Understanding what is stock options trading: Options Trading in the modern world of trading has become a Marvel of its own. It is specifically because of the Factor of “Leverage” that comes along with Options Trading. Leveraging gives you the ability to be able to participate in a bigger game than what your capital would allow in the cash Market.
Let us understand it with the help of this simple example. Say, you are willing to buy 250 shares of Reliance Industries. And the current share price of Reliance Industries is Rs. 2600 per share.
Total capital Required to buy shares in the Spot/Cash Market = Rs 250*2500 = Rs. 625000
Total capital Required to buy one lot (250 shares) in Futures Market = Rs. 1,44,388
Now, say the stock price of RIL rises to Rs. 2750, then the profit and ROI for both cash market and Futures trade would be –
In Cash Market
Capital Invested = Rs. 6,25,000
Selling Price = Rs. 2750*250 = 687500
Profit Made = Rs. 62500 (687500-625000)
ROI = 10%
In Futures Market
Capital Invested = Rs. 139744
Profit Made = Rs. 62500
ROI = (62500/139744)*100 = 44.72%
Now, if we look at the calculator above, it can safely be assumed that the Futures market is way better in terms of Return on Investment provided by the market. But, it would be a little too premature to assume that. Before coming to a Final conclusion, we should also see what would be the ROI if similar views were using Options.
Say, you have bullish views on the market but don’t have enough capital or you don’t intend to use a large amount of capital to express this view, you could simply express your bullish views by using a very small portion of your capital. Let us find out how-
You buy ATM (At the Money) Call option (Ce) of Strike price = 2500
The Premium for the same is = 80 units
Share per lot = 250
Total Premium Paid = 250*80 = Rs. 20000
Now, by the expiry of this contract if the share price of RIL goes to Rs. 2750, then the profit made on the Futures Contract would be –
Profit on Options Contract for RIL = (Final Price – Strike Price)*250 – Premium Paid
= (2750-2500)*250 – 20000
= 62500 – 20000 = 42500
ROI = (42500/20000)*100 = 212.5%
So, after all the calculations, it can be safely concluded that return on investment (ROI) is the highest for Options trading, followed by Futures trade and then Cash Market trading.
But, higher ROI comes with its own set of risks and challenges. Let us explore a little more about what is Stock Options Trading.
What is Stock Options Trading?
It is a simple form of trading whereby the bullish or bearish views on that particular stock can be expressed by using Options.
Say, if you have bullish views on the shares of XYZ company, then it can be expressed by buying Call Options and, if you have bearish views on the shares of XYZ company, then even that be expressed by buying Put Options.
What is a Call Option in Stock Options Trading?
Call Options to give the buyer of the option, the right to buy the shares of the particular company at the predecided price on or before Expiry. The Buyer of the option has the right to buy the underlying stock and the seller of the option is obligated to honour the contract.
What is Put Option in Stock Options Trading?
Put Options give the buyer of the option, the right to sell the shares of the particular company at the predecided price on or before Expiry. The Buyer of the option has the right to sell the underlying stock and the seller of the option is obligated to honour the contract.
What is Premium in the Stock Options Trading?
Premium is the price paid by the Option buyer to the Seller of the option to have the right on the underlying asset to be bought or sold upon expiry. The buyer has the right because he pays the money upfront and the seller is obligated because he received money upfront at the time of writing of Option.
Who are the Players involved in Stock Options Trading?
The profile of people using Options as trading products depends on the purpose of Trade. There are generally three categories of users.
- Hedgers – These are those categories of traders, who use options to hedge their existing position in the stock market. Say, you have bought shares of TCS and you have a bullish stance on the shares of TCS over a long time. But there are some rumours doing rounds in the market that might impact the share price of TCS in near future in a negative way. So, you could hedge yourself against downside risk by using options. You could simply buy Put Options and in case the market comes down, then you could protect yourself from downside risk and in case the market continues to keep going up, then all you stand to lose is the premium paid to buy the Put option.
- You have bought shares of TCS at Rs. 3200
- To protect against downside risk you hedge it by buying a Put Option of Strike price 3200 (Pe)
- The Premium for the same is 50 units.
- So, if the share price comes down to Rs. 3020
- Then the profit made on the Put Option bought would be (3200-50-3020) i.e., 130 units.
- And if the share price of TCS goes up to Rs. 3400, then the maximum loss on the Put option would be to the tune of Premium (50 units) paid. But the Position in the cash market would be in favour of Rs. 200 (3400-3200)
- Speculators – These are those categories of Market Participants who take a bet on the directional movement in the stock prices and take Options positions accordingly. And if the market goes in your favour, then the returns can be exponential as can be seen from the example of Reliance Industries above. If you expect the share price of the stock to go up, you could buy Call Option or Sel Put Option and if you expect the share price to go down, you could buy the Put Option or sell Call Option.
- Arbitrageurs – These are those market participants who benefit from the difference in prices and take advantage of it. And eventually, bring the market to parity.
How to Express Bullish or Bearish View using Options?
There are various combinations of strategies that one could formulate to express Bullish/Bearish views using Option in the Stocks. However, the following are 4 simple ways to express it:
- If your stance is Bullish, you could buy Call Option and Pay Premium, the profit potential here is unlimited.
- If your stance is Bullish, you could also sell/write the Put option and receive Premium, the profit potential is to the tune of Premium received but the loss potential is Unlimted. The Premium here is received at the time of selling the Option.
- If your stance is Bearish, you could buy Put Option and Pay Premium, the profit potential here is unlimited.
- If your stance is Bearish, you could sell/write the Call option and receive Premium, the profit potential is to the tune of Premium received but the loss potential is Unlimted. The Premium here is received at the time of selling the Option.
Option Trading brings along with it, a trading mechanism which can enable a trader with small capital to participate in a bigger game. But it does come with its own set of challenges, so one has to be careful and diligent while trading stock options.
That pretty much concludes our post on what is options trading today. We hope you enjoyed reading it. Happy Trading and Money Making!