How to Trade Options

Asad Dossani
Rs. 4,02,091 crores. The average daily turnover in the Nifty futures and options segment as of February 2013.

Limited risk and unlimited reward.

This is a sentence any trader or investor likes to hear. And it is exactly what options trading offers you. When we trade a futures contract, or an underlying asset, we have two options. We can go long (buy) or we can go short (sell). That's it.

Things are simple when we trade futures. There are only two possible things we can do, and our goal is simply to predict the direction of the market.

When it comes to options trading, the possibilities are endless. If you want to trade options, then keep reading. We'll devote the next few articles exclusively to options trading.

What is an option?

An option contract gives the holder the right to buy (or to sell) the underlying asset at a particular price on a particular date.

Let's walk through an example of a call option. Suppose we have a 1 month Nifty call option with a strike price of 8,000. How does it work?

Let's break this down piece by piece.

First, we have a call option. This gives us the right to buy the Nifty index.

Second, our option is valid for 1 month. This means we can exercise our option when it expires a month from now. Or we can sell it any time until then.

Third, the strike price is 8,000. This means we have the right to buy the Nifty at a price of 8,000.

Now let us think through the possible outcomes from buying this call option.

First, the Nifty could end up falling below 8,000 by the time the option expires. At this point, what should you do?

You could exercise your right to buy the Nifty at 8,000. But this would be a bad idea if the Nifty is trading below that level. Why use your option when you can buy the Nifty cheaper in the marketplace?

So if the Nifty closes below 8,000 when the option expires, the option becomes worthless. But what happens if the Nifty closes above 8,000? This is where you start making money. Now, your option is valuable because you can buy the Nifty at a cheaper price than what it costs in the market. If the Nifty closed at 8,100, you could exercise your option and make a profit of 100.

How do we get unlimited reward and limited risk with an option? Well, when you buy this call option, you pay a one off fee to do so. Once you own the option, you can't lose any more than what you paid for it initially. If the option expires worthless, you get nothing. If the option expires a profit, you can make that profit.

As you can see, options trading provides us with opportunities that aren't possible just by trading the underlying or the future. And this is why options trading is so lucrative.

But of course, there are caveats.

Trading options is more difficult than trading futures. Let's see why this is.

Go back to our Nifty call option. Remember that the option expires in 1 month. And we make money of the Nifty index is above 8,000 by the time the option expires.

Notice that for your option to make money, you need to correctly predict the direction of the Nifty and you need to correctly predict the time it will take to make its move. This option is useless if the Nifty goes up but only after two months.

And so, you are predicting both direction and timing when trading an option. With a future or underlying asset, you only need to predict direction. And this is what makes options trading more complex than futures trading.

But of course, just because it's more complex, doesn't mean that you can't learn to trade options. A little effort to learn about options can go a long way in helping your portfolio.

Do you trade options? Are you interesting in learning how to do so? Share your views in the Club or share your comments here.

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13 Responses to "How to Trade Options"
satinder singh
29 Jun, 2017
i have got my capital eroded during the current period of market crashes pl guide how to trade in call and put options with special ref to writtingLike 
umesh sahu
10 Oct, 2015
Out of money call and put short at a timeLike 
Ram N
22 Sep, 2015
Hi Asad, You have definitely raised the curiosity of "option traders" by your well written article. Keen to know your deep research on it, if you are wiling to share the same for the benefit your readers like me. Looking forward to.Like 
Rajesh
22 Sep, 2015
Thank you for explaining in such a simple language. Can you please provide more insight in to how to hedge the trades and make intra day bucks with few defined strategies which will help me/us build confidence in option trading.Like (2)
Govindarajan
09 Apr, 2015
Explanation about Futures & Options are very Interesting. Kindly suggest some books about F & O (for beginers) to learn, understand and implement. Also explain about Hedge.Like 
Manoj Tewary
27 Sep, 2014
Hi Asad, It would be great if we get your valued comments on our doubts & queries raised in our comments. That would be a real & specific value add over & above your general explanations in your newsletter - which certainly has to be so as that is addressed to a larger group with varied levels of expectations. If you can manage this we shall be really obliged.Like 
Manoj Tewary
25 Sep, 2014
Options is what the name means. There are so many options that it's very difficult to choose the suitable strategy. Which is better - selling or buying to make money consistently? After this what to buy ITM, ATM, OTM? Delta neutral short strangle for Index seems interesting, potentially it can easily give monthly returns of 5% on Total margin (the margin used + margin preserved to be used if required for adjustments, when one of the strike price is broken by the spot price) - but it's challenging to manage. If you can guide us to a comprehensive strategy for trading options to generate minimum 5% monthly returns on the total corpus, let's say 10 lacs - even if I use half the fund (the other half being preserved for adjustments required if any for capital safety) & sell OTM Calls & Puts of around 30 rupees premium, can earn 30k monthly, that's 3% monthly - but managing this also is not that easy, further I want to improve it towards 5% of the corpus. If you can help with a comprehensive strategy & action plan & do's/don'ts. Warm Regards, Manoj TewaryLike (1)
PRAKASH TANAK
23 Sep, 2014
Sir, Your article is very well written and quite informative. I would like to learn about the selection of strike price while doing the day trading in options. Should the criteria be always at or near to ATM? But then many a times it is too expensive and out of your budgeted capital. If you select deep in the OTM strike price, liquidity is the problem. Also for selecting the share, I use the criteria of the share from F&O list which has recorded the day High or day Low and analyse its price chart, see if any price pattern is seen or resistance/ support is broken. Is this the right approach? Is it also true that in the 2nd fortnight of the contract month, you should avoid buying options because of rapid time decay? In your future articles on the subject, can you please guide on the interpretation of Greeks which is a very complicated topic not taught by anybody? Thanks & Warm Regards. CA. Prakash TanakLike (1)
Drjlbansal
23 Sep, 2014
I prefer to trade options in long always,because you know your losses whereas profits are unlimited although there is price to be paid,while reverse is in writing an option but without paying for it.But trading in options can be possible only with the help of an expert adviser.And that can be done by Asad.Hope you will accept the suggestion.Like 
Trilok Gheyee
23 Sep, 2014
Enthusiastically looking forward to learning more on "How to Trade Options".Like 
Jagadish
23 Sep, 2014
Very interesting article. I am interested in learning more about options tratrading. Look forward to more articles & insights explaining the dimensions invovled. I understand this is one of the best ways to insure stocks against major downsides. If you can expain how to identify the various risks like implied volatility & effective strategies to cover through options, it will be very helpful. Regards Jagadish jLike 
Jagadish
23 Sep, 2014
Very interesting article. I am interested in learning more about options tratrading. Look forward to more articles & insights explaining the dimensions invovled. I understand this is one of the best ways to insure stocks against major downsides. If you can expain how to identify the various risks like implied volatility & effective strategies to cover through options, it will be very helpful. Regards Jagadish jLike 
Sanjeev
23 Sep, 2014
"For your option to make money, you need to correctly predict the direction of Nifty"? That is required for even stocks & futures. In fact, as we all know, options are great for direction-less strategies. If you know there's going to be a big move but are not sure in which direction, go for Long Straddle. You benefit from movement in any direction. "You need to correctly predict the time it will take to make its move"? Though critical for options, predicting the time is required even for stocks & futures, considering the cost of finance. Asad, I don't doubt your authority one bit and I don't mean to be offensive. But what I am looking is some expert knowledge or even some common knowledge which traders tend to overlook. "Profit Hunter" ought to be just what the name implies and not a forum for imparting basics.Like 
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