When you think of investment, buying stocks might be your first priority. Indeed, you can’t replace the real benefits of long-term stock investment by anything else. Some of you are probably completely unaware of the term options trading. You will find an enormous amount of derivatives out there in the market.
A stock option is one of them. A stock option is very popular among traders and is becoming more and more common for decades. Stock options trading are very similar to stock trading. In stock trading, your primary aim is to make profits by buying stocks at low and selling them at a higher price.
Similarly, you can trade options contracts for making profits by buying low and selling high. Options traders usually trade options for speculative purposes. However, some traders implement them for hedging purposes to insure their large stock position in case of any crash happen going forward.
Is Stock Option Suitable for Beginners?
Stock Option is not really a useful attempt if you are a newbie in the stock market. Chances are you may lose a boat lot of money if you’re not researched well and educate yourself enough. An option is a deteriorating asset. Occasionally you may manage to earn quick bucks. You can check here Investopedia options trading guide.
But it may not be always possible unless you know the basics of stock options trading. This is because of the fact that stock option pricing is dependent on many complex factors such as implied volatility of stocks and option Greeks that I will discuss in my upcoming posts.
Stock Option Definition:
Stock Option is a derivative of stock in the F&O segment (Future & Option). It is essentially a legitimate contract. It gives you the rights to buy at market price(not the obligation if you buy). But if you sell or write a lot (a bunch of stocks), you have the obligation to exercise it within a stipulated time frame.
A stock option contract has a time limit or expiration date that you can exercise anytime during the market hour. The specified option price termed as premium for a single piece of stock is driven by the various factors. They are implied volatility of stock, market demand/supply, and option Greeks. Option Greeks consist of Delta, Gamma, Vega, Theta and Rho.
How Can You Make Money Trading Option?
In options trading, you can make money usually in two ways. You can either take a long position or a short position on the underlying stock. If you think that a particular stock will go up in value, then you would buy a call option. And if that stock is likely to go down in value you will buy a put option. When you sell or write a call option or put option, you would have the obligation to buy it back within the expiry date.
Before giving the stock options a try, you should know that options trading is a much more complicated subject than stock trading and many a time it’s very daunting to beginners. You need to learn option terminology in detail before even invest your money. Fundamental as well as technical studies of underlying stocks, alongside the option Greeks can help you to grasp the basics of the subject.
How Does Stock Option Work?
The option works on the principle of giving you leveraging power. With this leveraging power, you’re able to buy a large number of high-quality stocks by paying a tiny amount termed as premium. Every stock options contract consists of exchange specified numbers of stocks or bunch of stocks called a LOT. In the USA, it’s usually 100 shares.
In the cash market, if you’re going to purchase that bundle of stocks, you will have to end up paying a huge sum of money. Fortunately, in a stock option trading, you don’t have to spend that money. With a fraction of your reserve fund, you will be able to buy a large number of stocks as a bundle or lot.
For example, you’re very bullish on Infosys Ltd and interested to buy 1200 quantity (Lot size) of it on 3rd October-2019 at a price INR 785 from the cash market. So you would have to spend INR 943,200.00 on this. Luckily in stock options trading, you need not spend that sums.
And here you’re supposed to buy One Lot (consisting of 1200 shares) Call Options contract of Infosys. You have opted for a Strike Price 790 CE and an expiration date 31st –October 2019 at a premium @ 23.50 (As per NSEINDIA) So your total investment would be approximately INR 28,200.00
If your prediction proves correct and within a couple of days it moved fast to 790 with a premium of say INR 30.00. Then with a small move of INR 5.00, you’ll be able to snatch a whopping profit of INR 6000.00. Here your ROI (return on investment) is around 21%. Wow! With even a bigger move, your profits really explode with endless potential. Now, would you be relishing? Unfortunately, this is not always possible.
What is the Stock Option Types?
There are two types of stock options that you will come across. One is Call Option and another is Put Option. A call option gives you the right to buy the underlying stock while Put Option gives you the right to buy it. But when you sell or write a call option and a put option, you have the obligation to exercise or buy back it again within the expiration date.
What does a Strike Price or Exercise Price signify?
The strike price is a fixed sequential price at which you can buy or sell an option contract. If you’re a buyer of the underlying call option or put option and it expires without your intervention, either it makes you money or ended worthless. When you’re a seller or writer, you must exercise the holding options or buyback before the expiry.
The strike prices are determined by the exchange in a sequential manner at which you’re able to bid an option contract. When you visit an Option Chain, you will find that there are many fixed price levels in a sequential manner at which you only can place your buy or sell bid. You can’t set your own buying or selling price.
What is Option Premium?
As an option buyer, you’ll need to pay the option seller a price that governs by the market demand and supply in exchange for the rights conferred by the option seller. This price is nothing but the Option Premium. Option premium varies with the market condition.
Sometimes the difference of ask-bid price is enormous. Many a time the premium is traded with fair market price. When there is a high level of volatility before any major event, the premium is quoted abnormally high. And right after the announcement of such events like the monetary policy of the Fed, the RBI or any central bank of respective countries, the premium dropped drastically.
What is the Different Style of Options?
An option contract is either American style or European style. Exercising of options contracts is depended on option style. American style options can be exercised anytime before expiration. While European style options can only be exercised on the expiration date. Mostly all of the stock options available today including the Indian marketplace are American-style options.
What is an Expiration Date?
Options are the contracts that are traded with a definite expiration date. This expiration date ranges from one month to several years. Before buying a stock option contract, you need to select a contract period or date of expiry of the contract. The option premium varies with the expiry date. If you chose a long period of contract, premium usually quoted higher.
Likewise, for short period of contract, premium is supposed to be lower. On the date of expiry, option contract either ended in ITM (In-the-Money), ATM (At-the-money) or OTM (Out-of-the-money) option. Once the stock option expires in ATM or OTM, your stock option becomes worthless.
What ITM, ATM, and OTM Signify?
If you’re an option buyer, you can easily calculate whether you’re in a profit or end up in a loss. On the date of expiry or anytime before an expiry, just seeing the price of your underlying stock, you can determine its profitability. If the stock price stays below the strike price of your call option, your call option ended in OTM and becomes worthless.
When the stock price just coincides with the strike price, your call option landed in ATM. And your option contract still becomes worthless as it has no intrinsic value. Your call option contract is only profitable when the underlying stock price rests above the strike price (in ITM).
Your put option contract is more or less in the opposite in character. When the stock price is hovering above the strike price of your put option, your put option expires in OTM and becomes worthless on expiry. And if the stock price coincides with the strike price, the put option still expires worthless. Your put option only becomes profitable when the stock price trades lower than the strike price and expires in ITM.
How Do You Calculate Your Stock Option Loss or Gain?
As you can cash-in profit only when your stock option landed in ITM (In-the-money), I am going to discuss the ITM scenario here for your ease of understanding. This is because you’ll get no intrinsic value for both your ATM and OTM options.
For instance, if the stock price of Infosys Ltd is trading at INR 790.00 and the premium of a call option for October-31st, 2019 at the strike price 790 CE is quoting approximately INR 25.00. Now, suppose on the day of expiry @ 31st October the stock price of Infosys to be close at INR 840.00.
Then what will be your gross profit? In this case, your total investment is INR 30,000.00 (lot size-1200*25.00). And your gross profit will be 1200*50.00=60,000.00. So your net profit before deducting brokerage and taxes would be 30,000.00 (60,000.00-30,000.00)
Why Should You Trade Stock Option?
A stock option is chiefly aimed at hedging purposes. For instance, if you have a large number of stocks in your holding and want to protect them from a big correction in a bear market. And in this case, what you need to do is buy sufficient lots of put options by paying premium to offset the loss. Needless to say you’re going to spend some money to acquire that can be a wasted endeavor.
But the loss you spent is scanty as compared to the loss thus you suffer had the underlying stock crashes during a correction. This is like you paid the insurance premium and a mishap happens in the near future. If an untoward incident really strikes, your insurance company will compensate you for the financial loss. But if your stock is not corrected as your predicted and stays there, you will end up losing your paid premium.
Market participants also trade stock options purely on the speculative ground. The speculators are the trader who bet on their money anticipating a big movement in the stock price in either direction. Let’s suppose you’re a speculator and very bullish on a stock that is very likely to go up in price.
Your prediction might have based on positive news or fundamental or technical analysis. To minimize your loss or owing to small fund size, you might buy a call option of that stock, instead of buying the stock outright by investing huge sums of money. An out-of-the-money call option may only cost bucks as compared to the full price of a single lot.
How Do You Exercise Options?
If you already hold an option in the American style, you can easily exercise a call option or a put option any time on or before its expiration date. This would allow you to trade the stock option at a predefined price regardless of what the current market price is for that underlying stock.
This way you will have the privilege of exercising stock options in a situation where you fear that the stock prices might go too high or too low for you. Thus you will be in a piece of mind for getting a certain degree of insurance on the investments you made.
How Do You Trade Options?
In trading options, you will often find that the premium or pricing of an option may not be justified and it proves quite complicated. Besides the implied volatility and option Greeks, the premium of an option contract is basically depended on two major factors- the pricing of the underlying stocks and the time remaining within the contract period.
The price of the underlying stock directly affects the premium or price of the option. If the demand for the stocks is high, the price for the options will also go up and vice versa. The amount of time left within the options contract also determines the price of option. As time expires, the price for the option may go down. This is happened because of the effect of Theta or time value.
Why Do You Sell or Write Options?
Selling or writing option contract is the most complicated part of options trading. When you write a stock option contract, it treats like a stock future contract. When buying a call option or a put option, you have no obligation but the right to do so and you need to pay the premium upfront. And in the case of selling or writing an option contract, you would receive the premium or your account would be credited. Wow, this is great! You may think so.
But in an actual case, you just expose your trading account to unlimited amount of loss. Every time your underlying stock moves in the opposite direction as you predicted, it could daunt your pocket heavily. This is why your broker may call for an additional margin to compensate the loss. You can consistently make a good amount of money month after month when you have enough suitable F&O stocks in your holding.
Selling or writing of options is opposite of buying an option. When you are bullish on a stock, you would write a put option. Similarly if you’re bearish on a stock, you would write a call option.
Suppose you have 300 quantities of AAPL (Apple) stocks sitting idly in your account and you’re bearish on that stock. You are aware that there is major resistance at around $233 and you don’t think it can break that resistance. So you sell or write three lots (containing 300 shares) of AAPL call option with a strike price of 230 and premium $3.7 per share for October 25, 2019 expiration. (As per Nasdaq )
This way your account is credited with $1110 which you got by selling the lots. This is done by using the sell to open order. If the stock price stays below the strike price, call option premium loses its value. This way when you buy back your call option, you would be able to book a whopping profit.
But if the stock price crosses the threshold limit of strike price with bullish signals, you would want to exercise the contract by buying it back to save you from disaster. This way you can minimize your losses that are aggravating further. Writing an option is usually a very riskier trade. But if you do it tactfully like a pro you would be able to trade option profitably.
A stock option is a derivative of the underlying stock. It can give you a tremendous leveraging power if you anticipate the movement of the stock precisely. But it’s almost impossible to predict the next move of the stock price accurately. It’s true that with the help of technical analysis as well as fundamental analysis, you only can make a rough prediction.
And if you’re a savvy trader, you will try to take advantage of result updates, implied volatility, and option chain analysis of a potential stock. On this basis, you become highly speculative and want to make short-term gains. But here, the value of Theta is the killer for you. Theta is basically the time value. The option premium is heavily subject to time decay.
As the time to expiration is approaching, option value decreases if the stock movement becomes stagnant. When a stock option is about to expire within a week, the premium is deteriorating very fast. Studies show that around 70% options buyer loses money. This is why I prefer to write stock option on the basis of technical analysis (especially Elliott Waves). And also analysis of option chain alongside with the implied volatility (IV) analysis.
But you should refrain yourself from options trading unless you acquire sound knowledge about options trading. Otherwise option trading is the only way to bankrupt you. If you want to know more details about option, you should visit Chicago Board Options Exchange. So before giving a try on options trading, you need to ask yourself “Is stock option trading my cup of tea?’’