An option is a mutual contract that gives the buyer a right to purchase or sell an asset at a set price within specified expiration date. In short, it’s a right to purchase or sell the asset as per time frame. This is basic definition of option, now let us understand briefly about basics of how to do trading in options stock.
Options are simply trading vehicles. The risk level is relative to size of the position you hold and profit making odds in your time frame before expiration of contract units. The same principles of successful trading apply to options that mostly apply to other financial markets. However, with option contracts you can take benefit of the rise movement of an underlying asset during a trend, while the downside can be sealed at the price you paid for the option. The risk level is maximum pertaining to your capital and the price of the option contract.
Options are useful for leveraging funds availability while limiting risk level on the down ward trend, allowing you to own more shares of a stock with a small percentage of your trading funds. This gives you opportunity for big wins while absorbing your losses, which is your prime concern as stock market trader.
Long Options vs. Short Options
Long options provide a safer risk reward ratio than short options, because in long options you can put small amount at risk to trade in large amount. In contrast, while dealing with short options, there is no hedging and you end up risking large sum of money for the stocks that usually give marginal profit in short term trading. While short option positioned with a hedge absorb losses.
Before the option markets officially began in 2001 in India, traders used margin (borrowed money) for buying power and leverage with internal arrangement of good faith. Option contracts are bigger trades through short term buying at a price level within a specified time frame. They reduce the risk to capital, and save money from losses for a leveraged trade. Citizens of India can obtain this leverage in their demat and trading account.
Option contract prices are determined using the pricing model for time, volatility, and the distance from the strike price. The pricing model attempts to price the odds that the option will have some intrinsic value at expiration, and is the primary mathematical model that determines the price of an option. However, it’s usual bid/ask valuation in the market that define what traders are willing to pay for buying and selling option contract units.
The option market is not as liquid as other markets such as stocks and commodity futures, and volume can be an issue with option trading. The tightest bid/ask spreads for options are found when there is good trading volume in a popular stock, and with options that expire in the front month and one month out. The capital intensive options are those with strike values that are close to the money. The more you move away from the capital in the strike price, the bid/ask valuation widens. So, you can lose profits on winning option trades when the options liquidate with large sum of money, to become almost unsaleable, and the bid/ask spread further expands. Use stock market learning app to learn fundamentals of trading in Indian stock market.