Understanding Option Trading
Option trading involves the buying or selling of options contracts on a recognized stock exchange, facilitated through the online trading platform provided by your stockbroker.
Termed as derivatives trading, options contracts derive their value from underlying instruments.
– A Call option is purchased to acquire the right to buy shares before the contract’s expiry date.
– A Put option is acquired to gain the right to sell shares before the contract’s expiry date.
Engaging in options trading does not necessarily entail exercising the right to buy or sell. In day trading options, transactions involve buying or selling options without the need for exercising these rights.
Options provide the opportunity to control a larger number of shares for a relatively small amount of money known as the premium, as opposed to directly purchasing the stock.
For instance, consider purchasing 1 call option contract for Reliance at a premium of Rs. 72.50. This contract, with a strike price of Rs. 1900, grants the right to buy 505 Reliance shares at Rs. 1900, regardless of the current stock price. The total investment for this option, covering 505 shares, would be Rs. 1,35,340.
In contrast, directly buying 505 Reliance shares at the market price of Rs. 1900 would require an investment of approximately Rs. 959,500 (1900 * 505).
How Option Trading Works in India
- Open an Options Trading Account
– To engage in options trading, it is necessary to have a trading account with a leading stockbroker such as Zerodha or Upstox.
– Options contracts in India are cash-settled, eliminating the need for a Demat account. A trading account linked with your bank account is sufficient for options trading.
– Options trading is conducted in lots, where each lot size comprises a fixed number of underlying instruments. For example, 1 lot of Infosys call or put options may consist of 1200 underlying Infosys shares.
– Full-service stockbrokers typically charge Rs. 50 to Rs. 100 per lot for options trading, while discount brokers offer a more cost-effective flat fee, often Rs. 20 per lot.
– The documents required to open an options trading account include:
– Aadhaar Card
– PAN Card
– Canceled Cheque displaying IFSC or MICR Code
– Salary Slip, IT Return, or Form -16 (for the F&O segment)
– During the account opening process, it is essential to choose the F&O (derivatives) segment. A recommended choice would be to open an account with Zerodha for a seamless options trading experience.
Option Trading in India – Key Aspects
- Require Margin Money
– Option trading involves higher risks due to the substantial number of underlying instruments and market volatility.
– Buying options contracts requires an initial amount equal to the premium multiplied by the underlying contract value. For instance, to purchase 1 lot of Bank Nifty Call options with an underlying value of 25 and a premium of Rs. 700, you need Rs. 700 x 25 = Rs. 17,500 in your account.
– Selling options contracts entails meeting exchange-mandated margin requirements based on the volatility of the underlying instruments. These margin requirements for selling options are typically higher compared to buying options.
– Traders usually need to maintain a minimum of Rs. 1.5 Lakhs to Rs. 2 Lakhs in their trading account, depending on their specific trading needs.
- Identify Liquid Options for Trading
– In options trading, liquidity is crucial for smooth transactions. Liquidity ensures that there is an active market for buying and selling options contracts.
– When selecting options for trading, it is advisable to focus on liquid options, which are options contracts that have ample trading activity.
– Stocks typically have multiple call options available, each with different strike prices. For instance, Asian Paints stock may have numerous call options contracts with varying strike prices.
Ensure to assess liquidity and choose options with sufficient trading volume to facilitate efficient execution of trades.
Option Trading in India – Additional Insights
And an equal number of Put options are available for trading. For trading options, you need to have the most liquid options contract so that you can buy/sell at any moment.
Generally, the options having a strike price near the current stock price are the most liquid.
However, to select the most liquid options for trading intraday, you can take the help of NSE India or MoneyControl, which list the details of the most active option contracts.
Types of Option Trading – Further Insights
You can engage in either day trading or positional trading in options based on your trading strategy.
- Options Day Trading
Options day trading involves the buying/selling of a specific option contract, similar to day trading stocks. You need to have a view of a particular stock and trade according to price action.
Utilizing charting tools and indicators, you can conduct technical analysis and execute trades based on your strategies. For instance, selecting a highly liquid option contract like SBIN JUL 200 CE, you can buy/sell or sell/buy multiple times based on your market outlook.
Your overall profit/loss will depend on the movement of the option price and the number of trades closed in profit. During the initial learning phase, focus on winning more trades with small profits rather than targeting substantial profits. For example, if you allocate Rs 1 lakh to options trading, aim for a daily profit target of Rs 1000.
- Options Position Trading
Positional trading in options involves buying/selling multiple options to create an option strategy that ensures positive cash flows as long as the options are held.
Option positions are established after forming a view on a specific index or stock, and multiple options are employed to limit potential losses.
For instance, if you are bullish on Bank Nifty and anticipate a moderate price increase, you might opt for a Bull Call Spread position (strategy).
To execute a Bull Call Spread
- Buy Bank Nifty calls at a specific strike price (e.g., Bank Nifty JUL 22100 CE)
- Sell an equal number of calls with a higher strike price (Bank Nifty JUL 22200 CE)
With a bull call position, you are capping both your upside (profits) and downside (losses) while holding the position.
The maximum profit per lot is the difference between the strike prices of the two call options minus the net option premium paid = 22200-22100-(the net premium paid).
The maximum potential loss is the entire premium paid while buying the call. Ensure that both call options have the same expiry date.
Developing such option positions and strategies requires time and calculations, which might be challenging initially.
Best Indicators for Intraday Option Trading in India – Insightful Overview
- Open Interest (OI)
Open interest represents the number of unsettled or open contracts for a specific option. While it doesn’t directly indicate an uptrend or downtrend, it provides valuable insights into the strength of a trend.
Interpretation
– Rising Price & Rising OI: Indicates market/stock strength.
– Rising Price & Falling OI: Suggests weakening market/stock.
– Falling Price & Rising OI: Implies a weakening market/stock.
– Falling Price & Falling OI: Indicates a strong market/stock.
- Put-Call Ratio (PCR) Indicator
The Put-Call Ratio measures the trading volume of put options relative to call options. Changes in this ratio help gauge market sentiments.
Interpretation
– PCR above 1: Indicates bearish sentiment (more puts than calls).
– PCR below 1: Suggests bullish sentiment (more calls than puts).
However, caution is needed as hedge fund managers may use put options to hedge their portfolios, leading to a misleadingly high PCR ratio.
These indicators provide valuable information for making informed decisions in intraday option trading in the Indian market.
- Intraday Momentum Index (IMI)
The Intraday Momentum Index (IMI) serves high-frequency option traders, providing insights for aggressive intraday trading based on option price movements.
IMI merges candlestick analysis with the Relative Strength Index (RSI), offering indications of when an option becomes overbought or oversold.
Interpretation
– IMI levels over 70: Suggest overbought conditions, signaling a potential sell trade.
– IMI levels below 30: Indicate oversold conditions, providing an opportunity for a long trade.
It’s crucial to consider the overall trend, as constant uptrends or downtrends may result in persistent overbought or oversold indications.
- Relative Strength Index (RSI)
The Relative Strength Index (RSI) acts as a fundamental momentum indicator, aiding in the identification of overbought and oversold conditions by comparing recent gains to losses. RSI values range from 0 to 100.
Interpretation
– RSI above 70: Points to overbought conditions, potentially signaling a short call or long put trade.
– RSI below 30: Indicates oversold conditions, presenting an opportunity for a buy call or sell put option.
RSI is particularly effective for options on individual stocks, as stocks tend to reflect overbought or oversold conditions more frequently than indexes.
These indicators empower traders with valuable insights for effective decision-making in intraday option trading.
Bollinger Band Strategy
The Bollinger Band comprises three lines, with the middle line representing the simple moving average of the last 20 candles’ price. The upper and lower lines create a band on each side of the middle line, with the upper and lower bands indicating the overbought and oversold zones, respectively.
Strategy
- Identification of Reversal Points
– When the price breaks outside the bands, it signals a potential reversal.
– Breakout above the top band: Consider initiating a long put or a short call position.
– Breakout below the lower band: Consider taking a long call or short put position.
- Executing Trades
– Sell calls when red candles re-enter the upper band and show a tendency to move lower.
– Buy calls or sell puts when the breakout is from below the lower band.
- Options Trading Platform
– Utilize a dedicated options trading platform that facilitates the quick creation of strategies based on your market views.
Hundreds of positional strategies can be crafted based on your perspectives, and the platform streamlines the process, making options trading more accessible and efficient.
This Bollinger Band strategy provides a structured approach to options trading, leveraging technical indicators for informed decision-making.
Option Trading Tips in India
If you aim to trade options and double your money with a few tips, caution is advised. Even seasoned options traders find it challenging to close all trades in profit. Below are essential tips for better risk management and confident trading.
- Set Target Prices
– Define a target profit and loss price before trading options.
– Establish clear exit points for both upside and downside scenarios.
- Cut Losses Prudently
– Close a trade and cut losses if it’s running in the negative.
– Avoid adding positions to average down, as it may backfire.
– Cut losses promptly and reassess for alternative trading opportunities.
- Opt for Liquid Options
– Choose liquid option contracts to ensure ease of trading.
– Illiquid contracts with wide spreads can be challenging to close.
- Allocate Wisely
– Allocate 2% to 5% of your capital for a single trade.
– Spread your risk by not placing all capital in one trade.
– Use stop-loss orders to limit potential losses and safeguard your capital.
– For instance, with a long position in a Bank Nifty Call at Rs. 700, set a stop loss at Rs. 680 to contain losses.
- Capture Small Moves
– Focus on capturing small price movements through frequent trades.
– Prioritize consistent cash flows from numerous winning trades over speculative large movements.
Options trading involves risk, impacted by global news, political events, and economic situations. Adopting these tips will help manage risk effectively and foster a disciplined approach to option trading.
Final thoughts
Options trading holds the promise of yielding substantial returns when approached diligently. As a full-time endeavor, it offers an additional income stream and serves as a valuable component for diversifying your trading portfolio.
For effective engagement in options trading, a well-defined strategy is imperative. A disciplined approach is equally crucial to navigate the complexities of the market and harness the full potential of options trading.
