What is Option Trading in Share Market
What is Option Trading in Share Market
Options trading provides investors and traders with the opportunity to buy or sell various securities, such as stocks and ETFs, at specific prices within predetermined timeframes.
This type of trading offers notable flexibility as it allows investors to abstain from purchasing a security at a particular date or price if they choose.
What are Options?
An “option” refers to a contractual agreement that grants an investor the ability, but not the obligation, to buy or sell instruments such as securities, ETFs, or index funds at a predetermined price within a specified timeframe.
The buying and selling of options take place in the options market. A “call option” is an option that allows the investor to purchase shares at a future time, while a “put option” is an option that enables the investor to sell shares at a future time.
Difference Between Options Trading and Other Instruments
Options are generally perceived as lower-risk instruments compared to traditional futures contracts utilized in stock, index, and commodity trading.
This is primarily due to the flexibility offered by options, allowing investors to opt out or terminate their options contract at any time.
Unlike stocks, options do not imply ownership in a company. Instead, the market price of an option, known as its premium, represents a fraction of the underlying security or asset.
How Does Options Trading Work?
When an investor or trader engages in buying or selling options, they possess the right to exercise that option at any time before its expiration date.
Merely purchasing or selling an option does not necessitate its actual exercise upon expiration.
This characteristic categorizes options as “derivative securities,” meaning their price is derived from other factors such as the value of assets, securities, and other underlying instruments.
Benefits of Options Trading
Options trading offers several advantages and flexibility for investors and traders:
1. Lower initial expense: Buying options requires a lesser initial expense compared to acquiring stocks outright.
The cost of obtaining an option, including the premium and trading fee, is typically more affordable than the price of purchasing shares directly.
2. Price freezing: Options trading allows investors to lock in the price of their stock at a predetermined amount for a specific period.
Depending on the type of option used, the fixed stock price, known as the strike price, ensures that traders can trade at that rate at any point before the options contract expires.
3. Portfolio enhancement: Options trading can improve a trader’s investment portfolio by providing additional income, leverage, and protection.
Options can be utilized as a hedge against a declining stock market, allowing traders to limit their downside losses. Moreover, options can generate a recurring source of income through strategies such as selling covered calls.
4. Inherent flexibility: Options trading provides inherent flexibility for traders. They can employ various strategic moves before their options contract expires.
This includes using options to buy shares and expand their investment portfolio, buying shares and selling them for a profit, or selling the option contract at a higher price to another investor before it matures and expires.
By leveraging these advantages and employing effective options trading strategies, investors can enhance their trading outcomes and potentially achieve their investment goals.
Here are some notable terms commonly used in options trading:
1. Premium: The price paid by the option buyer to the option seller is known as the option premium. It represents the cost of the option contract.
2. Expiry Date: The specified date in an option contract is referred to as the expiry date or exercise date. It is the last day on which the option can be exercised.
3. Strike Price: The price at which the underlying asset can be bought or sold when exercising the option is called the strike price or exercise price. It is predetermined and stated in the option contract.
4. American Option: An American option is an option that can be exercised at any time before or on the expiry date. This provides flexibility for the option holder to exercise the option when it is most advantageous.
5. European Option: A European option is an option that can only be exercised on the expiry date itself. It does not allow for early exercise.
6. Index Options: Index options are options contracts where the underlying asset is an index, such as the Nifty or Bank Nifty in India.
In India, settlement for these options follows the European style, which means they can only be exercised on the expiry date.
7. Stock Options: Stock options are options contracts where the underlying asset is an individual stock.
These options give the holder the right to buy (call option) or sell (put option) the underlying shares at the specified price. The regulator may authorize the American style of settlement for stock options, allowing for early exercise.
Understanding these terms is crucial for options traders as they navigate the options market and make informed decisions regarding their trading strategies.
