INTRODUCTION
If you are looking for a secondary source of income apart from your regular Full Time job, you have reached the right page. Often investment journey of an individual investing in stocks recommended by so called well wishers or misleading-TV channels or financial advisors. It is needless to say that 95% of the folks invest in stocks with little or no knowledge. I hope this write-up will help such investors to re-think and invest time in learning options which will help them to earn sort of rental income every month with little investment capital as low as one lakh rupees.
With options it is possible to see profits even when stocks are going up, down or sideways. With options you can cut losses, protect gains and control large chunks of stocks with a relatively small cash outlay.
Important note: On the other hand, option strategies sometimes are complicated and risky. If you cannot control your greed, you might end up losing the entire capital and some strategies may expose you to theoretically unlimited losses. So risk management with stop loss and mind management to control greed with play an important role.
This blog also gives essential 'Tips' which clarifies important concepts or will show you extra advice on how to implement particular strategy.
I certainly hope you will enjoy reading Options Playbook for Nifty and BankNifty
Cheers,
FFRE Team
(Financial Freedom and Retirement Early)
OPTIONS BASICS FOR ROOKIE INVESTOR
What Are Options?
Options are contracts that give bearer a right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires.
Options belong to a larger group of securities known as derivatives. A derivative's price is dependent on or derived from price of something else. Options are derivatives of financial securities; their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, mortgage-backed securities, among others
Key Option Terminology
- Index options: These options have index as the underlying. In India, we have European style settlement. Eg. Nifty options, Bank Nifty options.
- Stock options: There are options on individual stocks. It gives the holder right to buy or sell an underlying share(s) at specified price. They have an American style settlement.
- Buyer of an option: One who by paying option premium buys the right but not the obligation to exercise his/her option on seller/writer.
- Writer / seller of an option: One who receives option premium and is thereby obliged to sell/buy the asset if buyer exercises on him/her.
- Call option: It gives holder right but not the obligation to buy an asset by a certain date for a certain price.
- Put option: It gives holder right but not the obligation to sell an asset by certain date for a certain price.
- Option price/premium: It is the price which option buyer pays to option seller. It is also referred to as the option premium.
- Expiration date: It is the date specified in options contract. Indexes have weekly expiration and stocks have month expiration.
- Strike price: It is the price specified in options contract.
- In-the-money option (ITM): It is an option that would lead to a positive cash flow to the holder if it were exercised immediately. An ITM call option stands at a level higher than the strike price (i.e. spot price > strike price). A deep ITM call option is much higher than the strike price, the call is said to be deep ITM. In case of put ITM, the index is below strike price.
- At-the-money option (ATM): It is an option that would lead to zero cash flow if it were exercised immediately. An ATM call option stands equals the strike price (i.e. spot price = strike price)
- Out-of-the-money option: It is an option that would lead to a negative cash flow if it were exercised immediately. An OTM call option stands at a level which is less than the strike price (i.e. spot price < strike price). A deep OTM call option is much lower than the strike price, the call is said to be deep OTM. In case of put OTM, the index is above strike price.
Visual representation of ITM, ATM and OTM:-
- Intrinsic Value: The amount an option is in-the-money. Only ITM options have intrinsic value.
- Time Value: The part of an option price that is based on its time to expiration. If you subtract amount of intrinsic value from an option price, we get time value. If an option has no intrinsic value (i.e. it’s OTM) its entire worth is based on time value.
- Exercise: This happens when owner of an option invokes the right embedded in the option contract. In simple words, it means the option owner buys or sells the underlying stock at strike price, and requires option seller to take other side of the trade.
- Standard Deviation: Let us assume stocks have a simple normal price distribution, we can calculate what a one-standard-deviation move for the stock or Index will be. In general any stock will stay within plus or minus one standard deviation roughly ~70% of the time in a year span. This helps investors to figure out the potential range of movement for a particular stock or Index.
Index Options vs. Equity Options
Index options cannot be exercised prior to expiration whereas equity options can be exercised.
Every thursday is the expiry day for Nifty and Bank Nifty (Index) options (weekly expiry for Index). For equity it is the last thursday of every month (monthly expiry).
- Index options are cash-settled, but equity options result in stock changing hands.
Understanding Greeks
It is the amount an option price will move with every one point move in Index/Stock. ATM options usually have a delta of 0.5. If stock/index moves up one point then price of ATM options will go up by ~0.5. ITM options have more delta that ATM. Deep ITM options move almost 1 to 1 with the stock/index.
Gamma controls delta or in other words is rate of change of delta. With movement in stock/index price something has to change the value of delta as option moves from ATM to OTM or ATM to ITM.
Theta is the time decay value. It is the time factor in option premium. Time factor moves towards zero as expiration approaches. Theta is the amount the premium will decrease for one day change in the time to expiration.
What is Vega?
It is the volatility which reflects the amount option prices change for one point change in implied volatility.
It is the current interest rate offered by banks for a FD of 1 year. It is the amount option value will change with percentage change in interest rate.
Market Participants
As a market trader it is important to know who might be buying or selling options on the other end of your transaction. Generally below are the list of market participants;
- FIIs - Foreign institutional investors.
- DIIs - Domestic institutional investors.
- Pros - Professional investors.
- Clients - Retail investors.
Orders generated by each player goes through “exchanges”. Let us not get into the details of how exchanges work since figuring out just how options change hands can be a little confusing. We will just look at who each player is, then we’ll look at how your option orders get executed.
FEW MISTAKES TO AVOID WHILE TRADING OPTIONS
- Have well defined exit plan: We have definitely heard and read this multiple million times before. However, we continue to be liberal on loss making traders hoping that scenario will reverse. It is very critical in trading to control emotions and greed. Always have a definitive plan and ensure you stick to your plan. No matter what your emotions are telling you to do, never ever deviate from the plan. More often than not entries are overated and exits are under rated.
- Trade smart - Easier said than done: Plan should not confide to just exiting and it isn’t just also about minimizing loss on downside if things go wrong. You should have an exit plan, period – even when a trade is going your way. Please always choose your upside exit point and downside exit point in advance. Options are a decaying asset and that rate of decay accelerates as your expiration date approaches. Remember the classic statement, "if you are long in options then stay short in time and if you are short in options then stay long in time".
- Never try to make up for past losses by doubling up: We always have armor-plated rules: “I will never buy deep OTM options” or “I will never sell deep ITM options”. However we always break the rule and it’s quite funny how these absolutes seem obvious; until we find ourselves in a trade that’s moved against us. How often we all have faced scenarios where a trader does precisely the opposite of what we expect. “Doubling up” on options strategy almost never works. Options are derivatives, which means their prices don’t move the same way or even have the same properties as the underlying stock.
Close the trade, cut your losses, and find a different opportunity that makes sense now. It’s a much wiser move to accept a loss now instead of setting yourself up for a bigger catastrophe later. - Don't wait too long to buy back short strategies: If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Don’t be cheap. For example, if you sold a short strategy for 100 and you can buy it back for 20 few days before expiration, you should jump on the opportunity.
OPTION STRATEGIES - BASIC
Covered Call:
- You are the owner of a stock.
You will be profitable if the stock price stays below strike price A. The profit is limited to the premium received from selling the call.
Cash Secured Put:
- You are the owner of a stock.
Reward:
You will be profitable if the stock price stays above strike price A. The profit is limited to the premium received from selling the put.
- Collar:
- You are the owner of a stock.
OPTION STRATEGIES - Advanced
- Long Call:
- Buy a call at strike price A
Reward:
- Long Put:
- Buy a put at strike price A
- Long Call Spread:
- Buy a call at strike price A
Reward:
- Long Put Spread:
- Sell a put at strike price A
Reward:
- Leveraged Covered Call:
- Buy ITM call at strike price A (for weekly expiry in case of index)
OPTION STRATEGIES - ADVANCED (FOR SEASONED)
- Short Call Spread:
- Sell a call at strike price A.
- Short Put Spread:
- Buy a put at strike price A.
- Long Straddle:
- Buy a put at strike price A.
- Short Straddle:
- Sell a call at strike price A.
Reward:
- Long Strangle:
- Buy a put at strike price A.
- Short Strangle:
- Sell a put at strike price A.
Investing in stocks/mutual funds or any other instruments are subject to market risks. Any strategies or trades that are described here are only for educational purpose. Please do your own research or consult your financial advisor before investing.
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