Ever wonder how to take advantage of opportunities in the stock market beyond simply buying and holding shares? For investors looking to potentially hedge their holdings or increase returns, option trading provides a flexible toolkit. This in-depth guide, created especially for beginners, will provide you with the essential skills for successfully navigating the complex world of option trading.

Option Trading for Beginners: A Guide to Strategies and Tips

Option trading can seem daunting for beginners, but with the right knowledge and strategies, it can be a powerful tool for financial growth. In this guide, we’ll explore what option trading is, different strategies for option trading, and the best indicators to use. Whether you’re interested in option trading in Zerodha or looking to master option selling and buying strategies, this comprehensive guide will equip you with the essential information to get started.

Option Trading Explained: What is Option Trading?

Option trading involves contracts that grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price by a certain time. Stocks, indexes, or even other options may be the underlying assets of these contracts, which are known as options.

There are two main types of options:

1. Call Options (CE): They grant the buyer the right, by a specified expiration date, to purchase the underlying asset at a fixed price (the strike price). When they anticipate an increase in the value of the underlying asset, investors usually buy call options.
2. Put Options (PE): Upon expiration, the buyer of a put option is entitled to sell the underlying asset at the pre-established strike price. When they anticipate a decline in the value of the underlying asset, investors purchase put options.

Understanding Key Option Terminology

1. Strike price: This is the fixed price at which the buyer can purchase the underlying asset or sell it.
2. Expiry Date: The date on which the option contract expires and loses all of its value is known as the expiry date.
3. Option Premium: The amount of money for the option contract that the buyer gives the seller.
4. Intrinsic Value: If the option is in-the-money, its intrinsic value is the difference between the strike price and the current market price.
5. Extrinsic Value (Time Value): It is the portion of the option premium that depends on factors such as interest rates, volatility, and the remaining time before expiration. It represents the possibility that the price of the underlying asset will move in your favour prior to expiration.
6. In-the-Money (ITM): A call option is deemed “in-the-money” if its strike price is less than the asset’s current market price. The fact that you could use it right away to make money indicates that it has intrinsic value. In the same way, if the strike price of a put option exceeds the current market price, it is in the money (ITM).
7. Out-of-the-Money (OTM): If the strike price of a call option is higher than the going market price, it is considered OTM. Although this has no intrinsic value, it still has a time value (more on that later). If a put option’s strike price is less than the going rate in the market, it is out of the money.
8. At-the-Money (ATM): An option is deemed “at-the-money” if its strike price is equal to the asset’s current market price. Though it has no inherent worth, it still has some temporal value.

Option Greeks

1. Delta (Δ): It is a metric used to express how quickly the price of an option changes in relation to changes in the price of the underlying asset. For instance, a delta of 0.5 means that the option price will rise by ₹50 for every ₹100 increase in the price of the underlying asset.
2. Gamma (Γ): Gamma expresses how much the price of the underlying asset changes when the delta changes. It basically indicates how fast the rate of change of the option is increasing.
3. Theta (Θ): Theta shows how an option’s price decays over time. Time value erosion causes an option’s price to naturally decline as it gets closer to expiration; this daily decline is reflected in theta.
4. Vega (V): Vega measures the sensitivity of an option’s price to changes in implied volatility. The implied volatility measures how volatile the market believes the price of the underlying asset will be in the future.

Benefits of Option Trading

1. Flexibility: Compared to just buying or selling stocks, options provide greater flexibility. Options allow investors to design a variety of strategies for varying market situations.
2. Leverage: Compared to outright purchases, options enable investors to have more control over a larger asset with a smaller investment. This may increase profits, but it can also increase losses.
3. Hedging: You can use options to protect against possible losses and hedge current holdings.

Top Strategies for Option Trading

Investors can speculate on stock prices, hedge other assets, or make money with a range of options trading strategies. Below is a summary of some well-liked options trading techniques:

Basic Strategies

1. Long Call: This bullish strategy involves purchasing a call option with the intention of profiting if the stock price rises above the strike price before it expires.
2. Long Put: This bearish strategy involves purchasing a put option and making money if, by the time it expires, the stock price drops below the strike price.

Spreads

1. Bull Call Spread: This strategy limits possible profit while lowering risk by purchasing a call option and selling another call with a higher strike price.
2. Bear Put Spread: This strategy involves selling one put option and buying another with a lower strike price, with the goal of profiting if the stock price falls.

Covered Option Strategies

1. Covered Call: Buying a stock and selling a call option on it, earning money from the premium but limiting potential upside if the stock price rises.
2. Covered Put: Selling a stock and selling a put option on it and generating income from the premium received. The risk is that if the stock price rises, you may be obligated to buy the stock at a higher price than when you shorted it.

Volatility-Based Strategies

1. Straddle: Buying both a call and put option with the same strike price, profiting if the stock price moves significantly in either direction.
2. Strangle: Similar to a straddle, but with call and put options at different strike prices, benefiting from moderate to high volatility.

Here are some additional points to keep in mind:

1. Direction: While bearish strategies profit from declining prices, bullish strategies seek to profit from rising prices.
2. Risk and Return: While income-generating techniques and spreads generally have smaller potential rewards, they also reduce risk.
3. Volatility: Although they can lose money in sideways markets, strangles and straddles profit from high volatility.

Option Buying Strategies for Beginners

All of these strategies are intended for investors who have a bullish or optimistic view on the price of an underlying asset (stock, index, etc.) in the future. Depending on how much volatility you anticipate and how strongly you think the price will rise, each offers a different risk-reward profile. We will be using Sensibull to see what the trade will look like, and we can use their strategy builder tool to stress test the trade before taking it. Their strategy builder is a premium tool that you can access for free with a Zerodha account.

Bull Call Spread

This involves selling one call option at a higher strike price (out-of-the-money) and purchasing another at a lower strike price (in-the-money or ATM). It makes money when the price increases, but only up to a certain point, limiting your gains. The difference between the premiums received and paid is the maximum amount of risk.

Bull Put Spread

This is a put-based version of a bull call spread. One put at the lower strike price is purchased, and another put at the higher strike price is sold. It limits gains but makes money if the price increases. The benefit is that it produces income up front and gains from higher volatility, which has the potential to drive up put option prices.

Call Ratio Back Spread

In this scenario, one call option is sold at a higher strike price, and two call options are purchased at a lower strike price. Though it costs more up front, it offers more leverage than a bull call spread (potential for magnified profits). Additionally, the risk is specified and kept to the differential in premiums.

Long Calendar Spread with Calls

In order to do this, a longer-dated call option must be purchased, and a shorter-dated call option must be sold at the same strike price. It benefits from time decay in the shorter-dated option if the price increases gradually over time. A gradual and consistent increase in the underlying price is advantageous for this strategy.

Bull Condor

To accomplish this, it is necessary to sell a bull call spread (selling an ATM call and buying an OTM call) in addition to a bear put spread (selling an ATM put and buying an OTM put). It is profitable if the price remains within a specific range. This strategy is ideal for low volatility expectations.

Bull Butterfly

In this scenario, one call option is purchased at a medium strike price, two are sold at higher strike prices, and a third call option is purchased at an even higher strike price. It restricts gains but makes money if the price increases to a given target level. The maximum risk is the difference between the premiums paid.

Range Forward

This is a combination of a bull put spread and a bear call spread, both with the same strike prices and expirations. It profits if the price stays within a certain range but also benefits from increased volatility.

Option Selling Strategies for Beginners

Bear Call Spread

This strategy profits from flat or declining stock prices. It involves selling a lower strike call option (attracting a premium) and buying a higher strike option (paying less) with the same expiration date. The maximum profit is the premium received, and the maximum loss is the strike price minus the premium.

Bear Put Spread

Like the bear call spread, but bearish. Selling a higher strike put for a lower premium with the same expiration is possible here. Falling stock prices benefit it. Maximum gain is strike prices minus premium paid, and maximum loss is premium paid.

Put Ratio Back Spread

This involves buying more put options with a lower strike price than you sell with the same expiration. It costs more than a bear put spread but has a higher profit potential. This strategy is for strong bears expecting a larger downside move.

Long Calendar with Puts

This uses a long-dated put to allow a price drop and a short-dated put to generate income. If the stock falls, you can profit from the long put. This strategy benefits from stock price drops but returns less than a bear put spread.

Bear Condor

Selling a bear call spread and buying a bear put spread with the same expiration date creates this four-option spread. It profits from stock price stability. This strategy is less profitable than directional bear spreads like the bear call spread but has a defined risk and profit potential.

Bear Butterfly

Like a bear condor, but with three options. Selling a call and a put at the same strike price (usually the current stock price) and buying two calls or two puts at different strikes is it. This strategy profits from a limited stock price decline and has defined risk and profit potential.

Risk Reversal

This involves buying a put and selling a call option with the same strike price but different expiration dates. A near-dated call is usually sold for more than a near-dated put. This strategy profits if the stock price drops significantly before the put option expires. Unlike a bear put spread, it is leveraged bearish and riskier.

Best Indicator for Option Trading

There’s no single “best” combination of indicators for option trading, but some well-regarded pairings can give you a more well-rounded picture of the market. Here’s a breakdown of some popular options and why they work well together:

RSI and Bollinger Bands

1. RSI (Relative Strength Index) measures whether an asset is overbought (above 70) or oversold (below 30) based on price movements.
2. Bollinger bands highlight periods of high or low volatility. The bands expand when volatility increases and contract during periods of low volatility.
3. This combo is useful because the RSI can identify potential entry points (when exiting overbought or oversold zones) and Bollinger Bands can indicate if the move is likely to be sustained based on the current volatility.

SMA and Stochastic Oscillator

1. SMA (simple moving average) is a basic trend indicator that shows the average price over a chosen period.
2. The stochastic oscillator is similar to the RSI; it gauges whether an asset is overbought or oversold, but on a 0-100 scale.
3. This combination helps confirm trends. The SMA shows the overall direction, and the stochastic oscillator helps pinpoint potential buying and selling opportunities based on overbought or oversold signals within that trend.

ATR and Parabolic SAR

1. ATR (average true range) measures the average volatility of an asset.
2. Parabolic SAR (stop and reverse) is a trend-following indicator that generates buy/sell signals based on price movement relative to the SAR.
3. This combo is valuable for understanding volatility’s role in potential price movements. The ATR gives you a volatility baseline, and the Parabolic SAR uses that to identify potential entry and exit points based on the trend’s strength.

But don’t rely solely on indicator combinations. Factor in fundamental analysis and your trading strategy. No indicator is perfect, and there will be false signals. Use them as guideposts, not guarantees. By understanding how these indicators work together, you can create a more comprehensive trading strategy for options.

You can see and demo-trade one such combination of indicators.

Option Trading in Zerodha and Sensibull

Zerodha is a popular Indian brokerage firm known for its low-cost trading platform, Kite. Along with that, there is another service that comes free with a Kite account called Sensibull. It is designed to simplify and enhance options trading. It offers:

1. Intuitive Interface: A user-friendly platform that makes options trading accessible to beginners.
2. Strategy Builder: It helps you create complex option strategies with ease.
3. Option Chain Analysis: It provides in-depth analysis of option chain data.
4. Educational Resources: It offers learning materials to improve your understanding of options.
5. Direct Trading: You can execute trades directly from the Sensibull platform without any additional cost, as it is a lot quicker to execute through the strategy builder.
6. Risk Management: Through the strategy builder, you can stress test your trade or even take a virtual trade there and then to actually see if your strategy works or not.

By combining the power of Zerodha’s trading platform with Sensibull’s analytical tools, you can significantly enhance your options trading experience.

Final Word

Option trading for beginners can be complex, but understanding the basics and implementing sound strategies can lead to success. Remember, the key to successful option trading is continuous learning and practice. Whether you’re trading on platforms like Zerodha or using specific indicators and strategies, staying informed and avoiding common mistakes will enhance your trading experience.

FAQs

What are options in basic terms?

Options are contracts that allow you to buy or sell an asset, like stocks, at a set price by a certain date. There are two types: call options for buying and put options for selling. Options differ from stocks because they expire, making them time-sensitive for managing risk or betting on price changes.

What are call and put options for beginners?

A call option allows you to gain if the asset’s price goes up. Buying a call lets you buy shares at a set price, even if the market price goes up. A put option allows you to sell shares at a fixed price, which is helpful if you think the asset’s value will decrease. Both need an upfront premium, and beginners should practice with small, low-risk trades.

What are the main risks in options trading?

The main risks are losing your premium if the option expires, time decay, and leverage increasing losses. Options can expire and become worthless, so beginners need to manage risk properly by setting stop-loss limits and trading appropriate quantities.

What are the safest options strategies for new traders?

Beginners should use easy, low-risk strategies such as buying covered calls or protective puts, but more importantly, they should keep their quantity low so as to limit losses and focus on the learning process. These strategies reduce risk and teach you how options work with your current investments.

What is the minimum amount needed to start trading options?

Start with a small amount. Some brokers let you begin with a small account balance, based on the strategy.Start with $100 or ₹10,000. Focus on learning and managing risks instead of investing what you can’t afford to lose.