Even as the equity derivatives market in India has come a long way today from its nascent stage, a lot of Indian retail investors still shy away from it because they are not very clear what it exactly is and how to go about dealing in these instruments.
What Are Equity Derivatives?
Equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are the most common equity derivatives, however there are many other types of equity derivatives that are actively traded.
Both futures and options (F&O) enable investors hedge their portfolios against high risk of any kind associated with the market due to any upcoming events (election results, government announcements etc). In this article, we have focused on basics of options trading and strategies followed by most of the traders to avail the advantages it offers.
What Is An Option?
An option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a stated price, for a price.
The party taking a long position i.e. buying the option is called buyer/holder of the option and the party taking a short position i.e. selling the option is called the seller/writer of the option.
The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. Therefore, option buyer/holder will exercise his option only when the situation is favourable to him. On the other hand, option writer would be legally bound to honour the contract when he decides to exercise.
Options Are Primarily Of Two Types –
• Call Options – It is an option contract in which the holder has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
• Put Options – Opposite of a call option, it is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.
How Options Trading Works:
The price at which an underlying stock can be bought or sold if option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset.
The price of an option is called the premium. An option’s premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. An option premium is priced on a per share basis. Buying an option creates a debit in the amount of the premium to the buyer’s trading account. Selling an option creates a credit in the amount of the premium to the seller’s trading account.
Options contracts have 3 consecutive monthly contracts, additionally 3 quarterly months of the cycle March/June/September/December and 5 following semi-annual months of the cycle June/December would be available, so that at any point in time there would be options contracts with atleast 3 year tenure available. On expiry of the near month contract, new contracts (monthly/quarterly/half yearly contracts as applicable) are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract.
The contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Most Common Options Strategies Followed By Traders:
Stock market is always moving somewhere, it’s up to the stock trader to figure out what strategy fits the markets for that time period. As per our observation, the most common strategies used by traders in different market scenarios are:
In A Bullish Market
Long Call – The long call option strategy is the most basic option trading strategy whereby an options trader buy call options with the belief that the price of the underlying security may rise significantly beyond the strike price before the option expiration date.
Bull Call Spread – Bull call spread option trading strategy is employed when traders think price of an underlying asset may go up moderately in the near term. Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month.
Long Put – When executing long put strategy, investors buy put options with the belief that the price of the underlying security may go significantly below the striking price before the expiration date.
Bear Put Spread
The bear put spread strategy is employed when an options trader thinks the price of the underlying asset will go down moderately in the near term. Bear put spreads can be implemented by buying a higher striking in-the-money put option and selling a lower strikingout-of-the-money put option of the same underlying security with the same expiration date.
Bullish On Volatility
The long straddle, also known as buy straddle is a neutral strategy in options trading that involve the simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.
The long strangle, also known as buy strangle or simply “strangle”, is a neutral strategy in options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stockand expiration date.
Bearish On Volatility
The short straddle or sell straddle is a neutral options strategy that involves the simultaneous selling of a put and a call of the same underlying stock, striking price and expiration date. Short straddles are limited profit, unlimited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience little volatility in the near term.
Short strangle, also known as sell strangle, is a neutral strategy in options trading that involves the simultaneous selling of a slightly out-of-the-money call of the same underlying stock and expiration date. Traders use this strategy when they think the underlying stock may experience volatility in the near term. Out-of-the-money put and a slightly.
Conclusion – Having reviewed the fundamentals and advantages of options trading, it can be assumed that this target based investment tool may lure more traders in times to come. Which is also possible given the fact that a lot of online brokerages are providing direct access to the options markets through the internet at competitive costs.