited to the premium already paid.
Investors who have a good market understanding and who are able to research well above expected price movements are able to perform better in the options market. Yes, there are automated tools that the new investors can use for knowing the price signals but there is no replacement to the research work. You must use an options contract only when you have good knowledge of the same or else you can incur significant losses.
This is a guide to How to Trade Options?. Here we also discuss the definition and example of trade options along with an explanation. You may also have a look at the following articles to learn more –