Options Trading for Beginners: A Beginner Guide on Options Trading
The financial markets offer traders various methods of generating returns by investing their funds. For many beginners, buying and selling stocks is the go-to method of generating such returns. However, instruments like options can also help generate substantial returns. In this blog, we will look at options trading for beginners and its pros and cons.
What are Options?
Before we explore options trading for beginners, it is crucial to understand what options are and the types of options.
Options are financial contracts that give the buyer the right but not the obligation to buy or sell an asset at a predetermined price on a specific date. Options are derivative contracts and derive their value from the underlying asset such as stocks, indices, currencies, or commodities. As a result, a change in the value of the underlying asset leads to a change in the option contract. An option contract has no intrinsic value and expires worthless at the end of a specific period.
Companies | Type | Bidding Dates | |
| SME | Closes 21 Jan | ||
| SME | Closes 22 Jan | ||
| Regular | Closes 24 Jan | ||
| SME | Opens 22 Jan | ||
| Regular | - |
Types of Options
There are two types of options:Â
Call – A call option gives the buyer the right but not the obligation to purchase an asset at a predetermined price on a specific date. The value or premium of the call option increases with an increase in the value of the underlying asset.
Put – A put option gives the buyer of the contract the right but not the obligation to sell an asset at a predetermined price on a specific date. The value of the put option is inversely related to the underlying asset. A fall in the price of the underlying asset will increase the premium of the put option.
What is Options Moneyness?
For beginner options traders, understanding the moneyness of an options contract is vital. The moneyness of an options contract is the difference between the strike price of an options contract and the present price of the underlying asset.
A call option is known to be in-the-money (ITM) when the price of the underlying is higher than the strike price. If the strike price is similar to the price of the underlying, the option is at-the-money (ATM). In the case when an option’s strike price is higher than the price of the underlying, the option is out-of-the-money (OTM).
Meanwhile, if a put option’s strike price is lower than the price of the underlying, it is OTM. If the put option’s strike price is higher than the price of the underlying, it is in ITM. Similar to the call option, if the strike price of the put option is similar to the price of the underlying, it is ATM.
Typically, the value of an options contract increases the more in-the-money it is. Whereas OTM and ATM options expire worthless.
Read more : Difference Between ITM, OTM, ATM in Call and Put Options
Option Trading Strategies
Options are handy tools for traders as they allow them to benefit from any up-move, down-move, or even sideways movements in the market. There are numerous options trading strategies for beginners as well as for experienced traders.
Primarily, options trading strategies are directional or non-directional.
Directional strategies are used when a trader expects the market to move in a particular direction. Meanwhile, non-directional strategies are useful when the market moves sideways or is trading in a range.
Let’s look at an example of an options trading strategy
One of the most accessible options trading strategies for beginners is going long on a call or put option.
Suppose stock ABC is trading at Rs 200. The trader expects the stock price to move to Rs 250. To benefit from this up-move, he purchases a call option of the 230 strike price which has a premium of Rs 100.
The price of ABC moved from Rs 200 to Rs 250, which led to an increase in the premium of the call option from Rs 100 to Rs 300 resulting in a profit.
But if the price moved contrary to the trader’s expectations, the call option’s premium would decline. The call option would expire worthless if it is ATM or OTM on expiry, resulting in a loss of the premium of Rs 100.
In the case the trader expected the price of ABC to fall to Rs 150, the trader could have purchased a put option and benefitted from the down-move.
Traders can also short-sell an option. If a trader short-sells an options contract, he will benefit from the decline in the premium. However, if the trader has not hedged the positions, the losses can be unlimited.
Read more : How to Trade in Options with Small Capital
Benefits of Trading Options
- One of the key benefits of options trading is the potential upside that it offers. Since options are leveraged positions, the potential for profits can be substantial.
- Options are flexible tools allowing traders to create and deploy complex strategies to benefit in various market scenarios.
- Options contracts can also be used by investors to hedge their investments and reduce the overall risk.
Disadvantages of Trading Options
- Options trading is complex and requires experience and involvement.
- Since options are leveraged, the potential for the downside can be equally large as the upside, which increases the risk.
- Options trading can be volatile and is affected by multiple factors. As a result, it is not suitable for all types of traders and investors.
Key Points to Remember While Trading Options
Here are some key points to remember while trading options:
- Select the correct strike price as the premiums of an option are affected by how in-the-money an option is.
- Â It is of utmost importance to manage your risk. Select the appropriate lot size and place stop-loss orders to prevent steep losses.
- Conduct your own research and analysis instead of relying on tips.
- Study and research different strategies that can allow you to benefit in various market conditions.
Read More: 10 Things That Every Options Trader Must Know
Conclusion
Options trading for beginners has become accessible and convenient with developments in technology. With the help of various resources and tools, even beginner traders can benefit from trading options. However, options trading can be risky and calls for proper risk management to prevent capital erosion. A beginner options trader should conduct more research and learn about various strategies to make the most of options trading.
Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.