How to Do Options Trading – Step-by-Step Beginner’s Guide

With ₹1,00,000, 28-year-old Abhinav wants to try his hand at options trading. He was conscious that a call option allowed him to buy stock before it expired at a fixed price. Reliance, for example, was priced at ₹2,500. 

For a premium of ₹50 per share, he bought a call option with a strike price of ₹2,550 that would expire in a month. He had paid ₹25,000 (₹50 × 500) since one contract includes 500 shares. He could profit by exercising the option. Excited by the potential gains and risks, Abhinav began his options trading journey.

Understanding the Basics: What Are Options?

Options are financial derivatives that give the holder the right, but not the responsibility, to purchase or sell an underlying asset before or on a given expiration date at a predetermined price (the strike price). Because of this flexibility, traders can make money, hedge current positions, or speculate on price fluctuations.

Read More – How to Learn Trading – Step-by-Step Guide for Beginners

Types of Options:

1. Call Option: Gives the holder the right to buy the underlying asset at the strike price. Traders purchase call options when they anticipate the asset's price will rise.
   
   
2. Put Option: Gives the holder the right to sell the underlying asset at the strike price. Traders purchase put options when they anticipate the asset's price will fall.

Option Premium

The cost of purchasing an option is known as the premium. This amount is paid upfront to the seller (writer) of the option. The premium is influenced by factors such as the underlying asset's price, strike price, time to expiration, and market volatility.

Example:

Let’s suppose, Reliance Industries is trading at ₹2,500 per share.

• Call Option: You buy a call option with a strike price of ₹2,550, expiring in one month, at a premium of ₹50 per share. Since one contract covers 500 shares, the total premium paid is ₹50 × 500 = ₹25,000.
  
  
  • If Reliance's stock price rises to ₹2,600, you can exercise the option to buy at ₹2,550 and sell at ₹2,600, making a profit of ₹50 per share. Total profit = ₹50 × 500 = ₹25,000. After subtracting the premium paid, net profit = ₹25,000 - ₹25,000 = ₹0
    
    
  • If Reliance's stock price remains below ₹2,550, the option expires worthless, and you lose the entire premium paid, i.e., ₹25,000.

Risks and Rewards

• Maximum Loss: The maximum loss when buying options is limited to the premium paid.
  
  
• Maximum Gain: Theoretically unlimited for call options if the underlying asset's price rises significantly.
  
  
• Breakeven Point: For a call option, it is the strike price plus the premium paid. In this example, breakeven = ₹2,550 + ₹50 = ₹2,600.

Options trading can be a valuable tool for investors seeking to diversify their strategies. However, it's essential to understand the mechanics and risks involved before participating. Always consider consulting with a financial advisor to align options trading with your investment goals.

Opening an Options Trading Account

Example:

Abhinav opens an account with Zerodha, uploads his salary slip showing ₹6,00,000 per annum, and activates the F&O segment. He funds the account with ₹50,000, then buys 1 lot of a Nifty 18,500 Call Option at a premium of ₹100, costing ₹5,000. When he sells it, he pays STT of ₹3.13 and brokerage of ₹20.

What are the Risk Management Strategies?

Options trading offers significant profit potential but also carries substantial risk. Implementing effective risk management strategies is crucial to protect capital and optimise returns. Below are key strategies, supported by numerical examples, to manage risk effectively in options trading.

1. Position Sizing

Position sizing involves determining the amount of capital to allocate to a particular trade, ensuring that no single trade can significantly impact the overall portfolio. A common approach is the 2% rule, where no more than 2% of the trading capital is at risk on any one trade.

Example:

• Capital: ₹1,00,000
• Risk per Trade: 2% of ₹1,00,000 = ₹2,000
• Option Premium: ₹20 per share
• Lot Size: 500 shares
• Maximum Number of Contracts: ₹2,000 ÷ (₹20 × 500) = 0.2 contracts

Here in this example, the trader should not enter a position that risks more than ₹2,000, which limits exposure and potential losses.

2. Stop-Loss Orders

A stop-loss order automatically sells your options if the price falls below a certain level, limiting losses and preventing emotional decision-making.

Example:

• Initial Option Premium: ₹50
• Stop-Loss Level: ₹40
• Loss per Share: ₹50 - ₹40 = ₹10
• Lot Size: 500 shares
• Total Loss: ₹10 × 500 = ₹5,000

By setting a stop-loss at ₹40, the trader limits the potential loss to ₹5,000, providing a clear exit strategy if the market moves unfavourably.

3. Hedging with Protective Puts

A protective put involves buying a put option to protect against a decline in the price of an asset you own, limiting potential losses while retaining upside potential.

Example:

• Stock Holding: 1,000 shares of HDFC Bank at ₹1,700 each
• Put Option Strike Price: ₹1,600
• Put Premium: ₹20 per share
• Total Cost of Put Options: ₹20 × 1,000 = ₹20,000.

If the stock price falls to ₹1,500, the put option increases in value, offsetting the loss in the stock position. The maximum loss is limited to the premium paid for the put options, ₹20,000, providing downside protection

4. Implementing Spreads

Spreads involve buying and selling options of the same class (calls or puts) on the same underlying asset with different strike prices or expiration dates, limiting both potential gains and losses.

Example:

• Current Nifty 50 Index Price: 23,900
• Sell Put Option: Strike Price ₹23,500, Premium ₹100
• Buy Put Option: Strike Price ₹23,700, Premium ₹50
• Net Premium Received: ₹100 - ₹50 = ₹50
• Maximum Profit: ₹50 (net premium received)
• Maximum Loss: (₹23,700 - ₹23,500) - ₹50 = ₹150