how-to-start-option-trading-from-basics

Option Trading – Introduction

how-to-start-option-trading-from-basics

Options are the most versatile trading tool today . No other investment vehicle seems to have a unique set of characteristics and flexibility that options provide to a trader . In this blog we will learn the basics of option trading and how to start option trading .

It gives investors and traders a lot of efficient ways to strategies their trades efficiently achieving better risk rewards to their trades . Option can help the traders in volatile and unpredictable markets by enabling them to profit in numerous ways .

Options being the most versatile instrument in the derivative segment helps the traders in many ways .It is used to manage risk , generate income , leverage the existing trades and make profits under almost all types of market conditions .

Terms related to Option

ITM – In the Money Option

OTM – Out the Money Option

Risk Reward profile –

 Volatility –

These are the basic terms related to option trading . Apart from these basics terms the are some terms like Alpha , theta etc which we will discuss in our next blog . In  this blog we will focus on

Major Categories of Option Strategies –

Naked Option Strategies

Spread Strategies

Hedging Strategies

Volatility Strategies

Range Bound Strategies

We Will learn about these strategies in details one by one . starting from Naked Call Strategies .

Naked Call Strategies –

Long  call

Short call

Long put

Short put

Spread strategies are also generally four types

Bull Spread

Bear Spread

Ratio Back – Spread

Ratio front – Spread

Hedging Strategies –

Covered call

Protective call

Volatile and Rangebound Strategies ;-

Collar

Straddle

Strangle

Strap

Short Butterfly

Short Condor

Long Butterfly

Long condor

Chance of making profit by an option trader – option seller has a 2/3^rd chance of making profit with unlimited risk that can be hedged by adopting strategies . where as option buyer has only 1/3^rd chance of making profit with limited Risk .

Option are decaying asset .

The premium decay with the passage of time .

If other factors i.e option premium price , such as the price of the underlying stock , its volatility remain the same , that option  will be worthless at expiration . this time is always in the favor of the option seller  and against the option buyer .

Long call –

What is a Long Call –

Purchase of Call Option is called Long Call . This is a Bullish Strategy .

KEY FEATURES OF THE LONG CALL STRATEGY : –

Limited Risk and Unlimited Profit , when Indices / Stock Rises .

A Premium of long call increases in value from a  rise in the underlying stock and volatility Expansion .

Premium Declines when

Decline in underlying stock

Time Decay

Volatility Contraction

The high are the strike price of a call the premium are lower , and the lower the delta greater the leverage .

ATM and OTM Option seams lucrative for Option Buyer .

Short Call –

What is Short Call ?

 A Short Call is a Selling a Call Option .This is a bearish strategy .

KEY FEATURES –

Limited Reward and Unlimited Risk

A short call strategy has a positive pay off when there is a fall in the underlying stock or voltality contraction .

The strategy has  a negative pay – off when there is an incrase in underlying stock or volatility expansion.

Normally it is advisable for trader to sell the call at a strike price which is greater than the current market price i.e SELL OTM CALL

PROFIT SCENARIOS –

The key incentives of selling a Call is that you can profit under three Scenarios –

1. When the underlying stock declines ,
2. Move Sideways
3. Or rise Slightly

– The probability of success in the trade is 2/3^rd. An advantage of selling a naked call is that is can structured to have a higher prob. Of success than trading the underlying stock or buying a Call with disadvantage of unlimited Risk .

A call option seller has time on his side with each passing day .

Long Put –

What is Long Put ?

Buying a put option is called Long Put . It is a bearish strategy . in this strategy there is a chance of unlimited profit and limited risk  to the extent of premium paid only .

• A trader profit from a long put strategy when the underlying asset falls below the strike price .
• A long put normally increase in value from a decline in the underlying stock or volatility expansion .
• It declines In value from a rise in the underlying stock , time decay or volatility contraction .
• The lower the strike price of a put the premiums are lower , and the lower the delta , the greater is the leverage ..
• ATM and OTM option seems lucrative for the put option buyer .

Short Put

What is Short Put ?

Selling a put option is called the short put . this is slightly bullish strategy and neutral strategy . In this strategy there is  a chance of limited profit with unlimited Risk .

• Limited Profit and Unlimited Risk .
• Profit Upto the Premium Received .
• Positive Pay out when there is an increase in the underlying stock or volatility contraction .
• It declines in value from a declines in underlying stock or volatility expansion .

Profit Scenarios –

1. When the underlying Stock Rise .
2. Move Sideways .
3. Or Fall Slightly
4. The probability of success is 2/3^rd and the disadvantage is unlimited risk , if the asset price falls and goes below the strike price .
5. A put option seller has the time on his side and with each passing day premium falls .

Long Call Vs Short Put

• Long Call and  a short put are both bullish strategies .
• Buying Call is  a limited Risk , selling a  put envolves unlimited risk .

Factors and Inferences –

1. If the trader is bullish in the short term  then buy call .
2. If the trader is bullish but believe that the underlying stock can fluctuate and the underlying will take time bullish move to occur , then Sell put .
3. If increase in volatility is expected , then buying call are always better while selling put . The premium may not decay fast .
4. If want to Sell a Put , it is always better to initiate it towards the second half of the expiry period ,Since the expiry are near , premium decay are faster .

Long Put Vs Short Call –

• A long Put and a short call both are bearish strategies .
• Buying a Put is limited Risk where as selling a Call is an Unlimited Risk Strategies .

Factors and Inferences :

1. If a trader us bearish in the short run , then the purchase of a put may be appropriate .
2. If the view is bearish but believed that the underlying stock can fluctuate and that it will take time for the bearish move to occur , then selling OTM call may be appropriate.
3. If increase in volatility is expected , then buying put are always better as while selling a call , the premium are not decay fast .
4. If you want to sell a call it is always better to initiate it towards the second half of the expiry because expiry is near premium decay are faster .

This is the basis understanding of call and put option . ln our next blog we will learn different strategies for the different call put option .