Published on: September 1, 2024
Trading options in the stock market can be like learning a new language. The jargon, the strategies, and the seemingly complex nature of options trading can overwhelm any new trader. But just as with any new language, once you understand the basics and practice regularly, the concepts become clearer, and the fear dissipates. Let us simplify options trading for beginners.
Understanding the Basics
Imagine you are in Mumbai, the financial capital of India. You are at a bustling street market where people buy and sell everything from spices to sarees. Among them is Rahul, a 30-year-old IT professional who has recently developed an interest in the stock market. One day, Rahul’s friend Amit, an Options trader, introduces him to the concept of options trading.
Amit explains, “Rahul, think of options like this: In this market, you can either buy an item directly or pay a small amount to reserve the right to buy it later at a specific price. This is similar to an option contract. An option gives you the right, but not the obligation, to buy or sell a stock at a predetermined price on or before a specific date.”
Rahul nods, trying to grasp the concept. Amit continues, “There are two main types of options: Call options and Put options. A Call option gives you the right to buy a stock, while a Put option gives you the right to sell it. It’s like having a reservation at a restaurant—you have the option to go if you want, but you’re not obligated.”
Example:
Let’s say you think the stock of Reliance Industries, currently trading at ₹2,400, will go up in the next month. You can buy a Call option for Reliance with a strike price of ₹2,500 and pay a premium of ₹100 for this right. If Reliance’s stock price goes up to ₹2,600 before the option expires, you can exercise your option and buy the stock at ₹2,500, making a profit of ₹100 per share (excluding the premium). But if the stock price doesn’t rise above ₹2,500, you simply let the option expire and lose the ₹100 premium. Your maximum loss is limited to the premium you paid.
Rahul’s eyes widen. “So, it’s like betting on the direction of the stock, but with a limited downside?”
Amit smiles 😊, “Exactly. And the same principle applies to Put options, except you are betting on the stock going down.”
The Story of the Farmer and the Merchant
Amit shares an ancient story with Rahul to further demystify options, which traders often use to explain options.
Once upon a time, in a small village in Maharashtra, there was a farmer named Ram. He grew mangoes and wanted to ensure he would get a good price for his crop the following season. Ram approached Shyam, a merchant in the village, and made a deal. Ram paid Shyam ₹10,000 to have the option to sell his mangoes at ₹50,000 in three months. This deal is like a Put option: Ram pays a premium (₹10,000) to secure the right to sell at ₹50,000.
As the months passed, a storm hit the village, damaging many crops, except for Ram’s mangoes. The price of mangoes in the market soared to ₹70,000 due to the shortage. Now, Ram didn’t need to sell to Shyam at ₹50,000—he could sell at the market price of ₹70,000, making a good profit even after deducting the ₹10,000 premium. Here, Ram’s option expired worthless, but he was protected from any downside risk.
On the other hand, if the storm hadn’t occurred and the price of mangoes had dropped to ₹40,000, Ram would have exercised his option to sell at ₹50,000, limiting his losses.
Rahul listens intently and realises that options can be a powerful tool for managing risk.
Practical Steps to Start Option Trading
Rahul, now more comfortable with the concept of options, wants to dive deeper. Amit outlines the practical steps to start option trading:
1. Understanding Option Contracts: Each option contract represents a lot size (pre-defined quantity). When you buy one Call or Put option, you are buying the right for a lot of the underlying stock.
2. Choosing a Broker: Rahul needs a reliable broker to start trading. Amit recommends Definedge Securities because we offer good educational resources, reasonable fees, and a robust trading universe comprising of solutions for learning, analysis and trading.
3. Learning the Jargon: Terms like ‘Strike Price’, ‘Expiry Date’, ‘Premium’, ‘In-the-Money’, ‘Out-of-the-Money’, and ‘At-the-Money’ are crucial. Rahul spends time understanding these terms through videos, books, and online courses. Amit suggests the ‘Everything about Trading Options’ book available for free on Shelf.
4. Paper Trading: Amit suggests Rahul start with paper trading, a simulated trading environment where he can practice without risking real money. This helps him understand market movements, option pricing, and trading strategies. He can do this easily with the Option Simulator in OPSTRA Options Trading Terminal.
5. Starting Small: Amit advises Rahul to start with small trades, using only a portion of his investment capital. “Options can be volatile. It’s essential to manage your risk and avoid betting the farm on a single trade,” she cautions.
6. Analysing the Market: Rahul learns to analyse the market using technical and fundamental analysis. He uses tools like moving averages, RSI, and support and resistance levels to predict potential market movements.
7. Developing a Strategy: Amit emphasises the importance of having a strategy. Whether it’s buying calls when bullish, buying puts when bearish, or employing spreads to limit risk, having a clear plan is key.
Rahul’s First Trade
With a few months of paper trading experience under his belt, Rahul is ready for his first real trade. He decides to buy a Call option for TCS, which is trading at ₹4,500. He believes the upcoming earnings report will be positive and the stock price will rise.
He buys a Call option with a strike price of ₹4,500, expiring in two weeks, and pays a premium of ₹50 per share, amounting to ₹8,750 for the contract (the lot size is 175 shares). As the earnings date approaches, the stock price begins to climb, reaching ₹4,550. Rahul’s option is now ‘In-the-Money (ITM),’ and he decides to sell it, locking in a profit of ₹2,000.
Rahul’s excitement is palpable. He has made his first successful trade because he guessed the direction right and followed a process-driven and objective approach. He understood the risk, managed his capital, and executed his strategy.
Lessons Learned and Moving Forward
As Rahul continues his trading journey, he learns several valuable lessons:
1. Risk Management: No trade is guaranteed. By only risking a small percentage of his capital on any single trade, Rahul protects himself from significant losses.
2. Continuous Learning: Markets are dynamic. Rahul continues to learn by reading books, attending webinars, and discussing strategies with fellow traders through events and conferences like DECMA.
3. Emotional Control: Trading can be emotional, especially when facing losses. Rahul learns to control his emotions and not let greed or fear drive his decisions.
4. Using Tools and Resources: Platforms like RZone and OPSTRA Options Analysis & Trading terminal offer valuable tools for analysing market trends and scanning for opportunities for option traders.
5. Diversifying Strategies: Rahul doesn’t stick to just one type of trade. He explores various strategies, such as spreads and straddles, to find what works best in different market conditions.
Rahul’s journey into options trading in the Indian markets is just beginning. Through patience, education, and practice, he is transforming from a beginner to a confident trader.
For anyone starting in options trading, remember Rahul’s story. Begin with the basics, practice diligently, manage your risks, and never stop learning.
To ease your options trading journey, you can start learning with a FREE COURSE by Prashant Shah – Learn Trading Options from Basics available on Gurukul by Definedge. All you need for this course is a demat account with Definedge Securities.
