Options Trading: How It Works, How To Trade, Examples

Published on Monday, June 4, 2018 by Chittorgarh.com Team | Modified on Wednesday, November 13, 2019

Options are one of the most versatile investment instrument. But they are highly complex too. Even more than trading in stocks. While trading stocks, you choose a company, buy stocks of the company and hold it. In Options trading, you need to do these things and a lot more. Let's understand in detail on How Options work with examples.

Options Trading Basics Explained

Before we go into how Options Trading works, it is essential to understand the basics of Options-

• Options are a type of derivatives. The other type of derivatives is Futures. Derivatives mean derived from. So, Options too, are derived from some underlying asset like equity, commodity, and currency etc. Options derived from equities or stocks are called equity or stock options. In stock options, you have a single stock option wherein the stocks of a single company are the underlying asset or index options like Nifty, Bank Nifty where indexes are the underlying asset. Similarly, options derived from commodities and currency are called commodity options and currency options.

• Options are contracts that give the buyer the right to buy the underlying asset at a specified price and within a specified period. But it is not an obligation. So a buyer of an Option can choose to not exercise his right. However, if you are a seller of an Option then it is obligatory to sell the underlying asset as per the Option contract.

• Options have fixed life or expiration date. Beyond which it expires worthless. In India, Options have 3 contract cycles- weekly, monthly and 3 months. Options expire on the last Thursday of their contract cycles.

• Options are of two types: Call and Put. Call options give a trader the right to buy the underlying asset as per the contract while Put options give him the right to sell the underlying asset.

• To buy an Option, you need to pay a premium. When you sell an Option, you receive a premium. The premium is decided by the exchange like NSE or BSE and is calculated using Options pricing models. There are many factors like the current price of the underlying, volatility in the stock, interest rates, dividends etc., that play a role in deciding the price of an Option.

• The premium is defined per share. Options are available in lot sizes which is a group of shares of the underlying. Example- For Nifty 50, lot size is 75 shares. So if the premium for the Options is Rs 10 then to buy 1 lot of Nifty 50, you need to pay- Rs 10 X 75 shares= Rs 750.

• All Options have a strike price. It is the price at which the buyer and seller have agreed to buy or sell the underlying asset in the contract. Every Option is available at different strike prices, both lower and higher than the current price of the underlying. You can buy or sell an Option for any available strike price.

How To Trade Options?

To trade in Options, you would need an Options Trading Account with a broker who is registered with SEBI for Options. Not all brokers facilitate trading in all types of Options. The Options trading account is different than the stocks trading account. So, if you already have a stock trading account then check whether it allows trading in Options. If not then you need to open a new Options trading account.

How To Choose a Stock Broker For Options Trading?

But before that, you need to choose a broker. There are two types of options brokers in the market- Discount brokers likeZerodha, Upstox etc., and Full-Service brokers like ICICI Securities, Sharekhan etc. Here's the difference between the two-

Choosing the right broker depends on your trading experience, the volume of trade and comfort with technology etc. A beginner would need assistance in the initial days where the advisory services of a full-service broker can be useful. If you are a high volume trader then a discount broker with low brokerage plans can be the right choice. If you are tech-savvy then discount brokers will meet your expectations.

Opening an Options Trading Account

Opening an Options trading account is easy these days. Most of the brokers have websites wherein you can apply for Opening a trading account. The broker representative will contact you to process your application. You need to submit documents- ID, Address etc.. and within a week your account will be opened.

Many brokers, especially discount brokers, have a paperless account opening process. The process is quick and easy. And is completely online. Here, you need to-

1. Visit the broker's website.
2. Fill in your personal details.
3. Give your bank details.
4. Upload required documents like PAN, Aadhar, Address and Income Proof etc.
5. Make Payment
6. E-sign the application form.

And done. Your application process is complete.

Options Trading: Things To Consider Before Trading

Before you place the trade, you must answer following questions:

• What type of Options to trade? Do you want to trade-in equity or Commodity or Currency? If equity then is it single stock or Index?
• What direction do you think the underlying asset will move? Do you think prices will move upward, downward or remain sideways?
• How high or low the price of the underlying will move? What will be your strike price?
• What is the time period? Is it a week, month or 3-months?

I did the same exercise before doing my trade. Here are my answers to above questions-

• I wanted to trade in equities, specifically Nifty 50.
• My view was that the prices will move up. So I choose to BUY CALL option.
• Nifty 50, at the time of the trade, was hovering around 10,500. I thought the price will cross 10,700. So my strike price was 10,700.
• My time period was 1 month. So I choose the monthly Option contract.

Options Trading: How To Trade, Buy & Sell Options With Example

I have a 3-in-1 account with Kotak Securities with Options trading facility. I would be using this account to demonstrate how to buy/sell Equity (Nifty) options. Though I have chosen Nifty Options, the process remains same for all Options trading.

Here's how the 'Place Order' page looks in my Kotak account-

You need to fill in following details:

• Action: Choose whether you want to buy or sell options. I chose Buy.
• Market Exchange: Choose whether you want to trade in NSE or BSE. Nifty Options are traded in NSE.
• Stock Name: Enter your stock/index name. My Index name was Nifty 50.
• Expiry Date: Select your expiry date from the options available. I choose April 26 as expiry date.
• Instrument Type: Choose from OI and FI
• Option Type: Select CE for Call Option and PE for Put Option. I selected CE for call Option.
• Strike Price: Select your strike price from the options available. My strike price was 10,700.
• No Of Lots: Enter the number of lots you want to trade. I traded in 1 lot.
• Quantity per Lot: This is exchanged decided and is system filled. The quantity per lot for Nifty 50 is 75.
• Price: The current trading price of the Option will be prefilled in the box. However, you can enter your own price (increase/decrease) at which you want to trade. Your order will only be executed when the index reaches that price.
• Order Type: Kotak gives me 4 choices in order types: Normal, Margin Trading, Super Multiple, Derivative Plus. Choose Normal order.
• Stop Loss Trigger Price: This is used to limit the losses and saves you from regularly monitoring the price of the index. You can set a price at which you want to buy or sell the traded option. It will get triggered when the price of the index touches the price and order will be executed.

Click on the 'Place Order' button and done.

You have a chance to modify or cancel the order if it is not immediately exercised.

Depending on the communication rules of your broker, you will receive an SMS and an email on the successful execution of the order. By the evening of the trading day or next working day, you will receive a derivative bill and contract note providing the details of your trade.

Realizing that Nifty 50 is not going to touch 10700 within the expiry period, I decided to limit my losses. I could have left the contract to expire worthlessly but that would have eaten into all my investments. So I squared off the trade by selling 10700 Call Option at a premium of Rs 6.95. Here's my transaction-

I received my derivative bill and contract note for the sale the next day.

My trade ended up in a loss. But there was a time when it was delivering a small profit. I should have booked profit by squaring off my position. But I wanted to earn maximum profit. I was within striking distance of achieving it. But that's the way markets work. Even good trades result in losses. And that's why you need to make multiple trades, minimize your risk and losses. And score more wins than losses to earn an overall profit.