Guide to Options Trading 101

Most people are still unfamiliar with options trading, even though it has enormous potential for potential gains. The sole tenet of options markets is high risk and high return. So let's just break down options and explain every single concept of option trading in today's blog.

Introduction

Options trading is a financial instrument that is still not widely understood or utilized by most individuals, but it holds great potential for significant gains. Options are financial instruments that provide the buyer or seller with the right but not the obligation to buy or sell an underlying asset at a specified price on a specific date. These derivative contracts can be used for hedging positions, generating income, and speculating on the price movement of various financial instruments such as stocks, bonds, currencies, and commodities. 

Types of Options

There are two main types of options: call options and put options.

A call option grants the holder the right to purchase an underlying asset at a specified price within a specified time frame. A put option, on the other hand, grants the owner the right to sell the underlying asset at a specified price within a specified time period. Before entering into the contract, both option holder requires to pay a premium for the right to either buy or sell the asset.

Regulatory Authority in Options

Options trading is regulated by the Securities and Exchange Board of India (SEBI) in India. Only 198 stocks are available for options trading, and there are strict guidelines in place to reduce the risk of default by either party involved in the contract. SEBI also requires that upfront margins, known as Initial Margins, be maintained before entering into a contract and that these margins change as the contract value rises and falls. These rules help to create a fair and safe environment for investors, while also ensuring that they can protect their investments

Pros and cons Option Trading

Pros: The advantage of options contracts is their adaptability, which allows traders to speculate on or hedge against price swings. This provides traders with the flexibility to tailor their trades to their specific investment goals. Additionally, options contracts provide the leverage to earn significant returns with minimal initial investment, making them an attractive option for traders looking to maximize their profits.

Cons: However, options trading carries significant risk and requires a high level of knowledge and expertise to use effectively. Options contracts have an expiration date and may lose value if not exercised or sold before that date, resulting in a loss for the trader. Additionally, options contracts require traders to put down an initial margin to enter into a binding contract, which can limit their flexibility and make them less appealing to traders with a limited appetite for risk.

 
Five Fundamentals of Options pricing

The price of options depends on five fundamental factors:

• The spot price of the underlying asset: The market price at which the underlying asset call or put option is available is referred to as the spot price.
• The strike price: Aside from the spot price, the strike price is the price at which the underlying call or put option is actually bought or sold.
• Volatility: Volatility has a significant impact on option prices; volatility refers to price movement in the underlying asset.
• Time of Expiration: The time of expiration also plays an important role; the longer a contract's expiration date, the higher its price.
• Risk-free interest rate: Higher interest rates result in higher call and put option prices.

For example, if the underlying asset's price rises, the value of the call option will also rise, while the value of the put option will fall. On the other hand, if the underlying asset's price falls, the value of the call option will fall, while the value of the put option will rise.

Conclusion

Eventually, options trading is a valuable financial instrument for those who want to limit their potential losses while still having the opportunity for high returns. Before entering this market, it is critical to understand the various types of options, the regulations in place, and the factors that influence option prices.