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

Published on Monday, June 4, 2018 by Chittorgarh.com Team | Modified on Tuesday, February 20, 2024

Options are one of the most versatile investment instruments. But they are also very complex. Even more complex than trading shares. When trading shares, you choose a company, buy shares in the company, and hold them. In options trading, you have to do these things and much more. Let us explain how options work in detail using examples.

Options Trading Explained

Before we go into how options trading works, it is important to understand the basics of options trading

• Options are a type of derivatives. The other type of derivative is Futures. Derivatives mean derived from. Options are also derived from an underlying asset such as shares, commodities, currencies, etc. Options derived from shares or securities are referred to as stock options. Stock options are a single stock option where the shares of a single company form the underlying or index options like Nifty, and Bank Nifty where indices form the underlying. Similarly, there are options derived from commodities and currencies: Commodity Options and Currency Options.

• Options are contracts that give the buyer the right to buy the underlying asset at a certain price and within a certain period. However, it is not an obligation. The buyer of an option can therefore decide not to exercise his right. However, if you are the seller of an option, you are obliged to sell the underlying asset following the option contract.

• Options have fixed life or expiration date. After this date, they expire worthless. In India, options have 3 contract cycles - weekly, monthly, and 3 months. Options expire on the last Thursday of the respective contract cycle.

• Options are of two types: Call and Put. Call and Put. Call options give a trader the right to buy the underlying asset according to 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 determined by the exchange (e.g. NSE or BSE) and is calculated using option pricing models. Many factors such as the current price of the underlying asset, volatility of the stock, interest rates, dividends, etc. play a role in determining the option price

• The premium is defined per share. Options are available in lots representing a group of shares of the underlying stock. Example: For Nifty 50, the lot size is 75 shares. So if the premium for the option is Rs 10, you have to pay Rs 10 x 75 shares = Rs 750 to buy 1 lot of Nifty 50.

• All Options have a strike price. This is the price at which the buyer and seller have agreed to buy or sell the underlying asset of the contract. Each option is available at different strike prices, which may be lower or higher than the current price of the underlying asset. You can buy or sell an option at any available strike price

Options Trading Requirements

To trade options, you need an options trading account with a broker that is registered with SEBI for options. Not all brokers allow trading in all types of options. The options trading account is different from the stock trading account. So, if you already have a stock trading account, check if it allows options trading. If not, you will need to open a new options trading account.

How To Choose a Stock Broker For Options Trading?

But first, 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, trading volume, familiarity with the technology, etc. A beginner will need support in the early stages, where the advisory services of a full-service broker can be useful. If you are a high-volume trader, a discount broker with low brokerage plans may be the right choice. If you are technically savvy, discount brokers will meet your expectations.

Opening an Options Trading Account

Opening an options trading account is easy these days. Most brokers have websites where you can apply to open a trading account. The broker's representative will contact you to process your application. You will need to submit documents - ID, address, etc. - and within a week your account will be opened.

Many brokers, especially discount brokers, offer a paperless account opening procedure. The process is quick and easy. And it's handled entirely online. To do this, you need to visit the broker's website.

1. Fill in your details.
2. Enter your bank details.
3. Upload the required documents like PAN, Aadhar, address proof, income proof, etc.
4. Make the payment.
5. E-sign the application form.

And that's it. Your application process is complete.

Options Trading: Things To Consider Before Trading

Before you enter into a transaction, you must answer the following questions:

• What type of options do you want to trade? Do you want to trade shares, commodities, or currencies? If you are trading shares, is it a single share or an index?
• In which direction do you think the underlying asset will move? Do you think prices will move up, down, or sideways?
• How high or low will the price of the underlying move? What will your strike price be?
• What is the time frame? Is it a week, a month, or 3 months?

I did the same exercise before I traded. Here are my answers to the above questions: I wanted to trade stocks, especially the Nifty 50.

• I believe that the prices will go up. So I decided to go for the BUY CALL option.
• At the time of trading, the Nifty 50 was hovering around the 10,500 mark and I expected the price to cross the 10,700 mark. So my strike price was 10,700.
• My time frame was 1 month. So I chose 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 an 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 the same for all Options trading.

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

You need to fill in the 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 the 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 the 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 the 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, and 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 the 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.

Options Trading Tax India

Income or losses from options trading are considered business income or capital gains. They must be declared using tax form ITR-4. The tax is levied at the prescribed income tax rates after deductions.

Section 43(5) of the Income Tax Act states that all transactions carried out in the course of trading in futures and options are to be regarded as non-speculative transactions. This means that gains from such transactions are taxed in the same way as income or gains from carrying on any other business. Therefore, the taxpayer can deduct all expenses related to futures and options trading, such as telephone, electricity internet bills, etc. from tax.

Treatment of income from futures and options as business income

If income or gains from trading in futures and options are treated as commercial income, the following consequences arise:

1. All administrative costs are considered deductible.
2. Securities Transaction Tax (STT) is also considered deductible.
3. Unabsorbed losses can be offset against income that the taxpayer receives from other transactions and can be carried forward for a maximum period of 8 years.
4. Losses from futures and options trading can be offset against income from the taxpayer's residential property, from other businesses, and from sources other than the taxpayer's regular salary.
5. Tax audit is mandatory if the turnover or income from trading in futures and options is more than Rs 1 crore.

Treatment of income from futures and options as capital gains

1. All income is considered short-term income or gains and is taxed at the regular income tax rate.
2. Securities Transaction Tax (STT) is not deductible, unlike futures and options trading expenses.
3. Any loss is treated as a short-term capital loss which can be set off against capital gains earned by the taxpayer from other sources. This loss can be carried forward for a maximum period of 8 years.

Options Trading Platforms in India

Several brokers in India offer platforms for options trading. Before deciding on a platform, a trader must consider the following points:

1. Cost - subscription, Brokerage Fees & Commissions: Some options trading platforms charge you a fee per lot size, while others charge a fixed commission per transaction. It would be advisable to opt for the latter as the commission is fixed.

2. In-built tools: Choose an options trading platform that allows you to read and analyze the charts so that you can check resistance and support levels when needed.

3. Customer service: Make sure that your options trading platform has good customer service.

We have compiled a list of some of the best brokers in India. Find out more.

Options Trading - Paper Trading or Virtual Trading

Paper trading or virtual trading is a technique often used by traders to test strategies under different market conditions. Beginners can also use this method to gain experience in trading without investing real money.

The term paper trading dates back to a time when budding traders practised trading on paper before risking money on the real markets, long before online trading platforms became the norm. While traders used to write down all their records by hand on paper, paper trading has now been replaced by virtual trading. Traders can practice trading with an electronic stock market simulator that looks and feels like a real trading platform.

Paper trading advantages and disadvantages

Advantages of paper trading or virtual trading

• Elimination of the risk of losing money. Since no real money is used in virtual trading, traders do not lose their real money in the event of a trading loss.
• Test strategies. Traders can test different strategies before they go live. This is a great mechanism to test and familiarise yourself with the strategies before actually investing.

Disadvantages of paper trading or virtual trading

• Paper trading or virtual trading isn't perfect because it doesn't work with real securities. It can therefore give a false sense of security and often leads to distorted investment returns.
• No potential for a return. Since the trader does not invest real money, he makes no profits even if the trade goes well.
• Paper trading or virtual trading enables basic investment strategies, such as buying low and selling high, which are more difficult to follow in real life but relatively easy to achieve in paper trading.

Options Trading vs Intraday Trading (Day Trading)

Options Trading vs Swing Trading

Options trading indicators

Understanding market indicators is one of the most important steps in options trading. Market indicators can depict market movement, strength of market direction, etc. Here are some of the most commonly used indicators for options trading:

1. Moving Average: The moving average is one of the most commonly used technical analysis tools to understand the market. It is the average of the price of an underlying asset over a certain period. Traders use moving averages to identify support and resistance levels and to determine the general trend of the market.
2. Relative Strength Index (RSI): The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. It is a popular indicator used by traders to identify overbought and oversold conditions in the market. When the RSI is above 70, it is considered overbought, and when it is below 30, it is considered oversold. Traders use this information to enter or exit trades. It is one of the best indicators for options trading.
3. Bollinger bands: Bollinger bands consist of three lines - the middle line is a moving average and the upper and lower bands are two standard deviations away from the middle line. The bands widen and narrow depending on the volatility of the underlying asset. When the price of an asset moves towards the upper band, it means that the asset is overbought, and when it moves towards the lower band, it means that the asset is oversold.
4. Supertrend: The supertrend indicator is plotted on price charts for investors and highlights visible trends, that are shown in red when prices are falling and green when prices are rising.
5. Open interest (OI): The open interest (OI) is the number of outstanding contracts for a particular option. The OI is a useful indicator for options traders as it helps them understand market sentiment. If the OI rises with the price of an option, it indicates that traders have a positive attitude towards that stock or index. If the OI rises while the price of an option falls, this indicates a pessimistic attitude on the part of traders.
6. Implied volatility (IV): Implied volatility is a measure of the market's expectations regarding the future price volatility of an underlying asset. It is calculated by taking the market price of an option and then working backwards to determine the level of volatility expected by the market. Implied volatility is an important factor in determining the option price. The higher the IV, the higher the option premium, and vice versa. Traders use IV to assess whether an option is over- or undervalued compared to historical volatility, and it is one of the best indicators for options trading.
7. Volume: Total number of contracts traded during a given period. It is an important indicator as it helps traders to determine the liquidity of a particular option. A high volume indicates that there is a lot of interest in that option and that it is easier to enter or exit a position. Low volume, on the other hand, indicates less interest and it may be difficult to buy or sell options.

Options trading strategies for beginners

Options trading can be complex but with proper knowledge, research, and preparations beginner traders can also perform well in this area. Here are some of the options trading strategies for beginners:

1. Long Call: A long call option trading strategy is one of the basic strategies. In this strategy, the trader is bullish in his market assessment and expects the market to rise shortly. In this strategy, the trader takes a single position and buys a call option (either ITM, ATM, or OTM). This strategy has limited risk (the maximum loss is equal to the premium paid) and unlimited profit potential.
2. Long Put: A long put strategy is a basic strategy with a bearish market view. Long put is the opposite of a long call. Here you try to take a position to profit from a fall in the price of the underlying asset. The risk is limited to the premium, while the profits are unlimited.
3. Short Put: A short put is another bullish trading strategy in which you assume that the price of an underlying asset will not fall below a certain level. In this strategy, you take a single position by selling a put option. It has a low profit potential and is associated with unlimited risk.
4. Bull Call Spread (or Bull Call Debit Spread): A bull call spread strategy (or bull call debit spread) is intended for investors who are moderately optimistic about the market and expect the price of the underlying asset to rise slightly. This strategy involves taking two positions: Buying a call option and selling a call option. The risk and return are limited with this strategy.
5. Synthetic call: A synthetic call strategy is used by traders who currently hold the underlying asset and are optimistic about the long term. However, he is also concerned about the downside risks shortly. This strategy offers unlimited return potential with limited risk.
6. Bear call spread: In a bear call spread strategy, you buy a call option and simultaneously sell a call option with a lower strike price on the same underlying asset and with the same expiry date. You receive a premium for selling a call option and pay a premium for buying a call option. Your investment costs are therefore much lower. The strategy is less risky and the return is limited to the difference between the premium received and the premium paid.
7. Protective call: The protective call strategy is a hedging strategy. In this strategy, a trader takes a short position in the underlying asset (sell shares or futures) and buys an ATM call option to hedge against an increase in the price of the underlying asset.
8. Long straddle: The long straddle (or buy straddle) is a neutral strategy. In this strategy, a call and a put option of the same underlying, the same strike price, and the same expiry date are bought simultaneously.
9. Long Strangle: The long strangle (or buy strangle or option strangle) is a neutral strategy in which Slightly OTM put options and Slightly OTM call options with the same underlying and expiry date are bought simultaneously.

Read more here.