Option trading is different from trading in stocks. While stocks give you a small piece of ownership in the company, options are just contracts that give you the right to buy or sell the stock at a specific price (strike price of the option) on a specific date (expiry date of the option contract).
There are two variations of options - call and put. When you buy a call option, you have the right but not the obligation to purchase a stock or index at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock or index at the strike price any time before the expiration date.
There are two parties to every option transaction: a buyer and a seller. So, for every call or put option purchased, there would always be a counter party who is selling it. Trading option is a speculative activity- something like betting on a horse. In horse racing, they use pari-mutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's profit is the option seller's loss and vice versa; any payoff diagram for an option purchase must be the mirror image of the seller's payoff diagram.
Lets us now understand, as a buyer of options what rights he owes and as a seller of an option what his obligation is.
Suppose, Stock ABC is trading at Rs 920 levels in cash market segment and Rs 940 call option is trading at premium of Rs 18. The option lot size is 500. Naresh is bullish on ABC and hence buys Rs 940 call option. Being pessimistic on the same, Sarvesh sells (technically called as ‘writes’) Rs 940 call option. In this transaction Naresh pays Rs 9000 and Sarvesh receives same for writing option. The consideration of Rs 9000 is arrived at multiplying Rs 18 by the lot size of 500.
Scenario 1- Stock moves up to Rs 980 levels on expiry
In this case Naresh makes a profit of Rs 11,000 (difference between spot & strike price minus the premium paid and multiplied by the lot size). The same amount is lost by Sarvesh - seller of call option.
Scenario 2-Stock corrects to 900 levels on expiry
In this case, Sarvesh’s view holds good and he gains the total premium received- Rs 9000. Naresh losses the premium he paid.
After understanding how the options work, let’s look at some of the important factors before you start trading options:
Selection of strike price: Most of us have a tendency to buy things at a cheaper rate and the same concept they apply while trading in options. Many traders generally look to buy options that are deep out of the money strikes, which are available at low premium. But the probability of getting that strike price in-the-money is very low. Since, we trade into options with a limited period to exercise our rights; one should prefer at-the-money or slightly out of the money strike prices as the probability of it getting exercised is high.
Behaviour of time value in options: Premium in options consists of two components - intrinsic value and time value. Suppose, Stock ABC is trading at Rs 920 and Rs 900 strike price call option is trading at Rs 32. Here, Rs 900 call is already Rs 20 in-the-money, which is the intrinsic value. While, the remaining Rs 12 is the time value of Rs 900 call option which gets decayed as the expiry approaches.
Avoid trading in illiquid options: Traders should initially check whether there is sufficient volume in the strike price they are looking to trade.
Avoid averaging in same strike: Traders those who have bought options either call or put and are incurring losses due to stock or index moving either in opposite direction or trading in a range should avoid averaging in same strike prices. Averaging is not advisable but those who want to should select the nearest strike to add on to their positions, as once the stock moves in the direction expected, the at-the-money strike will fetch more profit due to which your losses will reduce or will get covered completely.
Aggressive positions during stock result: Retail traders with limited understanding of the market should avoid buying options one or two days prior to quarterly results as implied volatility (IVs) jumps higher resulting in higher premium. And even though stock moves in your favour or remains subdued, you may end up losing due to fall in IVs.
Selection of expiry: Traders having view on a particular stock or index should also take time into consideration. Suppose, trader is expecting 7% move in a stock within 3-4 weeks and the current expiry is closer then trader should prefer next month expiry.
Building a proper strategy: There are many people who tend to adopt single trading strategy, either they only buy options or they only sell options. Instead they should opt for strategies that suits market scenario. They can buy both call and put options (Long straddle) or sell both (Short Straddle) as per volatility expected in the counter. They can also buy and sell different strikes of call options (Bull call Spread) or buy & sell different put options (Bear Put Spread) if they are mildly bullish or bearish. Similarly, there are various such strategies which a trader should explore as per market conditions.