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4 Basic Options Strategies for Beginners

17 Apr, 2022

4 Basic Options Strategies for Beginners

The derivatives market was introduced in India in the year 2000. "It is a matter of great pride for us and our country that NSE has emerged as a global leader and achieved the distinction of being the largest derivatives exchange in the world for the 3rd consecutive year and the 4th largest exchange in cash equities by the number of trades," Vikram Limaye, MD & CEO, NSE, said. Options are one of the four derivatives that can be traded in the Indian Stock Market.

Index, stock future & options are traded in India in the equity derivative market. Options give buyers the ability to buy or sell an asset at a specific price and a particular date. Trading options requires a little in depth strategy. The process of opening an options trading account is not complicated at all. All you have to do is submit an additional document - 6 months bank statement, copy of ITR, salary slip or demat holding statement.

Before we get into the strategies, let's first understand how options are different from shares.

All futures and options have an expiration date, which means they no longer exist or can be traded after they expire. On the other hand, shares of stock have no expiration date and can be held forever. This means that when you are choosing options you have to pick a time frame for your position.

Options also have a strike price. This means that you can use the option to buy or sell stocks at the strike price. A share at a price X can be purchased at price X too. But an option of price Y has to be multiplied by the lot size to get its actual value or premium. Index options such as nifty and bank nifty have a fixed lot size, but different stock trading in the derivative segment have different lot sizes.

Did you know that risk-averse traders also delve into options to enhance their overall returns? Investors who are bullish on a stock are the ones who buy call options as they can use that leverage. Some traders invest in call options for better selling prices. They can sell calls they'd like to divest. If the price rises above the call's strike, they can sell the stock and take the premium as a bonus.

The expiry date of futures and index options is the last Thursday of the month. For example, if you buy a futures contract on the 2nd of March 2022, the expiry date of the contract would be the 26th of March 2022, the last Thursday of the month. The closing price or settling price is always as per the closing in the cash market. However, an exception is listed equity options contracts, which are often settled by delivery of the actual underlying shares of stock.

As the value of the option increases the intrinsic value decreases. In the money ITM or out of the money OTM options have the most intrinsic time value. Time value is the highest when the option is at the money, in the money and at the beginning of the month, or the more the days till the expiry date of the contract the more is the option price.

the reason being that the potential for intrinsic value begins to rise at this juncture. An option also starts losing its value as it reaches maturity or expiry date. This is called theta decay. An option can be exercised at any time, even if it is very close to its expiry. Option premiums tend to increase and decrease very quickly as the expiry approaches, depending on the spot price of the underlying asset. Traders simply take advantage of the price movement at any point in time. The deeper the contract the more the premium rises. But if the option loses intrinsic value, the premium dips. Price of all the out of the money contracts become 0 (zero) on expiry.

Does corporate action have any effect on options?

Corporate actions including stock splits, dividends, mergers and acquisitions, rights issues and spin-offs can leave a major impact on the stock prices of a company. Corporate actions speak volumes about the company's intentions towards their shareholders and even otherwise. They are a matter of reputation and goodwill for the company. They result in adjustments in the futures and options of the stocks undergoing the corporate action.

Let's take a look at what beginners can do with options to minimize their risks with these 4 basic option strategies: Long call, covered call, long put and short put.

1. Long call:

In the long call strategy, traders wait for the stock price to increase or exceed the strike price by the time it expires. This helps the trader earn multiple times their initial investment.

For the upside on a long call the sky's the limit. In case the stock rises before expiration, the call can keep increasing. But in case the stock closes below the strike price, the call expires at zero price which means the trader loses all the money he has deployed in that contract.

So traders go for this strategy only when they expect the stock to rise before it expires.

2. Covered call:

A covered call is selling a call with a twist that involves buying the stock too. By doing this, the trader can actually turn a potentially risky trade into a relatively safer, income generating one. In this situation, the trader expects the strike price to be higher than the stock price before expiration. In the case of the opposite, the owner will have to sell the stock at the cash market.

The good part in this option strategy is that the call is limited to the premium, even if the stock prices rise. But if the stock prices plunge very low , that would mean a complete loss for the trader.

Go for this option strategy (selling call) when you already own the stock and don't expect its price to increase in the future. This strategy turns your existing holding into a source of income. You can earn the premium, as it becomes zero on the expiry date Only disadvantage is retail investors who have less shares (less than the derivative lot size) should avoid selling call against the holding as derivatives have a fixed lot size.

3. Long put

In this strategy, the trader buys options and hopes the stock price will fall more sharply than the strike price and his paid premium, by the expiration date. In case the stock falls, the good part about this trading strategy is the ability to have multiple of the initial investment.

Selling stock is actual delivery, but selling naked puts increases the risk of the trader. In case the stock closes below the strike price before the option closes, the trader incurs a net loss. A long put is a good choice when you expect the stock to fall significantly before the option expires.

4. Short put

In this strategy, the trader sells options and hopes the stock price to be higher than the strike price by its expiration date. The trader receives a cash premium in exchange for selling the put. If the stock closes below the strike price, the trader buys it at the strike price.

Like the covered call, the maximum return on a short put is what the seller receives upfront. The flipside of this strategy is the total value of the underlying stock minus the premium received, in case the stock turns zero. It is possible to close the position before expiration and take the net loss without having to buy the stock.

When you plan to purchase a put or a call option you should know the impact of your move on the price of the option. You will find that option prices tend to have a life of their own regardless of market movements. However you will soon realize that volatility is the usual culprit.

Knowing the effect that volatility has on the option price behaviour can help you cushion against losses or added as a bonus to winning trades. The trick is to understand the relationship between changes in volatility and the underlying stocks.

If you haven't opened a Sharepa Discount Broker in India yet, you can do so right now with ease and start with a low-cost option till you learn to grow your wealth. Begin your trading journey with The Best Broker for Option Trading in India

Happy Trading!

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