Learn Basics, Strategies, Risk Evaluation, & Risk Management in Options Trading
Options can be great instruments for hedging and risk management. Options also open up a whole new world of trading strategies you can explore and use to make profits.
We’ve put together an options trading guide to help you get started.
Here’s what you will learn in this guide:
1. What are Options?
An option is a contract that gives the buyer the right (without the obligation) to buy or sell the underlying security or asset at a predetermined price (strike price) by a predetermined date (expiry).
Options belong to the derivatives segment, as their price is derived from the price of something else, which is the underlying asset or security.
2. What are Call and Put Options?
There are two types of Options – Call option and Put option
A call option means that the buyer of the call option has the right but not an obligation to buy the underlying security at the strike price.
A put option means that the buyer has the right but not an obligation to sell the underlying security at the strike price.
The four main actions traders can take with options are:
1. Buy call
2. Sell call
3. Buy put
4. Sell put
Similar to buying a stock, buying a call option gives a long position to the trader on the underlying security.
And similar to short selling a stock, selling a call option gives the trader a short position in the underlying security.
Buying a put option means the trader is taking a short position in the underlying security.
Selling a put means the trader is taking a long position in the underlying security.
These four scenarios are crucial to understanding Options Trading.
Buyers of options are known as holders and sellers are known as writers of options. The difference between holders and writers is:
1. Call holders and put holders do not have the obligation to buy or sell the underlying security/options. They have the choice whether they want to exercise their right. This limits the risk of holders to losing the premium spent to buy the options if the markets do not go their way.
2. Conversely, call writers and put writers must buy or sell if the option expires in the money. This is because the writers need to make good their promise to buy or sell. This shows us that writers usually are exposed to more risk, as they can lose much more than the premium paid for the options. Sometimes, the risk to writers is unlimited.
3. What are the uses of Options?
A. Speculation
Speculation is essentially betting on where the price of a security will go in the future.
If a trader thinks that the price of a security will go up within the next one month based on his analysis, he/she will either buy the stock or a call option to benefit from the price rise.
An option is a more attractive instrument, as it provides leverage (one only has to pay option premium and not the price of the underlying security) and costs significantly lesser than the stock.
B. Hedging
Options were invented for hedging.
Using options to hedge helps traders reduce risk at a lower cost.
For instance, if a trader invests in a security assuming that its price will increase, they can hedge their position by buying put options of the same underlying security.
Thus, if the price increases, they will earn as the security price rises. And if the price falls, they will minimize their losses by making money on the put options.
4. How do Options work?
Here are 3 factors you need to know to understand how options work:
Relative Value:
Options are used by traders to profit from determining the probability of future events.
If the probability of an event is high, the option that makes bets on the event happening is more expensive than that of an option of an event less likely to occur, i.e., an event whose probability is low.
Thus, for example, the call option’s price goes up as and when the underlying security’s price goes up. Thus, one must understand the relative value of options to trade in it.
Time Value:
The price of options depends on time.
Therefore, if the option would expire soon, its price would be lower than the option whose expiry is after a longer time period.
This is also because determining the probability of an event (in this case – price rise or price fall) becomes easier as the expiry date comes closer.
This means that options are a time-diminishing asset.
For instance, if one buys an option with a one-month expiry, and the price of the stock does not move, then the option’s value decreases with each passing day.
So, a one-month expiry option is cheaper than a three-month expiry option.
This is because the probability of a price move in your favor increases if the time available increases.
Volatility:
The more volatile the underlying stock’s price, the more is the price of the option.
This is because more volatility implies that the price can go either way with larger swings, thus making the possibility of price movement in either direction greater.
Here’s an illustration of how option pricing works:
Most of the time, traders choose to make money by trading their positions, so the option holders usually sell their options in the market.
Only ~10% of options are exercised, 60% are traded, and 30% expire.
5. How do traders use options? (Basic Options Strategies)
As we know, traders use options to either speculate, hedge their trades or simply trade to make profits. To make maximum profits, option traders use some strategies while trading.
Let us look at some strategies here:
1. Long Call
In this strategy, the trader goes long on a call, i.e., the trader buys call options expecting that the price of the underlying security will go up.
For instance, a trader buys a contract with 100 call options for an underlying security whose current price is Rs. 10.
The option price, say, is Rs. 2.
Therefore, the trader spends Rs. 200 for the contract.
The trader will be at a no-profit no loss position (at the money) when the security price reaches Rs. 12 (strike price).
As the security price increases over Rs.12, the trader will start making profits.
Thus, a long call can give unlimited profits to the trader, as the price of the underlying stock can increase infinitely.
If the stock price falls below Rs.12, then the trader may sell it off at a loss or let the option expire and lose Rs. 200 only.
Thus, this strategy has an unlimited upside and limited downside, which traders use when they are fairly certain of the increase in the underlying stock’s price.
2. Short Call
In this strategy, the trader sells a call option, expecting that the price of the underlying stock will decrease over a predetermined time frame.
Thus, the trader can make unlimited profits if the price of the underlying stock decreases.
However, the trader may face significant losses if the price of the underlying stock increases, as in that case, he/ she would have to purchase the stock at higher prices and deliver.
3. Covered Call
To protect against such losses, the trader goes for the covered call strategy.
This involves holding a long position in the underlying while shorting a call.
Here, since the trader already buys the underlying stock, they gain on the stock price if it increases and gain on the call option if it falls.
This strategy limits the losses and profits of the trader. Experienced traders usually use this strategy of covered calls to generate income from their stock holdings.
4. Long Put
This strategy is like that of a long call except that the trader buys put options instead of call options when they are fairly certain that the price of the underlying stock will fall below a certain level in a fixed time frame.
For example, if a trader buys a contract with 100 put options for an underlying stock whose price is Rs. 10 at a strike price of Rs. 8, they will be at a no profit no loss position (at the money) if the stock price falls to Rs. 8.
Thereafter, as the stock price falls further, the trader will be in the money, till the stock price reaches 0.
As the price of the underlying security cannot fall below zero, gains as well as losses are capped.
This is because if the price moves in the opposite direction, the trader can choose to let the options expire and suffer a loss of Rs. 200.
This strategy is used when the traders are fairly confident of the stock price falling below a certain level.
5. Short Put
In this strategy, the trader will write/ sell a put option, i.e., bet that the price of the underlying security will increase over a fixed time period.
Here, the maximum profit for the trader is limited to the premium amount collected.
But, the maximum losses can be unlimited because they will have to buy the underlying stock to fulfill their obligations to buyers if they decide to exercise their option.
This can be an effective strategy if the trader is fairly certain that the price of the underlying stock will increase.
The trader can also buy back the option when its price is close to being in the money and generate income through the premium collected.
These strategies would have seemed vague if you wouldn’t be able to see payoffs, right?
Well, here you go!
Now, let’s move on to understanding risk measurement in options and risk management strategies.
6. Risk Measurement in Options Trading
An option’s price can be influenced by several factors that can either help or hurt traders depending on the type of positions they have taken.
We need to understand the factors that influence options pricing, which are known as “Greeks”—a set of risk measures named after the Greek letters that denote them.
Greeks show how sensitive an option is to time-value decay, changes in volatility, and movements in the price of its underlying security.
These four primary Greek risk measures are known as an option’s Delta, Theta, Gamma and Vega.
An option’s “Greeks” describe its various risk parameters.
1. Delta is the measure of the change in an option’s price or premium resulting from a change in the underlying asset.
2. Theta measures its price decay as time passes.
3 Gamma measures the Delta’s rate of change over time as well as the rate of change in the underlying asset. Gamma helps forecast price moves in the underlying asset.
4. Vega measures the risk of changes in implied volatility or the expected volatility of the underlying asset price in the future.
7. Risk Management using Options
Options are used to offset risk when trading in the market. Using options to hedge helps traders reduce market risk at a lower cost.
Here, we will look at a few option trading strategies that traders use to minimize their risks:
1. Protective put or Married Put
In a protective put, the trader invests in a security assuming that its price will increase.
They also hedge their position by buying put options of the same underlying security.
Thus, if the price increases, they will earn as the security price rises. And if the price falls, they will minimize their losses by making money on the put options. This strategy limits the losses and profits of the trader.
The only downside to this strategy is that the trader has to let go of some gains as risk mitigation.
2. Covered call:
A covered call is used by traders who intend to hold the underlying stock for a long time, but do not expect a considerable rise in price in the near term.
Selling a call (covered call) protects against a fall in the stock price and thus hedges their position.
The maximum profit from a covered call is if the stock price rises to the strike price that has been sold. Thus, this strategy is not meant for very bearish or very bullish expectations.
These are the simple strategies for risk management in options. There are more complex option spreads too, which traders use to mitigate risk.
8. Using Leverage effectively in Options Trading:
Let us first understand what is leverage and how it relates to options trading.
There are two ways leverage is used in options trading.
A. Avoid: Using the same amount of capital to bet on a larger position
This means that 1 rupee invested in a stock and the same 1 rupee invested in an option does not equal the same risk.
Consider the following example. You’re planning to invest Rs.10,000 in an Rs.50 stock, but also have the option to buy options contracts worth Rs.10 as an alternative. After all, investing Rs.10,000 in a Rs. 10 option allows you to buy 10 contracts (one contract is worth 100 shares of stock) and control 1,000 shares. Meanwhile, Rs.10,000 in an Rs.50 stock will only buy 200 shares.
In this example, the options trade is riskier than the stock trade. With the stock trade, your entire investment can be lost, but only if the stock price falls 100% from Rs.50 to Rs.0.
However, you stand to lose your entire investment in the options trade if the stock drops to the strike price.
So, if the option strike price is Rs.40 (for an in-the-money option), the stock only needs to drop below by 20%, i.e., below Rs.40 by expiration for the entire investment to be lost.
B. Better: Maintaining the same position by spending less money
This is the definition of leverage that a consistently successful trader incorporates into his/her trades. Understanding the risk in this way of leverage is as explained below:
There is a huge risk disparity between owning the same amount of stocks and options. To understand this, let us examine two ways to balance risk disparity while keeping the positions equally profitable.
i. Conventional Risk Calculation
The first method to balance risk disparity is the standard and most popular way.
Let’s go back to our example to see how this works:
If you were going to invest Rs.10,000 in a Rs.50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts of 100 shares each at a considerably lower cost. By purchasing the options, you spend less money, but still control the same number of shares.
This excess money which you saved when buying an option can be used in other trading opportunities with greater diversification. Thus, this leveraging strategy can free up your funds for other trades.
ii. Alternative Risk Calculation
In this alternative risk strategy, the trader balances cost and quantity based on risk.
For example, if you buy a stock at Rs. 50, keeping a stop loss at Rs. 40.
You are ready to lose Rs. 10 in case the stock does not behave according to your expectations.
So, for these Rs. 10 you can buy a put option of the same underlying security with strike price Rs. 40.
What you can achieve with this strategy is that you can limit your loss to Rs. 10 in this trade. All other price movements, like above Rs.50 and below Rs. 40 will generate profits for the trader.
Thus, the trader needs to determine the right amount of money to invest in an options position, which allows the investor to unlock the power of leverage.
The key is managing risk while maintaining your exposure and profit probability.
Before we conclude, here are some advantages and disadvantages of option trading:
9. Pros and Cons of Options Trading:
Pros of Options Trading:
Options trading can be very helpful for traders. Some of them are listed below
1. Leveraging potential:
Options come with huge leveraging power. A trader can get an options position equal to a stock position at a much lower cost and margin, or at the same investment cost, the trader can control a much greater number of securities using options.
2. High Return Potential:
The returns on options trading would be much higher than buying shares on cash. This is because the trader can get options on lower margin and get the same profitability, hence, the percentage return on investment would be much higher comparatively.
3. Lowering Risk of Holding Underlying:
Options are surely riskier than owning equities, however; there are also times when options are used to mitigate risk. Options are used widely to hedge positions. The risk in options is pre-defined as the losing the premium paid to buy the option.
4. Risk Management in Options Trading:
There are more strategies which are used by regular traders to trade options along with trading equity. The trades can be combined to create a strategic position with the help of a call and put options to mitigate and control risk when trading in the market.
Cons of options trading:
As we have seen above, options can be highly rewarding. However, there are some drawbacks to options trading.
1. Less Liquidity:
Some stock options have lower liquidity, which makes it very difficult for a trader to enter and exit trades.
2. High Trading Costs:
Option trading is typically more expensive as compared to stock trading, as most full-service brokers charge higher fees for trading in options.
3. Time Decay:
The value of your option premium decreases by some percentages each day irrespective of movement in the underlying.
4. Non Availability of All Stock Options:
All the stocks registered with exchanges do not have options contracts. This makes it difficult for a trader to hedge his position with options strategies.
Wow! Looks like you’ve got it all ‘covered’!
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Image caption: Here’s a married put example while the trader is holding Axis Bank shares and how easy PHI 1 makes trading options.
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