What is Options Trading? Meaning, Benefits & Strategies Explained

Options trading is buying and selling contracts that provide the right, but not the obligation, to buy or sell an asset at a set price within a specified time. If your goal is to manage risk or enhance potential returns, adding options trading to your overall stock market investment strategy may be useful. This article explains what is options trading, its benefits, strategies, and a lot more.  

Understanding Options Trading

In the financial world, an option is a contract that allows (but does not obligate) an investor to purchase or trade securities, ETFs, or index funds at a predetermined rate after a certain period. Additionally, in options trading a "call" is a right to buy a security, whereas a "put" is a right to sell it. 

However, it is more complex than stock trading, but if the price of the security rises, you may make gains. The reason is that an options contract does not require you to pay the full price for the security. Similarly, options trading may limit your losses if the price of the security falls, which is called hedging. 

How Does Options Trading Work?

Options trading works by letting investors buy or sell the right, but not the obligation, to trade an underlying asset (like a stock) at a predetermined price within a specific period. Additionally, options are also called derivative securities because their price is based on other factors like the value of assets, securities, and other underlying instruments. In simpler terms, the price of an option depends on the value of something else, rather than being a fixed amount on its own. 

Now that you know the meaning of options trading, let’s understand the strategies of options trading.  

Types of Options

The two main types of options are:

1. Call Options

A call option provides the buyer the right (but not the obligation) to buy an underlying asset at a predetermined price (called the strike price) before or on the expiry date. Investors use call options when they expect the price of the asset to go up. 

2. Put Options 

A put option gives the buyer the right (but not the obligation) to sell an underlying asset at a predetermined strike price before or on the expiry date. This is useful when investors expect the asset’s price to go down. 

Strategies in Options Trading

The following are the strategies in options trading.  

• Buying Call Options 

Buying call options is a strategy which is used when you expect the price of the underlying asset to rise. This strategy gives you the right to buy at a fixed price later. By using this strategy, you can make gains from upward movement. 

• Buying Put Options 

Buying put options is a suitable strategy for individuals who expect the asset’s price to fall. This strategy provides you with the right to sell at a fixed price.  This might help in making gains from a decline. 

• Covered Call 

This strategy involves owning the underlying stock and selling a call option on it. It can generate extra income but limits your upside if the stock rises sharply. 

• Protective Put 

The protective put is a strategy that is used as a hedge. This involves buying a put option while holding the stock. It helps limit potential losses if the stock’s price drops. 

• Straddle 

In a straddle strategy, you buy both a call and a put option at the same strike price and expiry. With this strategy you may gain from significant price movement in either direction. 

• Iron Condor 

The iron condor is a more advanced strategy that involves multiple options contracts to potentially gain from low volatility. It limits not only the probable gains but also the losses. 

Participants in Options

Options trading typically involves two primary participants: the option buyer and the option seller (also known as the writer). Each plays a distinct role and has different responsibilities.  

Option Buyer 

The buyer pays a premium to obtain the right, but not the obligation, to either buy or sell the underlying asset, depending on the type of option. This right can be exercised within the specified period according to the terms of the contract. 

Option Writer/Seller 

The seller receives a premium in return for taking on the obligation to fulfil the contract if the buyer chooses to exercise their right. This means the seller must buy or sell the underlying asset as agreed in the option contract. 

Key Terms in Options Trading

Options trading involves several key terms that help define how contracts function and may be exercised. They include: 

• American Option: This refers to an options contract that allows the holder to exercise their right at any time before the expiry date.  

• European Option: This type of option can be exercised only on the specified expiration date and not before. 

• Strike Price: The predetermined price at which the buyer and seller agree to buy or sell the underlying asset if the option is exercised. It is also referred to as the exercise price. 

• Premium: The amount paid by the option buyer to the seller in stock exchange for the rights associated with the contract. 

• Expiry Date: The final date on which the option contract remains valid. After this date, the contract cannot be exercised. 

Advantages of Options Trading

Trading options has the following advantages: 

• When you buy options, it can be cheaper than buying actual stocks. You only pay a smaller amount called the 'premium' and a trading fee. 

• With options, you can lock in a specific price for a certain period. This price is called the strike price. You can trade at that price any time before the options contract expires. 

• Options may offer additional income, leverage, and protection. For example, you may use options as a hedge to protect against losses in the stock market.  

• Before your options contract expires, you have different strategic choices. You can use options to buy more shares for your portfolio. You can also buy shares and sell them later for potential gains. Another option is to sell your contract to someone else at a higher price before it expires. 

Disadvantages of Options Trading

The following are some of the disadvantages of options trading: 

• It adds complexity to the investing process because you need to make decisions about direction, price, and time. 

• In options trading, there is an extra step. Brokers need to approve your account for options trading after you fill out an agreement. This is done to make sure you understand the risks involved. 

• To make capital from options trading, you must set price alerts and closely monitor the market. Additionally, you need to be aware of the risks and trading fees associated with different options strategies. 

• Unlike trading stocks, options trading may have fees and commissions. These can vary, and you need to consider them when calculating the profitability of your options strategy. 

• Futures & Options (F&O) income is treated as non-speculative business income (not short-term capital gains) and taxed as per income tax slab rates via the ITR-3 form. 

Profitability Scenario in Options

In options trading, profitability could be assessed based on the relationship between the market price and the strike price.  

• In-the-Money (ITM): An option is considered in-the-money when exercising it would result in a positive outcome for the holder.  

• At-the-Money (ATM): An option is at-the-money when the market price and the strike price are equal, resulting in neither gain nor loss if exercised. 

• Out-of-the-Money (OTM): An option is regarded as out-of-the-money when exercising it would lead to an unfavourable outcome.  

Conclusion

Options trading allows investors to buy or sell the right, not the obligation, to trade assets at a set price within a specific time. It offers advantages like hedging, limited capital use, and strategic flexibility. Though more complex than regular stock trading, it can enhance portfolio performance when used appropriately. With the right knowledge, options trading may helps investors manage risk and capitalise on market movements effectively. 

Disclaimer: This article is for informational purposes only. Trading in options involves significant risk, and you should always do your own research or consult a financial advisor before making investment decisions.