Option Trading An Opportunity

Options market is gaining more popularity amongst the market participants as markets become more volatile and unpredictable ahead of a major national event, such as national elections. Not that options trading was unpopular before—it is just that with the advent of a national event of immense importance, speculators are finding it lucrative to trade in options in order to tackle the volatility.

While it is a known fact that option prices rise and fall sharply with increased volatility in the markets, the two most important questions that any trader or investor needs to ask himself/ herself are — (1) do I need to trade in options? and (2) what should be my strategy if at all I have to trade in options?

Indeed, several traders enter options market without actually assessing the need to do so. Option markets is not for faint-hearted and, definitely not for someone who is not research (data) oriented. Says Yagnesh Patel, who is a Gujarat-based options trader and trainer, “I find that people indulge in option markets without ascertaining the end goal and without having any strategy in place for different market conditions. Traders buy mostly OTM (out-of-money) call options because they are cheaper. The beginner’s luck at times allows them to make three to four-fold profits in no time. Later on, the reality sinks in and the need for an appropriate, relevant strategy is felt— which most traders do not have. I can say from experience that those traders without a strategy fail almost 100 per cent of the times, while those with a predefined strategy and know-how on options market find it easy to make decent returns consistently.” 

"Option trading is for active investors and may not be suitable for long term investors who do not track markets on a daily or weekly basis."

Like in equity markets, the success in options market also depends on understanding the underlying market trend and participating in a disciplined manner. The difference, however, is that option traders have to be extra careful in understanding the rules of the game. The beginners have to essentially understand the difference between options and stocks. 



How are options different from stocks?

There are many differences between stocks and stock options. We can start off by saying that stock is an investment instrument that can be bought and sold at any point of time, but on the other hand, stock option is a trading instrument that comes with an expiration date. Post the date of expiration, the stock option cannot be traded. Options contract is an agreement between a buyer and a seller which is bound by an expiration date, which can be a week, some months or years, complying with the regulations and the type of options contract being considered. Unlike stock owners, option owners have no access or right in a company and have no voting or dividend rights. Another vital point of distinction is that you can benefit from options even when the price of the underlying stock falls. We are aware of the simple functioning of bagging profits in stock equity wherein one gains when the stock price goes up from the buying price and incurs a loss if the stock price goes below the purchase price. In options, you can profit even if there is drop in the price of the underlying stock. A profit can be realized in all directions in options, however, it greatly depends on the position or the strategy you are holding. Coming to the point of valuations, stock prices are chiefly dependent on the market forces and company fundamentals such as company’s earnings outlook, market share of products, etc. The stock option prices are largely based on the price of the underlying stock, the price to expiration and certain other factors.

Why is options trading attractive?

Most traders swear by options for not only higher returns but also for steady and consistent returns. Majority of the marketsavvy option traders focus on writing call options for regular income. For those with a relevant strategy in place, options market is proving to be highly profitable.

Option trading is attractive because: -

1. Trader can bet on both the directions
2.Option trading requires relatively less capital
3.If a strategy is in place, the RoI is very high within a short duration of time
4.It is the only instrument available which allows limited risk with unlimited profit potential
5.A variety of underlyings can be traded on (stocks/indices/ currencies/commodities)
6.Can be used for speculation as well as hedging
7. Traders need not analyse complex financial reports of the underlying stocks and rely only on option data for decision making |
8.Technical analysis can be applied for option trading 9. Abundant liquidity in most of the popular underlyings
9.Accurate interpretation of options data can provide insight into market direction, which can be used to make investment and trading decisions in cash market as well.

What is required to trade in options?


Just like a demat account is required to trade or invest in equity markets, to trade in the options market, a demat account is a must. An additional form is to be filled by traders who intend to participate in the markets. The additional form is required only to check if the participant in the options market knows and understands completely the risks involved in options market. Once the demat account is activated for options trading, traders can simply take a directional call on either the markets (index)
or underlying stocks.

What know-how is essential while trading in options?


To start with, the option trading mechanism is to be understood practically. The whole cycle from buying an option till the expiry needs to be observed. All the rules of the games are to be understood perfectly, otherwise it may happen that the underlying security is moving in the desired direction but the end result is unprofitable. It is is essential to know and understand thoroughly the concept of lot size, option premium, moneyness of the options, expiry dates, strike price and how all these factors interplay with price movement.

What is Money-ness of the option?

Moneyness defines the relationship between the strike price of an option and the current price of the underlying stocks. Numerous strategies are played around moneyness of an option. For an options trader, it is of extreme importance to understand the options moneyness. The three kinds of moneyness are: option in-the-money (ITM), option out-of-themoney (OTM) and option at the money (ATM).

In-The-Money (ITM) Option

Call Option:

A call option is said to be ITM when its strike price is below the spot price (current market price) of the underlying. i.e, the strike price < spot price of the underlying. If the strike price is far below the spot price, then the option is called Deep ITM.

Put Option:
A put option is said to be ITM when its strike price is greater than the spot price. i.e. strike price > spot price of the underlying. If the strike price is far above the spot price, then the option is called Deep ITM.

Example: The stock "A" put at strike of 4400 is in-the-money when the spot price of stock "A" is at 4100. When this is the case, the put option has value because the put option holder can sell the stock "A" at 4400, an amount greater than the current stock "A" of 4100.

Out-of-The-Money (OTM) Option


Call Option:
A call option is said to be OTM when its strike price is above the spot price (current market price) of the underlying, i.e., the strike price > spot price of the underlying. If the strike price is far higher than the spot price then the option is called as Deep OTM.

Put Option:
A put option is said to be OTM when its strike price is below the spot price, i.e. strike price < spot price of the underlying. If the strike price is far below the spot price, then the option is called as Deep OTM.

At-The-Money (ATM) Option

Call Option:
A call option is said to be ATM when its strike price is equal to the spot price of the underlying, i.e strike price = spot price of the underlying.

Put Option: A put option is said to be OTM when its strike price is equal to the spot price of the underlying, i.e strike price = spot price of the underlying.

Option trading and volatility

Volatility is the blood stream of the options markets and it is something that options traders should be well-versed with. Volatility in simple terms is defined as the up and down movement of an underlying security, i.e. the amount that the stock price fluctuates without regard to direction. A stock which trades relatively stable is said to have low volatility, while a stock that is prone to sharp price movements in either direction is said to have high volatility. Many naïve option traders do not fully understand the implication of volatility and this can lead to problems. It Is not possible to make any kind of accurate forecasts about how the price of options will move without having a clear insight into volatility and its impact.

As a trader one needs to be aware about the two types or measures of volatility, namely, historical and implied. As per the textbook definition, historical volatility is defined as ‘a statistical measure of the dispersion of returns for a given underlying over a given period of time’ (Investopedia). In addition to historical volatility, traders should also know about implied volatility, popularly known as IV, which is also known as projected volatility. IV is an estimation of the future volatility of an underlying security. IV is a dynamic figure that changes based on activity in the options marketplace.

Why is it important to understand implied volatility?

Basically, it helps us to answer the question: Are options relatively expensive or relatively cheap? In the next section, we will talk of two vital methods which help an option trader to gauge how cheap/expensive an option is relative to the past.

Implied Volatility Rank
:
Implied volatility rank (IV Rank) narrates a stock’s current IV to its IV range over a certain time period (usually one year). In simpler terms, IV Rank indicates where the implied volatility ranks between the selected periods’ high and low.

Formula to calculate one year IV Rank:

Current IV – IV Minimum (low) of the period / IV Maximum (high) of the period– IV Minimum (low) of the period *100.

Example for calculation of IV Rank:
Let us assume stock named ABC has an implied volatility of 25% with a one year IV high and low range between 18% and 38%, so the IV Rank for the particular stock would be calculated as follow: 25–18/38-18*100=35%. This gives us an IV Rank of 35%, indicating that the difference between the current IV and the low IV is only 35% of the entire IV range over the past one year, which means the current IV is nearer to the low end of the historic levels of implied volatility.

Implied Volatility Percentile:
Implied Volatility percentile (IV percentile) tells you the percentage of days in the past that a stock’s IV was lower than its current IV. In simple terms, IV percentile data point out the percentage of days with implied volatility closing below the current implied volatility over the given period of time.

Formula to calculate IV percentile:
Number of days with IV lower than current IV/Number of days in the chosen period * 100 Example: The current IV of stock named XYZ is at 30%. Now you want to measure the IV percentile for the last 252 days and let us assume that in the last 160 out of 252 days, the stock’s IV has been below 30%. In this case, the stock’s 30% implied volatility represents an IV percentile: 160/252*100= 63.49% An IV percentile of 63.49% tells us that the stock’s current IV has been below 30% approximately 63% of the days over the past year.

For an option trader, it is essential to know IV rank or IV percentile while initiating an option strategy because the whole concept of trading options and selecting the right strategies depends on the concept of volatility and pricing.

What are the steps to be taken by option trader?

Any option trader should follow the following basic steps: -


✓ Assess the market trend and the trend for the underlying security
1.Take the help of technical analysis
2.Study option data – Open Interest, Volume, Implied Volatility (IV) and Option Greeks
 
✓ Decide on your bet (underlying security – buy or sell)
✓ Decide your time horizon (expiry date)
1. Based on your view using options data and technical analysis

✓ Decide the quantity of lots you want to buy or sell
1.Depends on your appetite for risk and financial capacity

✓ Decide entry price – target price – stop loss price
1.Based on your overall analysis and prevailing market conditions.

Core elements in an options trade:

✓ Decide which direction you think the stock is going to move.
✓ Predict how high or low the stock price will move from its current price.
✓ Determine the time frame during which the stock is likely to move.

What are Option Greeks?

The Greeks quantifies the sensitivities of derivative products like options. They actually calculate the various aspects of risk in an option position and, at the same time, show a parameter on which the value of an option is dependent. They can be used to measure the risk in owning an option, and the portfolio can be adjusted to achieve the desired exposure.

Remember that seven factors affect the option premium
✓ Type of option (call or put)
✓ The underlying asset price
✓ The strike price of the option
✓ The expiration date of the option
✓ The risk-free interest rate
✓ The volatility of the underlying asset
✓ Dividends payable and stock splits

If these factors affect the pricing of an option, then it stands that option premium must be sensitive to them. We can distil this further by highlighting the following sensitivities



For consistent performance in option trading it is very important that the trader understands option Greeks. In case any trader struggles to use option Greeks, it is recommended that the trader should undergo training in options trading that teaches in detail how to use option Greeks for profitable experience in the options market.

Bonanza Portfolio


To Remain Profitable In Option Trading Game, One Needs To Be A Great Risk Manager


What skill-set is required to make money in the option market?

Any investment requires proper understanding before we come out with the investment decision. Option trading is no different. Before investing in options, one should possess some skill-set to minimize losses and maximize profit.

Technical Analysis: A lot of people who trade in options make handsome profit by analyzing the charts of the particular option or its underlying. Identification of the trend in the underlying helps in choosing the type of option; like, call option is to be bought when the market or the stock is likely to be in the uptrend or put option when the trend is expected to remain downward. In addition, estimated target price of the underlying helps in deciding which strike price is to be taken to invest in options.

Implied Volatility (IV): Implied volatility can be termed as the ECG of the market as it decides whether or not the option is alive. A dying IV is often an indication of a dead option. On the other hand, a sudden spike above the normal range of the in the IV means risk of buying an overpriced option, which may end in the loss of total investment. Therefore, one has to know how to read the IV chart of an option before jumping the gun.

Option Greeks: Understanding option Greeks is a must to master the investment in option segment. There are six main option Greeks – Delta, Gamma, Theta, Vega, Rho and Phi. Proper understanding of these main Greeks provides edge in maximizing the gain.

Option Pricing Model: Among the many option pricing models, Black-Scholes Model is the most popular, which is followed by the many successful option traders. Binomial model is another popular pricing model for options. Option pricing model is used to calculate the fair value of an option.

Who (Investor/Trader) should avoid investing in option market?


Options are derivative instruments where the total investment may be lost (buyer of option) or the investor may see unlimited losses (writer of option). Therefore, investors who are not well-informed, option trading is not their cup of tea. Investor with “buy and hold strategy” may not smile at the end, as with the passing of every single day, option dynamics change.

What is the way to remain profitable in option trading game?


If it’s a game, there is always a chance that you may lose and another person will win, and vice versa. One needs to keep in mind that not every trade will end in a profit, no matter what strategy you use. Therefore, to remain profitable in the option trading game, one needs to be a great risk manager. Exiting from the wrong trade soon after realising it can minimise risk, which will add to the overall profitability. Also, one needs to keep in mind that in the option trading world, it is said “small is big”, and unlike stock investment, smaller expectation always has better pay-off in the option market.

Conclusion

Options trading should be looked at as an opportunity to make money in different market conditions. The beauty of options trading is that the results are quick and traders can consistently keep booking profits if the market trend is assessed correctly and the strategy selection and execution is immaculate. The basics of options trading should not be ignored and the trader should focus on reading volatility- it is of paramount importance. Before entering any option position, the trader should understand all the possible ways to close the position. Most traders do not know how and when to exit the options they have bought.

The way to go for options trader is to study the market data and assess the market direction using technical analysis. The correct interpretation of market direction and options data can lead to excellent money-making opportunities on a regular basis. 

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