Stock market trading demands a higher level of market expertise to be successful. But not every investor starts there. But the good thing is that stock market trading is flexible enough to welcome every investor. If you are new to the stock market, you will probably start with safer, long term buys. But as you move along and gain expertise, you may stumble upon many complex yet beneficial strategies. Options trading is one such helpful tool. Let us learn more about options trading and dissect some of its most popular strategies.
If you are new to stock markets, what does the term stock market trading mean to you? The basics of stock markets will tell you to buy a stock and sell it when the price increases to pocket a profit. But stock market price fluctuations can bring you opportunities much bigger.
Options trading is one such method.
In simple terms, an option is a contract that you make with a stockbroker, according to which you have the option to buy a stock at a predefined price before the term of the contract expires. The most important thing to understand here is that when you choose an option, you have the option to buy the stock, but there is no obligation.
As an investor, you can use this if you see the stock price going in a particular direction in a time frame. For instance, if the price of a stock, which is currently Rs.50 per share, is expected to rise to Rs.100 per share in 1 week, you could enter into an option to buy the stock at a smaller price, let us say Rs.70, within one week. Then, when and if the price reaches Rs.100, you have the option to buy the stock for Rs.70 and immediately sell it to make a profit of Rs.30 per stock. Options are usually sold in bulk and not for individual stocks. Hence, your profit will be higher.
But what do stockbrokers gain from this? Doesn't it seem like they will lose money on this? Here, only a stockbroker that thinks the particular stock's price will go in the opposite direction to your prediction will enter an agreement with you. For instance, in the above example, the stockbroker will think the stock's price will go below Rs.50. But we have said above that there is no obligation for you to buy the stock. You will not be buying the stock higher price in such a situation. So, when the price action goes opposite your prediction, the broker will benefit from the option fee you have paid. This is paid when you buy the option itself.
As we have mentioned above, an option is a contract between the seller and the buyer. But entering into an agreement is time-consuming, and finding a seller or a buyer who wants to enter into an agreement with you can be difficult. Hence, options are sold through stock market trading platforms similar to stocks. You can buy options that you think are in a match your needs for a fee. Here the maximum loss you could have is a fee since there is no obligation for you to buy the stock if the stock market doesn't go according to your prediction.
Because of the above reasons, buying a stock option can be complex compared to buying stocks. Therefore, you might need to understand the complexities of the stock market and formulate your own strategies. But because of the same reason, it can be highly beneficial as well. Moreover, options trading is an excellent way to manage volatile markets. In times of uncertainty, it reduces an investor's risk. For instance, when you buy a stock in an uncertain market, there are chances for your investment to go down. On such an occasion, you might end up invariably losing money. But when you buy stock options, you need not have to fulfil the buying agreement, and this can limit the loss you make to just the options trading fee.
But that doesn't mean options trading is risk-free. Like any stock market investment, options had to be understood thoroughly before.
By now, you understand the basics of options trading and its risk and reward potential. Now, let us look at how you can start trading options.
With more and more resources available for people to gather information, stock market trading is no longer rocket science. Furthermore, trading platforms have become more accessible, too, with many brokers offering free or lower charge brokerage accounts.
But most of these accounts are limited to day-to-day stock market trading only. An options trading account is a premium version of this, and since there are multiple factors at play, the broker will want to know more about you before they offer you an options trading account.
The information a broker would want from you here includes your objectives, experience, and personal finance information. Once the broker verifies all this information, they will deem if you are eligible for an options trading account. If you are approved, you will be asked to do a KYC. After that, you should have your trading account ready, and you can start exploring the world of options trading.
Now it is time to formulate your trading strategies. As discussed above, an option gives you the option but not the obligation for a trade. There are two types of options in general - a call option and a put option. A call option will give you the prospect to buy a share, while the put option will give you the choice to sell a share. Another critical thing to notice here is the strike price. A strike price is a set price that the stock has to cross in order for you to excise your option. In the case of a call option, the strike price is above the current price, and it is the opposite of a put option.
Now, there are multiple ways you can take advantage of options, but the consensus is that if you think the stock price is going up, you can buy a call option or sell a put option.
Here, a buy option will ensure you can buy the stock at a discounted price when it goes up, and a sell option can ensure you get can pocket the trading charges.
On the other hand, if you think the stock price will go down, you can consider either buying a put option or selling a caption.
The call or put option you trade is only valid till the expiration date of the same. Hence, setting a strike price that is reasonable is important. For instance, if you are buying an option for stock that you think will reach a price point of Rs.150, and the current price is Rs.50, you should set a strike price based on the expiry date of the option. Even if the price of the stock might reach Rs.150 with time, if the expiry of the option is one week, it is wise to set a lower price than the stock can reach well within one week.
It is equally important to set the proper time frame as well. This can ensure that the strike price you met is set within the time of your prediction. For instance, if your strike price is at a 30% up, you should do the math to make sure you select a time frame that is adequate for your prediction to come true.
Options trading does come with its set of disadvantages. While the long term benefits do offset the slight disadvantages, it is important that you understand the cons too to make the best out of it.
There are two types of taxes that gain from stock markets attract - long term capital gains and short term capital gains. Long term capital gains are from stocks that you have invested in for more than one year. At the same time, short term capital gains are from shorter investments.
Long term capital gains are taxed lesser than short term capital gains. But options are always short term. That means you will end up paying more tax.
Stock market trading platforms usually have lower fees when you just want to do normal trading. But when you choose to do option trading, which is much more advanced, the fee will also be higher.
Options trading is a beneficial choice to do low-risk trading. But make sure you always do thorough research as options trading is much more technical as well. It is always wise to take the help of an investment advisor to make the best out of options trading.
Soure: Times of India