This article is part 1 of the F&O section of our Stock Market Learning series created by SMJ to help you understand key concepts in the stock market. The world of options trading, explaining how it works and the steps you can take to get started in the Indian market. Whether you’re looking to hedge risk, generate income, or profit from market movements, this article will provide you with the foundation needed to begin your options trading journey.
Options trading is a popular and versatile form of trading in the financial markets, allowing investors to speculate on or hedge against the price movements of various assets.
Unlike traditional stock trading, where you own shares outright, options trading gives you the right—but not the obligation—to buy or sell an asset at a predetermined price within a set time frame.
This flexibility makes options an attractive tool for traders who want to limit risk, increase potential rewards, or protect their investments from market volatility.
In the Indian stock market, options are primarily traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), with contracts based on underlying assets such as stocks, indices (like Nifty and Bank Nifty), commodities, and even currencies.
Each options contract has a strike price (the price at which you can buy or sell the underlying asset) and an expiry date (the deadline by which the option must be exercised).
Also Read: What Are Derivatives? A Comprehensive Guide to Understanding and Using Financial Derivatives
The two main types of options are call options and put options –
- Call Options give you the right to buy an asset at a specific price.
- Put Options give you the right to sell an asset at a specific price.
Options trading in India follows the European-style settlement for indices (exercised only on the expiry date) and the American-style settlement for stock options (exercised anytime before expiration). This means that traders can either choose to exercise the option if it is profitable or let it expire worthless, limiting their risk to the premium paid for the contract.
Whether you are looking to hedge your portfolio or speculate on market trends, options trading offers a flexible and dynamic way to engage with the stock market. However, it is essential to understand the key concepts, strategies, and risks involved before diving in.
Basic Concepts in Options Trading
It’s crucial to understand the key concepts that form the foundation of this trading strategy. These concepts will help you make informed decisions and better manage risk as you navigate the options market.
Call and Put Options
At the heart of options trading are two main types of contracts – call options and put options.
Call Options –
A call option gives the buyer the right, but not the obligation, to buy an underlying asset (such as a stock or index) at a predetermined price, known as the strike price, before or on the option’s expiration date. Traders use call options when they believe the price of the underlying asset will increase.
Example –
You buy a call option on Reliance Industries with a strike price of ₹2,500 and a premium of ₹100. If Reliance’s stock price rises to ₹2,700 before the option expires, you can exercise the option to buy at ₹2,500, instantly profiting from the price difference.
Put Options –
A put option gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price before the expiration date. Put options are used when a trader expects the price of the underlying asset to decrease.
Example –
If you buy a put option on TCS with a strike price of ₹3,000 and a premium of ₹80, and TCS’s price drops to ₹2,800, you can sell at the higher ₹3,000 strike price and profit from the difference.
Strike Price
The strike price, also known as the exercise price, is the price at which the buyer of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. The strike price is a key element in determining whether an option is profitable or “in the money.”
In-the-Money (ITM) –
When the market price of the asset is above the strike price for a call option (or below for a put option), the option is considered “in the money.” This means exercising the option would result in a profit.
Out-of-the-Money (OTM) –
If the market price is below the strike price for a call option (or above for a put option), the option is “out of the money,” and exercising it would result in a loss.
Expiry Date
The expiry date is the date on which the options contract becomes void. After the expiry date, the option can no longer be exercised, and its value becomes zero if it is not profitable. In India, options contracts typically expire on the last Thursday of the month. Options trading in India uses two main styles of expiry –
- European-style options – Can only be exercised on the expiry date. This style is used for index options (like Nifty and Bank Nifty).
- American-style options – Can be exercised anytime before or on the expiry date. This style is commonly used for stock options in India.
Premium
The premium is the price you pay to buy an options contract. This upfront cost gives you the right to buy (call) or sell (put) the underlying asset. The premium is determined by several factors, including –
- The strike price of the option.
- The current market price of the underlying asset.
- The time to expiration (options lose value as they approach expiry, known as time decay).
- Volatility of the asset (higher volatility often increases the premium).
Example –
If you buy a call option for ₹50, this ₹50 is the premium you pay for the right to potentially buy the asset at the agreed-upon strike price.
Option Chain
An option chain is a table that shows the available options for a particular asset, including call and put options at different strike prices and expiration dates. This tool helps traders compare different options and make informed decisions. Key columns to focus on in an option chain include –
- Strike price – The price at which the asset can be bought or sold.
- Bid/Ask prices – The price buyers are willing to pay (bid) and sellers are asking for (ask).
- Volume and open interest – The number of contracts traded and currently open, indicating the liquidity and interest in a particular option.
Margin and Leverage
In options trading, traders often use margin—borrowed money—to take larger positions than their available capital would otherwise allow. This is where leverage comes into play, allowing traders to control a large position with a smaller investment. However, while leverage can amplify profits, it also significantly increases the risk of losses.
Example –
If an investor pays ₹10,000 in premium for an options contract that controls ₹1,00,000 worth of stock, any profit or loss is based on the ₹1,00,000 value, not the ₹10,000 premium. This amplifies both potential gains and losses.
Time Decay (Theta)
Time decay refers to the gradual decrease in the value of an options contract as it approaches its expiration date. The closer an option gets to its expiry date, the faster it loses value, especially if the underlying asset’s price remains unchanged.
Theta measures how much an option’s price decreases per day due to time decay. This is a crucial factor for traders because an option can lose value even if the price of the underlying asset doesn’t change.
Also Read: Understanding Futures and Options: Benefits, Risks, and Who Should Invest
Options Trading Strategies for Beginners
Options trading offers a range of strategies that can be used for different market conditions. For beginners, it’s important to start with simple, low-risk strategies before moving on to more complex trades. These basic strategies can help you gain exposure to the market, hedge risk, or potentially profit from price movements with limited capital.
Long Call (Buying a Call Option)
The long call strategy is one of the most straightforward options strategies and is used when you expect the price of the underlying asset to rise. By purchasing a call option, you gain the right to buy the asset at a predetermined strike price. If the asset’s price increases significantly, you can exercise the option for a profit.
When to Use It –
- You are bullish on the market or a particular stock.
- You expect a significant price increase before the option’s expiration date.
Example –
You buy a call option on TCS at a strike price of ₹3,000 with a premium of ₹100. The current market price is ₹2,900. If the stock price rises to ₹3,200 before the option expires, you can buy the stock at ₹3,000 and sell it at ₹3,200, netting a ₹100 profit per share (after deducting the premium).
Advantages –
- Limited Risk – Your loss is limited to the premium paid.
- Unlimited Profit Potential – There is no cap on how much you can earn if the stock price rises.
Risk –
- If the stock price doesn’t rise above the strike price by expiration, the option will expire worthless, and you will lose the premium.
Long Put (Buying a Put Option)
A long put strategy is used when you expect the price of an asset to fall. By purchasing a put option, you gain the right to sell the asset at a predetermined strike price. This strategy allows you to profit from a decline in the asset’s price.
When to Use It –
- You are bearish on the market or a particular stock.
- You expect a significant drop in price before the option expires.
Example –
You buy a put option on Infosys with a strike price of ₹1,500 and a premium of ₹50. The current market price is ₹1,550. If the price drops to ₹1,300 before the option expires, you can sell the stock at ₹1,500, making a ₹150 profit per share (after deducting the premium).
Advantages –
- Limited Risk – Your maximum loss is the premium paid.
- Profit from Price Declines – Allows you to profit in a falling market.
Risk –
- If the stock price doesn’t drop below the strike price by expiration, the option will expire worthless, and you will lose the premium.
Covered Call
A covered call strategy is ideal for investors who already own shares of a stock and want to generate additional income. In this strategy, you sell a call option against the shares you already hold. If the option is exercised, you will have to sell your shares at the strike price, but you will also earn the premium from selling the option.
When to Use It –
- You own shares of a stock and want to earn income from your holdings.
- You believe the stock price will remain stable or rise slightly.
Example –
You own 100 shares of Reliance at ₹2,500 per share. You sell a call option with a strike price of ₹2,600 and receive a ₹50 premium per share. If Reliance’s stock price stays below ₹2,600 by the expiration date, the option will expire worthless, and you keep the ₹50 premium. If the stock price rises above ₹2,600, you will have to sell your shares at ₹2,600 but still keep the premium.
Advantages –
- Generate Extra Income – Earn a premium from the call option in addition to any potential price gains.
- Hedging – If the stock price doesn’t rise significantly, you keep both the stock and the premium.
Risk –
- Limited Upside – If the stock price rises sharply, you will have to sell at the strike price and miss out on additional gains.
Protective Put (Married Put)
A protective put is used by investors who own a stock and want to protect themselves from a potential decline in its value. By buying a put option on the same stock, you ensure that you can sell the stock at the strike price if the market price falls. This strategy acts like an insurance policy against losses.
When to Use It –
- You own a stock but are worried about a potential price drop.
- You want to hedge your position while retaining ownership of the stock.
Example –
You own 100 shares of Tata Steel at ₹1,200 per share. To protect against a decline, you buy a put option with a strike price of ₹1,150 for a premium of ₹20. If the stock drops to ₹1,000, you can sell it at ₹1,150, minimizing your losses.
Advantages –
- Protection from Losses – You limit your downside risk if the stock price drops.
- Flexibility – You can still benefit from price increases, as you retain ownership of the stock.
Risk –
- Cost of the Premium – If the stock price remains stable or increases, you will lose the premium paid for the put option.
Cash-Secured Put
A cash-secured put involves selling a put option while holding enough cash to buy the underlying asset if the option is exercised. This strategy is useful if you want to buy a stock at a lower price but earn income in the meantime by selling the put option.
When to Use It –
- You are willing to buy the stock at a lower price and want to earn income while waiting.
- You believe the stock price will remain above the strike price.
Example –
You want to buy shares of HDFC Bank, currently priced at ₹1,600, but are willing to buy them at ₹1,500. You sell a put option with a strike price of ₹1,500 and receive a ₹40 premium. If the stock price falls below ₹1,500, you are obligated to buy the stock at that price but still keep the premium. If the price stays above ₹1,500, you keep the premium and are not required to buy the shares.
Advantages –
- Generate Income – Earn a premium while waiting for the stock to reach your target buying price.
- Lower Purchase Price – If the stock is assigned, you buy it at a lower price than the current market price.
Risk –
- Obligated to Buy – If the stock price falls significantly, you will have to buy the shares, potentially incurring a loss.
Also Read: What are Technical Indicators: Why & How?
Key Risks in Options Trading
While options trading can offer significant rewards and flexibility, it also comes with various risks that traders must understand before entering the market. Options are complex financial instruments, and their potential for both profit and loss can be high.
Risk of Losing the Premium (Buyer’s Risk)
When you buy an option (whether a call or put), the most you can lose is the premium paid for the option. If the underlying asset doesn’t move in your favor by the time the option expires, the option becomes worthless, and you lose the entire premium. This makes it possible for an option to expire with zero value, resulting in a total loss of your initial investment.
Example –
You buy a call option on HDFC Bank for a ₹100 premium, expecting the stock price to rise above the strike price. However, if the stock price doesn’t increase and the option expires without being exercised, you lose the ₹100 premium.
Risk Summary –
- Maximum loss – Limited to the premium paid.
- Potential impact – 100% loss of the premium if the market does not move as expected.
Leverage and Amplified Losses (Seller’s Risk)
When selling options (whether covered or uncovered), the risk can be unlimited. This is particularly true for uncovered (naked) option sellers. While selling options can generate income through premiums, sellers are exposed to significant risk if the market moves sharply against their position. In such cases, losses can be much larger than the premium earned.
Example –
If you sell a naked call option and the price of the underlying asset rises dramatically, you are obligated to deliver the asset at the lower strike price, potentially incurring massive losses.
Risk Summary –
- Maximum loss – Potentially unlimited for uncovered sellers.
- Potential impact – Large margin calls and financial losses if the market moves sharply in the wrong direction.
Market Volatility and Unpredictability
Options prices are highly sensitive to market volatility. Even if the price of the underlying asset moves as expected, a sudden spike or drop in volatility can affect the value of an option. High volatility increases the option premium, while low volatility decreases it. Traders who don’t account for volatility risk may end up with unexpected losses.
Example –
You buy a call option expecting the stock price to rise, but sudden market volatility causes a sharp drop in the option’s value. Even though the stock price moves in your favor, the volatility shift erodes your profit.
Risk Summary –
- Market unpredictability can make option values fluctuate wildly.
- Volatility shifts can negatively impact an option’s price even if the market moves as expected.
Time Decay (Theta Risk)
Time decay, or theta, refers to the gradual erosion of an option’s value as it approaches expiration. Options lose value over time, particularly if they are out-of-the-money. This time decay accelerates as the option nears its expiry date, which can result in significant losses for buyers if the underlying asset doesn’t move quickly enough.
Example –
You buy a call option with one month to expiration, expecting the stock price to rise. However, the stock price remains unchanged for three weeks, and the value of the option decreases significantly due to time decay. Even a price rise in the final week might not be enough to compensate for the lost value.
Risk Summary –
- Time decay accelerates as expiration approaches, reducing the option’s value daily.
- Out-of-the-money options are particularly vulnerable to time decay.
Liquidity Risk
Liquidity refers to how easily you can enter or exit an options position without affecting the price. Low liquidity can make it difficult to sell an option at the desired price or to close a position quickly, which can result in unexpected losses or missed opportunities.
Example –
You hold an option in a less-traded stock and want to sell it before expiration, but due to low liquidity, you’re forced to sell at a lower price than expected, reducing your profit or even turning a potential gain into a loss.
Risk Summary –
- Low liquidity can result in poor execution prices.
- You may struggle to exit positions quickly during market volatility.
Margin Calls for Sellers
If you’re selling options, particularly uncovered (naked) options, you will likely trade on margin. This means that if the market moves against you, your broker may issue a margin call, requiring you to deposit more funds into your account to cover potential losses. If you fail to meet the margin call, your positions may be forcibly liquidated, locking in significant losses.
Example –
You sell a naked put option, and the underlying stock’s price plummets. The broker issues a margin call, requiring you to add funds to your account to maintain the position. Failure to meet the margin call results in the broker liquidating your positions at a loss.
Risk Summary –
- Margin calls can occur if the market moves against your position.
- Forced liquidation may lock in significant losses if additional funds aren’t available.
Exercise and Assignment Risk
For American-style options, which can be exercised at any time before expiration, there is always a risk of early exercise by the buyer, especially if the option becomes profitable. If you are the option seller, this can result in sudden obligations that you may not be prepared for.
Example –
You sell a call option on stock, expecting the stock price to remain stable. However, the buyer exercises the option early, and you’re forced to deliver the stock at the strike price, potentially incurring a loss.
Risk Summary –
- Early assignment can happen at any time, leading to unexpected obligations.
- Forced action may disrupt your trading strategy.
Psychological and Emotional Risk
Options trading can be highly stressful, particularly when dealing with market volatility or significant losses. Traders may make emotional decisions, such as holding onto a losing position in the hope that it turns around or exiting too early due to fear. Emotional trading often leads to poor decisions and greater losses.
Example –
You see your option’s value rapidly declining, and out of fear, you sell it at a loss, only to see the market reverse shortly afterward.
Risk Summary –
- Emotional decision-making can lead to irrational trading behaviors.
- Stress from market fluctuations may result in suboptimal strategies.
Benefits of Options Trading in India
Options trading is an increasingly popular financial tool in India, offering investors various opportunities to profit from market movements while managing risk. Whether you’re a seasoned trader or just beginning, options trading provides unique advantages that can enhance your overall investment strategy.
Leverage – Maximize Gains with Lower Capital
One of the biggest advantages of options trading is the use of leverage, allowing you to control a large position with a relatively small initial investment. By paying only the premium, which is a fraction of the cost of the underlying asset, traders can gain exposure to price movements without having to buy the asset outright.
- High returns on small investments.
- Allows traders to take large positions with less capital.
Risk Management and Hedging
Options are widely used as a tool for hedging against potential losses in other investments. Traders can use put options to protect their portfolios from adverse price movements, limiting their downside risk. This makes options a valuable tool for investors looking to protect their portfolios during volatile market conditions.
- Provides a safety net against market downturns.
- Allows for controlled risk while maintaining ownership of assets.
Profit in Both Rising and Falling Markets
Options trading provides the flexibility to profit in both bullish and bearish markets. With call options, traders can benefit from rising prices, while put options allow traders to profit from falling prices. This flexibility makes options suitable for all market conditions.
- Flexibility to profit regardless of market direction.
- More opportunities to trade across different market conditions.
Limited Risk for Buyers
When you buy an option, your maximum loss is limited to the premium you paid, unlike other financial instruments where losses can be much larger. This limited risk feature makes options an attractive tool for risk-averse traders who want to participate in the market without exposing themselves to significant losses.
- Limited downside risk for buyers.
- Clear understanding of maximum potential loss upfront.
Income Generation with Covered Calls
One of the most popular options strategies in India is the covered call, where investors sell call options on stocks they already own. This strategy allows you to generate additional income from your stock holdings, regardless of whether the stock price rises or remains stable.
- Earn extra income from stock holdings.
- Profitable in sideways or slightly bullish markets.
Flexibility with Different Strategies
Options offer a wide variety of trading strategies, from simple to complex, giving traders flexibility based on their risk tolerance, market outlook, and financial goals. Some strategies include straddles, strangles, and spreads, which can be tailored to different market conditions.
- Flexibility to craft customized strategies for different market scenarios.
- Multiple strategies available to maximize potential profits while managing risks.
Cost Efficiency
Options trading can be a cost-effective way to gain exposure to the stock market. Since the premium paid for options is usually lower than the cost of buying the underlying asset outright, traders can achieve similar profit potential with much less capital.
- Allows access to high-value trades with smaller initial investments.
- Higher return on investment (ROI) due to the lower upfront capital.
Participation in Large, Diverse Markets
In India, options are available on a wide range of assets, including individual stocks, indices like Nifty 50 and Bank Nifty, and commodities. This provides investors with opportunities to diversify their portfolios and trade across multiple asset classes, further enhancing their ability to spread risk and capitalize on various market trends.
- Access to a wide range of assets, including stocks, indices, and commodities.
- Opportunity to diversify your portfolio.
The information provided in this article is for educational purposes only and should not be construed as financial advice. Futures and options trading involves significant risk and may not be suitable for all investors. Before engaging in any trading, you should conduct thorough research and consult with a qualified financial advisor. SMJ does not endorse or recommend any specific financial products or strategies.
