What is Option Trading

Meaning of Options Trading?

One can buy or sell stocks, ETFs etc. at a fixed price over a certain period by online trading options. This method of online trading also gives buyers the flexibility not to purchase the security at the defined price or date.

Although options trading is a little more complex than stock trading, options can result in great upside potential with low downside risk, which is only limited to the premium you pay while buying the option. Similarly, selling options will reduce your losses if the security price goes down, which is called hedging.

How Does Options Trading Work in Stock Market?

So, how does options trading work exactly? Let’s say you believe Stock A is going to rise next week. Instead of buying 100 shares (which can be pricey), you buy an option contract that gives you the right, but not the obligation, to buy the stock at a certain price (called the strike price) by a certain date (called the expiry date). If you’re right and the price shoots up, you make a profit. If you’re wrong, you just lose the premium you paid for the option. It’s kind of like placing a bet, but with smart money moves behind it.

Types of Options in Options Trading

Before diving deep, let’s break down the two main types of options:

Both call and put options can be used for speculation (high risk, high reward) or hedging (reducing risk in your stock holdings).

Options Trading Example

Let us try to understand the mechanics of options with the help of an example.

Suppose, you purchase a long call option for 100 shares of Company X at ₹110 per share for December 1. You’d be entitled to purchase 100 shares at ₹110 per share regardless of the actual price of the share is on December 1. On that day, if the shares of Company X are trading at a price higher than ₹110, you have the right to purchase them at a lower price, and hence, make profits. If, on the other hand, the shares are trading at a price lower than ₹110, you can simply choose not to exercise the option. The only loss you would have incurred would be the premium you paid while purchasing the call option.

Key Terminologies in Options Trading

Premium

It is the price you pay to the seller of the option for entering into the contract. You pay the broker the fee which is passed to the writer on the exchange and thereon. Premium is a percentage of the underlying, which is calculated by several factors, including the intrinsic value of the contract options. Premiums continue to adjust, depending on whether the option is in-the-money or out-of-money

American and European Options

‘American options’ are options that can be exercised on or before their expiry date at any time. ‘European options’ are options that can be exercised only on the expiry date.

Open Interest

Expiry Date

The expiry date is the last day your option contract is valid. After this date, the option disappears. If you haven’t exercised your right or sold the contract by then, it loses all value. Always keep an eye on this date because time is not your best friend in the options game.

In-the-Money

An option is ITM when it has intrinsic value. For a call option, this means the stock price is higher than the strike price. For a put option, it’s the other way around – the stock price is below the strike price. ITM options are usually more expensive but safer than the others.

Out-of-the-Money

This option has no intrinsic value. A call option is OTM if the stock is below the strike price. A put is OTM if the stock is above. Cheaper to buy, riskier to hold.

At-the-Money

An at-the-money option is when the stock price and strike price are almost the same. It’s that neutral zone where neither side wins – yet. These are often chosen by short-term traders who expect a quick price move.

Time Value

Time value is the extra money traders are willing to pay for the chance that the stock might move before the expiry. The more time left on your option, the higher its time value.

Intrinsic Value

This is the actual, real value of an option if you exercised it right now. For example, if a stock is ₹110 and your call option has a strike price of ₹100, the intrinsic value is ₹10. It’s the part of the premium that’s not affected by time or volatility.

Index Option

An index option is based on the performance of a stock index like the Nifty or the Sensex. You don’t deal with individual stocks, but with the entire market trend. These are settled in cash and don’t require physical delivery of shares, making them ideal for broad market plays.

Stock Option

Stock options are tied to individual companies like Reliance, Infosys, or Tata Motors. You’re betting on the price of one specific stock. Unlike index options, these can be settled with actual delivery of shares (if you choose to), and they’re usually more volatile.

Strategies in Option Trading

Now that you know the basics, let’s understand some smart strategies:

• Covered Call – Own the stock and sell a call to earn a premium. Safe and steady.
• Protective Put – Buy a stock and a put option to limit downside risk.
• Straddle – Expecting a big move but unsure of direction? Buy a call and put at the same strike.
• Iron Condor – A complex but low-risk strategy for range-bound markets. Ideal for advanced traders.

Want a simple options trading example?

Let’s say Infosys is at ₹1,500. You buy a call option with a strike of ₹1,520 for ₹20. If Infosys rises to ₹1,560, your profit is ₹40 – ₹20 (premium) = ₹20 per share.

Advantages of Option Trading

Here’s why options trading is profitable:

• Low upfront cost: You control more with less capital.
• Flexible strategies: Hedge, speculate, or generate income.
• Leverage time and volatility: Make money even if the stock doesn’t move much.
• Risk management: Use it to protect your portfolio from sudden drops.

Risk of Options Trading

Here’s what can go wrong:

• Total premium loss: If you’re wrong, you lose the premium paid.
• Market swings: Unexpected moves can kill your strategy.
• Complexity: Too many terms, too many moving parts.
• Time decay: Options lose value as expiry approaches.

Conclusion

Options may seem like complicated derivative instruments, but they can prove to be quite useful financial instruments, providing you with the risk mitigation or the leverage that you need, while also protecting any downside risk. If you’re well-versed in online trading options, there are sophisticated trading strategies in India such as a straddle, strangle, butterfly and collar that can be used to optimise returns.