What is Options Trading?

Options are derivatives tools that can also be considered similar to a contract or a promise between the buyer and seller of the options. An option buyer has the right to buy or sell the underlying assets on the date of expiry. On the other hand, an option seller bears the obligation to transfer the underlying to the option buyer on the date of expiry.

Options are considered as a separate asset class, where you can trade and generate some money. Option prices are determined by some external factors like volatility as well as some pre-defined parameters like the 'Options Greeks'. An option buyer or seller can buy and sell these options to generate a hedge on their investments or speculate on the price movement on them.

How is it different from common share trading?

Now that you know what is options trading, let's understand how it is different from share trading.

• Whenever you buy and sell a stock for more than a trading day, you take delivery of the asset and sell it later. Although you can short a stock on an intraday basis, it is not possible to carry forward your shorts in traditional equity investing. Whereas you can implement these with the help of options.

• Options are also leveraged, unlike traditional equity shares. You cannot purchase the shares of Reliance or ITC with leverage but you can buy a Call option of these shares with the help of leverage. With options, you can employ leverage of 10 to 20 times in some cases. An option buyer pays the premium, whereas an option seller collects the premium.

• The settlement on options happens on the last Thursday of every week/month. You can hold on to your option contracts without any excess charge. As options are mere contracts, you don’t have to buy/sell the underlying until the date of expiry.

What is Options trading considered riskier?

By now you must have put together a clear picture as to what are options and how they are different. Now, let's find out why they are considered riskier.

1. High leverage

The leverage in options can be a boom or a bust. In a favorable scenario, you can create extremely high returns on your capital. But at the same time, options contain the potential to erode your capital completely if the trade goes against you. Often traders take on extremely high leverage and end up losing their complete capital in a particular trade.

2. Potential for unlimited losses

Options trading have two aspects. One is options buying and the other is options selling. The buyer of an option pays the premium whereas the seller of the option collects it. The maximum profit potential of the buyer of the option is unlimited against a limited risk to the premium paid. Whereas an options seller bears an unlimited risk. If adverse market conditions result in extremely high option prices, the option seller has to either bear the loss or square off the position by realizing the loss. In both ways, if you sell a naked option, the maximum gain represents the premium collected whereas the maximum loss is uncapped.

3. Obligation for exchange of the underlying asset

Options trading involves another aspect of exchange that is absent in equity trading. Both the options buyer and seller have to exchange the underlying on the date of expiry. Although the option buyer doesn’t have the obligation to give/take the delivery of the underlying shares. An option seller has the obligation to exchange the underlying on the date of expiry. In case, you sell a stock option and hold it till the date of expiry, you will have to either buy or sell the required number of the underlying shares. For this, you will have to shell out a minimum of Rs 5-7 lakh. This could be a problem for many small traders who might not have this kind of liquidity. Due to this, option selling or buying is considered a high Capex investment and small traders should trade in them carefully.

Conclusion

By looking at some of the key risks involved in options trading, it is clear that options trading is a high-risk high-reward proposition. Although you can reduce the overall margin requirement by taking hedged positions, still you should not begin options trading unless you have sizeable capital and sufficient expertise in the field.