Start Options Trading – For Beginners

How to Start Options Trading and Earn Safe Money!

A common reason why many investors who want to do trading in Options are unable to start, is lack of knowledge and familiarity with the concepts surrounding Futures & Options. Let us go through how you can start options trading through the concept of short put, or selling put options in the market for a premium.

What does it mean to sell a Put Option?

A put option gives a right to the option-buyer to sell a stock (the underlying asset) to the option-seller at a specific price (strike price or exercise price) on a specific day (option expiry date). Keep in mind that this is a right and not an obligation, hence the word “Option”. Since this means that the buyer of the option is in an advantageous position; as he can sell the stock to the option-seller if the market price is lower than the strike price; and choose to sell in the open market if the market price is higher than the strike price. The option-buyer has to pay some money to the option-seller to acquire this right, and this is “option premium”.

In other words, as a seller of a put option, you are giving another person a right to sell some stock to you at a pre-decided price (strike price) on a pre-decided day (expiry date); and you’re receiving some money for giving this right in the form of option premium.

How to Understand and Calculate Profit and Loss

To understand the profit & loss situation, let’s see what will happen on the day of the expiry of the option. On the expiry date, if the market price of the underlying stock is lower than the strike price, the option is in-the-money (ITM); as the option-buyer is in a profit situation since he will sell the underlying stock to you; and he will receive more money from you than he would’ve received if he sold the stock in the open-market.

Conversely, if the market price is higher than the strike price of the option, then the option is out-of-money; as the option-buyer has no use in exercising the option now; because he can sell the underlying stock in the open market. An option-seller would be in a profit if the option expires out-of-money and may be in a loss if the option expires ITM, depending upon the amount of premium he received on the day of selling the option.

Let’s take an example to understand the above concept in more detail:

Consider Stock X with the following details:

Current Market Price (CMP)   = $99
Premium for 1-month $105 put           = $1

In the above case, the option-seller receives $1 from option-buyer on day 1.

After one month, on the day of expiry; if the market price of Stock X is more than $105, say $106, then the option will expire out-of-money; as the option-buyer can sell the Stock X in open market at a higher price than the strike price of $105. The option-seller can take home earnings of $1 in the form of premium; which he received on the day of selling the option.

On the contrary; if the market price of Stock X is below $105 on the day of option expiry (say $100); then the option is ITM and option-buyer would definitely sell the Stock X to option-seller for a strike price $105. In this case, the option-seller would have to buy the Stock X from option-buyer at $105; he can sell it in the open market for only $100 thus incurring a loss of $5; but he had earned $1 in the form of premium so his net loss would be $4 ($5 – $1).

How to select the strike price while selling a put option?

The answer to this question depends on the risk appetite of the investor and varies widely from individual to individual. If you are a conservative investor; and want to sell a put option which has a very low chance of being ITM; then the minimum difference that you should look for is 10%-15% from Current Market Price (CMP) i.e. the strike price of the put option that you’re selling should be at least 10%-15% below the CMP of the underlying stock.

As a rule of thumb, below chart can be used to classify different investors:
Aggressive put                  : Less than 10% difference
Reasonable put                 : Between 10% to 15% difference from CMP
Conservative put              : More than 15% difference from CMP

Since aggressive put option is risky for option-seller and has a higher chance of being ITM, the premium for it will also be higher as compared to the reasonable and conservative put options. As goes for every investment in any market, greater the risk, greater the reward.

Before you start Options Trading, you must also be aware that there is no guarantee that a conservative put will never be ITM, it’s only that the probability of a conservative put option being ITM is lower than the probability of an aggressive put option being ITM. In other words, the chance that a conservative put option will be ITM is low, but not zero.

Other things to keep in mind:

• Covered Put: One of the most important things to keep in mind is to sell only cash-covered put. This means that you should keep enough cash available with you to purchase the stocks in case the put goes in-the-money (ITM) so that you don’t have to incur immediate loss by squaring-off your position on expiry. Then you can sell the stocks in the open market once the price goes back up.
• Sell in progressions: Don’t exhaust your complete capacity at the first instance. Start by selling a small quantity of put options, then if and when it goes ITM, then sell more put options of a much lower strike price. Obviously, this strategy must be applied with extreme caution and only in good shares which have a good fundamental value and will not completely crash and become 0 in value.
• It’s a good idea to enter into a Straddle Strategy and sell both call and put options because of the following reasons:
  • Margin requirement gets clubbed so you’ll be able to earn more money on the same invested amount.
  • Both can’t be ITM, so you’ll be able to earn premium from at least one of the options and that would act as a cushion for your possible loss.

I hope this was a good read for you! Do let us know your thoughts in the comment section below.

Check out MKJ sir’s video on this topic by clicking on this link!

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