Trading Equity Options
An option is a tradable contract in the derivative market. Options traders can buy or sell the underlying security on a future date at the strike price mentioned in the contract. The underlying security can be a financial asset, like equity shares, bonds, commodities, equity indices, etc. When the underlying security is equity, it is an equity option. The price of the given shares determines the value of the option contract. Traders do not actually take the delivery of equities.
Basic Terms and Conditions to Trade Equity Options
The basic terms and conditions to trade equity options are as follows:
The trader needs to pay a premium to the option writer to accept the risk associated with the contract.
Options traders can consider equity options on margin – a percentage of the trade value in the contract. SEBI (Securities Exchange Board of India) has prescribed margin requirements for trading equity options.
The strike price is the pre-agreed price of the underlying stock in the contract. While entering into an option contract, the buyer and the seller should agree upon a price at which the stock can be traded.
Expiration and Settlement
Every option has an expiry date to exercise it at the strike price. Traders need to pull a well-calculated time frame for options trading. The expiry can range from days to months, typically nine months.
Since the traders do not actually take delivery of underlying stocks, opening an online demat account is an option in the derivative market. They can start options trading with a trading account only.
Risks Involved in Equity Options
Among various motivations for trade options, the primary motivation is an expectation of the rising pricing of the underlying stock during a period. If the security price increases (above the purchasing price), traders will gain significantly by exercising the option and purchasing the stock at a lower price than the market value. The following are the risk one needs to understand:
No Value After Expiration
Options are contracts with expiry, and the value declines as the expiry date comes near. The most obvious risk is that if the underlying stock does not move in the desired direction, options traders are forced to let the contract expire. It means they paid the premium for nothing.
Halts in Closing Transactions
There can be trading halts in the underlying stocks or an issue of liquidity. It may make it challenging for options traders to make a closing transaction that may cause huge losses, especially when the expiry is near. Options traders can approach a renowned discount broker offering advanced trading platforms with their trading accounts. The main difference between demat and trading account is that a demat account holds financial assets online and a trading account is the record of trades and the way to access stock exchanges.
Accuracy in Time Frame
Options trading involves a thorough analysis of whether a share price will rise or decline. Also, traders need to determine the time when it will make its move. It may be a correct prediction that the share of Company A is surging, but if the option expires before it rises, the trader will make a loss. Hence option trading is risky as traders not only need to find the right direction, but they need to consider the timing also.
Leveraging can expose an investor to unlimited losses
Options are highly leveraged derivatives that increase the risks and returns substantially. A change in the stock price, other than predictions and analysis, can cause a big swing in the option price, and work against the trader.
Thus, equity options trading is versatile but complicated too. Starting with options trading may take a lot of work for beginners as it involves a high risk and reward ratio. Working on the basics and researching on their own for fundamental analysis is necessary to reduce the odds of high risks.