Options Trading Basics

1. What Are Options?

An option is a financial derivative whose value depends on an underlying asset such as stocks, indices, commodities, or currencies. Each option contract grants the buyer certain rights based on the type of option:

Call Option: Right to buy the underlying asset.

Put Option: Right to sell the underlying asset.

The price at which the transaction may occur is called the strike price, and the time until the contract expires is the expiration date.

2. Types of Options
A. Call Options

A call option gives the buyer the right (not obligation) to purchase the underlying asset. Traders buy calls when they expect the price to rise.

If the asset price goes above the strike price → the buyer profits.

If the asset price stays the same or falls → the buyer loses the premium paid.

B. Put Options

A put option gives the buyer the right to sell the underlying asset. Traders buy puts when they expect the price to fall.

If the asset price falls below the strike price → the buyer profits.

If the asset price stays the same or rises → the buyer loses the premium paid.

3. Key Terminology Every Options Trader Must Know
Premium

The cost paid to buy an option. Calculated based on demand, volatility, time to expiry, and underlying price.

Strike Price

The price at which the underlying asset can be bought or sold via the option.

Expiration Date

Options contracts expire after a certain date—daily, weekly, or monthly.

Lot Size

Options are traded in predefined quantities (lots), not single shares.

In-the-Money (ITM), At-the-Money (ATM), Out-of-the-Money (OTM)

Call Option:

ITM: Spot > Strike

ATM: Spot ≈ Strike

OTM: Spot < Strike

Put Option:

ITM: Spot < Strike

ATM: Spot ≈ Strike

OTM: Spot > Strike

4. How Options Pricing Works (The Basics)

Option pricing is influenced by multiple factors. These are captured by a model called the Black-Scholes Model, and the key components are:

A. Intrinsic Value

The real value of the option if exercised today.

Call Intrinsic = Spot − Strike (if positive)

Put Intrinsic = Strike − Spot (if positive)

B. Time Value

Extra value based on how much time is left until expiration. More time → higher premium.

C. Volatility

Higher volatility increases the chance of significant price moves, resulting in costlier options. Implied volatility (IV) is a critical factor.

D. Interest Rates & Dividends

They have a relatively small impact but still influence pricing.

5. Why Trade Options? (Benefits)

Options offer advantages that stocks cannot provide.

1. Leverage

With a small premium, traders can control a large position.

2. Hedging

Options can protect portfolios from adverse market movements.

Example: Buying puts acts like insurance for a stock portfolio.

3. Flexibility

Options allow profit in up, down, and sideways markets.

4. Limited Risk for Buyers

The maximum loss for an option buyer is limited to the premium.

6. Risks Associated with Options

Options come with risks, especially for beginners.

A. Time Decay (Theta)

Options lose value as expiration approaches if the underlying doesn’t move favorably.

B. Volatility Risk

If volatility decreases after entry, options can lose value even if price moves correctly.

C. Liquidity Risk

Low liquidity can cause slippage and widen bid–ask spreads.

D. Unlimited Risk for Option Sellers

While buyers have limited risk, option sellers can face theoretically unlimited loss, especially in naked call writing.

7. Option Trading Styles
A. Intraday Options Trading

Positions are opened and closed within the same day. Highly dependent on volatility and market momentum.

B. Positional Options Trading

Holding options for multiple days or weeks; requires understanding of market trend and implied volatility.

C. Hedging Based Options

Used by investors and institutions to reduce portfolio risk.

8. Popular Option Trading Strategies
1. Buying Calls and Puts

Simple directional trades based on expected movement.

Buy Call → Bullish view

Buy Put → Bearish view

2. Covered Call

Holding shares and selling a call option against them → generates income.

3. Protective Put

Holding shares and buying a put → protects against downside.

4. Vertical Spreads

Buying and selling options of the same type and expiry but different strike prices.

Bull Call Spread

Bear Put Spread

These help reduce risk and cost.

5. Straddle

Buying ATM call + ATM put. Profits from big moves in any direction.

6. Strangle

Buying OTM call + OTM put; cheaper than straddle, requires large move.

9. Option Greeks – The Building Blocks

To understand how an option behaves with market changes, traders use Greeks.

Delta

Measures the sensitivity of option price to a ₹1 change in the underlying.

Call Delta: 0 to 1

Put Delta: −1 to 0

Theta

Measures time decay. A negative value indicates loss in premium daily.

Vega

Measures sensitivity to volatility. Higher IV → higher premium.

Gamma

Shows how quickly Delta changes with underlying movement.

Rho

Measures sensitivity to interest rates.

Understanding Greeks is essential for risk management and developing advanced strategies.

10. How Options Settlement Works

In India:

Index Options: Cash-settled

Stock Options: Physical settlement

If you hold an ITM stock option till expiry, you must:

Buy shares (for calls)

Deliver shares (for puts)

This increases margin requirements.

11. Best Practices for Beginners
✔ Start with Buying Options (Limited Risk)
✔ Avoid Selling Naked Options initially
✔ Use Stop Loss and Risk Management
✔ Trade liquid stocks/indices like NIFTY, BANKNIFTY
✔ Track Implied Volatility (IV) before entering
✔ Avoid holding OTM options to expiry
✔ Maintain a trading journal
12. Conclusion

Options trading is a versatile and powerful instrument that provides tremendous opportunities for traders—whether they seek profits during market movements, consistent income, or portfolio protection. However, the complexities of pricing, volatility, time decay, and risk require proper knowledge, discipline, and strategy. Understanding the basics—call and put options, premiums, strike selection, Greeks, and risk management—sets a strong foundation for successful trading. With practice, patience, and the right mindset, options can become a valuable part of every trader’s toolkit.