Option Trading: a dive into the derivatives

Hello readers, welcome back to Green Bull vs Red bear! Today's blog is about a type of derivative called options.

Options trading is potentially the fastest way to make a profit in the stock market, making it the most complex and risky type of trading. according to a report by SEBI about 90% of option traders make a loss in option trading while only 10 % make a profit. On average, the loss is up to 50,000 rs.

But worry not as we are going to try to understand what actually is option trading and how it works.

What is Options Trading?

Options trading is a dynamic financial practice where investors buy and sell contracts granting them the right but not the obligation to buy (call options) or sell (put options) underlying assets such as stocks or commodities at decided prices within a particular timeframe. It's the same as holding a flexible tool for future asset transactions, contingent upon market movements, without being bound to execute them. Within this realm, traders employ strategies tailored to their market outlook, aiming to profit from price fluctuations, volatility changes, and other factors affecting option prices. Options trading is not devoid of risks; the potential for total loss exists if options expire out-of-the-money. Thus, comprehensive understanding, meticulous risk management, and strategic execution are imperative for success in this nuanced financial arena.

So this is the basic idea behind the option trading. Now, let's discuss what Call and Put contracts are and what the differences are between them.

Call & Put Options

Call Options: In options trading, call options grant the holder the right, but not the obligation, to buy an underlying asset at the strike price within a specified period, regardless of the asset's actual market value. The buyer purchases the asset at the strike price, speculating its market value to exceed that price before the option expires. Call options are favored by traders anticipating bullish market movements. Call options provide investors with the opportunity to benefit from potential price appreciation of the underlying asset while limiting their risk to the premium paid for the option.

Put Options: Put options are commonly used by traders anticipating bearish market movements. When a put option is used, the seller is obligated to purchase the asset from the option holder at the strike price, hoping the market value to fall below that price before expiration. Put options offer investors the opportunity to profit from potential price declines in the underlying asset while limiting their risk to the premium paid for the option.

now that we have discussed what is put and call options let's discuss the difference between the 3 types of contracts based on the current price of the asset.

3 kinds of option contracts based on "Asset price"

The following are the 3 types of options contracts that are affected by the current market of the underlying asset of the option:

  1. In the Money
  2. At the Money
  3. Out of Money

These all have different impacts on their premium. Let's dive into the differences they all have in their own contrast.

In the Money

In options trading, a contract is called "in the money" when the underlying asset's price is favorable for the option holder's position. For call options, an option is considered in the money if the current market price of the asset is higher than the option's strike price. For put options, an option is in the money if the current market price of the asset is lower than the option's strike price.

"in the money" contracts refer to options that have already reached a profitable state before their expiration date. This means that the current market price of the underlying asset is favorable for the option holder to exercise their rights, should they choose to do so.

For example, if you hold a call option with a strike price of ₹500, and the current market price of the underlying stock is ₹600, your call option would be considered "in the money" because you have the right to buy the stock at ₹500 and sell it immediately at the higher market price of ₹600, thereby realizing a profit.

However, the concept of time decay also known as theta decay becomes pertinent here. As an option approaches its expiration date, its time value decreases, impacting its overall value. Therefore, even if an option is in the money, its value may still decrease as it approaches expiration due to time decay.

Traders must carefully monitor the time decay aka Theta decay and consider the remaining time until expiration when managing their positions. Time-bound "in the money" contracts represent opportunities for potential profit, but traders need to be mindful of the effects of time decay and other factors influencing options pricing.

At the Money

In options trading, a contract is considered "at the money" when the current market price of the underlying asset is approximately equal to the option's strike price.

For both call and put options, being "at the money" means there is no value associated with the option. In other words, if you were to exercise the option immediately, you wouldn't gain or lose anything in terms of the asset's value.

For example, if you hold a call option with a strike price of ₹500, and the current market price of the underlying stock is also ₹500, the call option is "at the money." Similarly, if you hold a put option with a strike price of ₹500, and the current market price of the underlying stock is also ₹500, the put option is "at the money."

"At the money" options are significant because they represent a point of neutrality in the market. Traders often use them to gauge market sentiment and potential price movements. Additionally, "at the money" options typically have the highest time value, as there is still potential for the option to become "in the money" before expiration. As a result, they are sensitive to changes in volatility and time decay. Understanding the dynamics of "at the money" options is crucial for traders when developing their options trading strategies.

Out of Money

In options trading, a contract is considered "out of the money" when the current market price of the underlying asset is not favorable for the option holder's position. 

For call options, an option is considered out of the money if the current market price of the underlying asset is lower than the option's strike price. This means that if the option holder were to exercise the option immediately, they would be buying the asset at a higher price than its current market value.

On the other hand, for put options, an option is considered out of the money if the current market price of the underlying asset is higher than the option's strike price. In this case, if the option holder were to exercise the option immediately, they would be selling the asset at a lower price than its current market value.

Out-of-the-money options have no intrinsic value. This means that there is no immediate financial benefit to exercising the option. However, they may still have some time value, depending on factors such as the time remaining until expiration and market volatility.

Traders often use out-of-the-money options for speculative purposes, hoping that the underlying asset's price will move in a favorable direction before the option expires. However, it's important to note that out-of-the-money options also have a higher risk of expiring worthless, as they need the underlying asset's price to move significantly to become profitable. Understanding the characteristics and risks associated with out-of-the-money options is essential for effective options trading strategies.

hopefully, this has clarified the different types of contracts that options trading has. now let's discuss the difference between buying and selling the option contracts

Buying and selling options

Buying an option and selling an option contract are very different in terms of their outlook, risk factors, and probability of winning a trade. Let's discuss how buying an option is different than selling the option.

Buying Options:


Call Options: 
Bullish Outlook Traders purchase call options when they speculate an increase in the price of the underlying asset. By buying call options, they gain the right to buy the asset at the strike price, regardless of its market price at expiration. If the market price rises above the strike price before expiration, the call option becomes profitable. Traders can either exercise the option to buy the asset at the strike price or sell the option at a higher premium before expiration (mainly happens in intraday). 

Put Options: Traders buy put options when they expect a decline in the price of the underlying asset. By buying put options, they acquire the right to sell the asset at the strike price. If the market price falls below the strike price before expiration, the put option becomes profitable. Traders can either exercise the option to sell the asset at the strike price or sell the option at a higher premium before expiration.

Risk Factor:

Option buyers mostly only have a 33% chance of making a profit at expiry according to simple math. A buyer only makes a profit when the strike price expires "in the money" Along with this the option buyers also have the following risks:

  • Limited Timeframe: Options contracts have expiration dates, typically ranging from days to months. If the anticipated price movement doesn't occur within this timeframe, the option may expire worthless, causing the entire premium paid for the option to be loss

  • Premium Outlay: Option buyers pay a premium upfront to acquire the right to buy (in the case of call options) or sell (in the case of put options) the underlying asset at a predetermined price within the specified timeframe. If the option expires out of the money, meaning the market price doesn't reach the strike price, the premium paid is lost.

  • Price Sensitivity: Options are highly sensitive to price movements in the underlying asset. Failure of the underlying asset to move in the anticipated direction can result in losses for option buyers due to time decay.

  • Volatility Impact: Options pricing is influenced by factors such as market volatility. Decreases in volatility can reduce the value of the option, potentially leading to a loss even if the underlying asset moves in the anticipated direction.

Selling Options:

Call Option Selling: Call option sellers, or writers, believe that the price of the underlying asset will either remain stagnant or decrease. By selling call options, they collect a premium upfront, which serves as compensation for undertaking the obligation to sell the asset at the strike price if the option buyer decides to exercise. If the market price remains below the strike price at expiration, the call option expires worthless, and the seller keeps the premium.

Put Option Selling: Put option sellers, or writers, anticipate that the price of the underlying asset will either remain steady or increase. By selling put options, they receive a premium upfront, agreeing to buy the asset at the strike price if the option buyer decides to exercise. If the market price remains above the strike price at expiration, the put option expires worthless, and the seller gets the premium at which he sold.

Risk Factor:

Option sellers or writers have a 66% chance of winning at expiry because the seller and writer will make a profit even if the market decides to move sideways or move in their direction. other than that the following are the other risks that follow Option writing:

  • Limited Profit Potential, Unlimited Risk: When selling options, traders receive a premium upfront, which represents their maximum potential profit. However, the potential profit is limited to the premium received, while the potential loss can be unlimited. For example, when selling a call option, the underlying asset's price can theoretically rise indefinitely, resulting in significant losses for the option seller.

  • Obligation to Fulfill Contract Terms: Option sellers must fulfill the terms of the contract if the option buyer decides to exercise their right. For call option sellers, this means selling the underlying asset at the strike price, while for put option sellers, it means buying the underlying asset at the strike price. This obligation exposes option sellers to the risk of adverse price movements in the underlying asset.

  • Price Movements: Options are highly sensitive to price movements in the underlying asset. Adverse price movements can result in losses for option sellers, particularly if the market moves against their position. For example, if the underlying asset's price increases significantly for call option sellers or decreases significantly for put option sellers, the option seller may incur losses.

  • Volatility Impact: Changes in market volatility can impact option values. Increases in volatility can lead to higher option premiums, while decreases in volatility can result in lower premiums. However, if volatility increases after the option is sold, it can increase the value of the option, resulting in losses for the option seller.

In conclusion

Options trading provides investors with a dynamic tool to navigate the complexities of financial markets and execute a wide array of trading strategies. It hinges on the principles of call-and-put options, each offering unique opportunities and risks depending on market conditions and investor objectives.

Buying options involves the payment of a premium upfront to acquire the right, but not the obligation, to buy (in the case of call options) or sell (in the case of put options) an underlying asset at a predetermined price within a specified timeframe. This strategy is often employed by traders who anticipate significant price movements in the underlying asset. However, option buyers face various risks, including the limited timeframe of the options contract, the initial premium outlay, sensitivity to price fluctuations, and the impact of volatility on option prices.

Conversely, selling options entails receiving a premium upfront by taking on the obligation to buy (for call option sellers) or sell (for put option sellers) the underlying asset at the strike price if the option buyer decides to exercise their right. This approach is favored by traders who anticipate little to no movement in the underlying asset's price or who seek to generate income from the premiums received. However, option sellers face risks such as limited profit potential, unlimited risk in certain scenarios, the obligation to fulfill contract terms, potential losses due to adverse price movements, and the impact of changes in market volatility.

That's all for this blog hopefully it was helpful in the next blog we will discuss how the chart works and various types of charts that are used for technical analysis.

this blog is just to provide theoretical knowledge about the stock market. Apply the methods in this on your own risk as the stock market is subject to market risk.

Comments

  1. Great job buddy this blog is very informative and will surely help those aspiring to pursue there career in the Stock market sector, keep growing bud..

    ReplyDelete
  2. Explained in simple ways, good writing.

    ReplyDelete

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