All About Options

Any trade, whether it be in cash market, futures or in options, cannot be placed at random. When it comes to an options trade, there are a lot more complications involved and you need to take care of these before you actually place your trade. Let us look at some very important steps to place an options trade.

Check that trading account is opened and F&O activated

For trading in stock markets, be it in cash market or in F&O, you need a trading account. That is the most basic thing. Once your trading account is opened, you have got your user name and password for online trading etc, you are ready to trade in the cash market. However, to trade in the futures and options market, there is an additional level of compliance you must go through. SEBI regulations stipulate that before allowing a customer to trade, the broker must satisfy themselves that the client is in a position to take F&O risk.

While understanding F&O is one side of the story, the broker is also required to check the income documents before allowing trading in F&O. So, if you are a client and your broker asks you for a copy of your pay slip or income tax returns to activate F&O, don’t be surprised. This is mandatory as per SEBI regulations and it is in your interest. So, do share these documents with your broker to activate F&O.

Ensure you have sufficient margins for trading F&O

What is margin and why do you pay margins to a broker? When you take any position in the market in futures or options, there is a risk that the price may move against you. Margin means the broker collects part of the payment due from you next day in advance. The exchange stipulates how much margins to collect on each stock, each index and on each contract. You cannot put an options trade, unless your margin account is funded.

Contract	Strike Price	Quantity	Initial Margin	Exposure	Total
RIL Futures	N.A.	250 shares	104,845	18,473	123,318
RIL Options Sell	2400	250 shares	47,958	18,380	66,338
Adani Ent Futures	N.A.	2000 shares	490,180	62,934	553,114

 

There are 2 things you must understand. The margin of 1 lot of Adani Enterprises is substantially higher than 1 lot of Reliance Industries. That is because Adani Enterprises is more volatile in terms of price. Secondly, when you buy RIL options, you only pay the premium. However, why is the margin on RIL options selling less than futures? That is because, when you sell options you earn premium and that is adjusted.

Provide for MTM losses on your options positions

What is an MTM loss? Remember, MTM or Mark-to-Market can be profit or loss. If you buy RIL at Rs.2100 and it goes to Rs.2300, it is MTM profit. But if RIL goes down to Rs.1900, it is MTM loss. When your MTM loss goes beyond a point, the exchange asks for additional margins. Make a provision for that. There is no MTM in option buying; only in option selling.

Do you want to buy options on stock or index?

That is your next decision point. If you are expecting the overall market to go up, you can buy call option on Nifty. If you expect banking stocks to rally, you can by call option on Bank Nifty. However, if you expect Reliance stock price to go down, then buy a put option on Reliance stock options. Be clear on that decision before you trade.

A very important point to check before buying options is whether the option is undervalued or overvalued. You can check the valuation of the option using the Black & Scholes calculator available on your trading platform. If the market price is much more than the option value, it is overpriced and the option must be sold. However, if market price is much lower than the option value, it is under-priced and the option must be bought.

What is the option strike you wan to buy or sell?

What do you understand by option strike price? For example, any option contract is always discussed with reference to strike price. For example, a 2350 call option on Reliance is the right to buy Reliance Industries at a price of Rs.2350. So, strike price is also the contract price. The table below features SBI calls and puts for Mar-21.

Data Source: NSE

In the above table the left side are the call options on SBI and on the right are the put options on SBI. Selecting a strike price is a trade-off and must be done with reference to the market price. Currently, the market price of SBI is Rs.378. You can buy a 380-strike call at Rs.10.10 but a 390-strike call at Rs.4.80. But this lower option price comes at a cost because the chances of SBI going above 390 are much lower than SBI going above 380.

Let us also look at a similar example with respect to put options (which is a right to sell SBI) in this case. Here again, you must select a strike price with reference to the market price. Currently, the market price of SBI is Rs.378. You can buy a 380-strike put at Rs.10.50 but a 370-strike put at Rs.6.15. But this lower option price comes at a cost because the chances of SBI going below 370 are much lower than SBI staying below 380.

This an important decision. Traders buy deep OTM options for example, SBI 405 call is available at Rs.3.15, but it is too far and does not make sense. Ideally, look at the market price and buy calls that are close to the strike, not too far away. Don’t buy calls or puts just because the premium or price of the option looks cheap.

Should you place a limit order or a market order?

What exactly is a limit order and market order? In a limit order you define the price, while in a market order you don’t define the price. For example, if you place a limit order saying that you want to buy RIL 2300 call option with limit price of Rs.10, then the order will only be executed if the price of Rs.10 or less than 10 is available. Similarly, if you place a limit order saying that you want to sell Nifty 15,000 call option with limit price of Rs.55, then the order will only be executed if the price of Rs.55 or more than 55 is available.

On the other hand, in a market order, the buy or sell order is executed at the best price available at the particular point of time. You have to be careful about such orders because you can get your order filled at a price that is off the current market price. So, when should you use a limit order in options trading and when should you use market orders?

Ideally use limit orders when the market is very volatile or when the option is illiquid and the bid-ask spreads are high. That way you will have better control over the price of the options trade. On the other hand, if the price movement is directionally up or directionally down, then use market orders to get the best sell price and the best by price respectively.

Verify your options trade once before placing it

This may look a very routine and clerical thing to do. But over time, you will appreciate how important this relatively simple thing is. When you place an order, always make it a point to write down the order details like the strike price, buy / sell, market order / limit order, price of trade execution, lot size, order size, stop loss, profit target etc. How do you verify?

Firstly, once your order is placed, go into the order book and confirm that all your orders are executed. The order book will show pending and executed orders and the order once executed moves to the trade book. At the order book level, you can modify or cancel your options trade. Once the trade comes into the trade book, verify all the trade details and compare with your order note. In case something is wrong, it is better you take corrective action sooner rather than later.

Monitor the trade closely

This is actually part of the post-trade, but very important. Once your order is placed and executed in the option trading system, you must keep a tab on a number of factors. For example, check how the stock price is moving. Is the stock becoming more volatile or less volatile since more volatility is good if you have bought call or put options? Finally, also check for news flows on the company for which  you bought the option like quarterly earnings, M&A news, dividend payments, splits/bonus, major orders etc.

Cross-check with the contract note at the end of the day

This is the final step of your options trade. Here your trade is already done but you need to verify with your e-contract note in the evening if all the details are fine and as per your requirement. In case you find any discrepancy, you must immediately escalate the matter to your broker so that corrective action can be immediately taken. Once this is done, your job with the options trade is complete. However, you must continue to monitor the open trade till the time it is closed out.

References: 

Options as a Strategic Investment by Lawrence McMillan: Click Here to Buy Now

Fundamentals of Futures and Options Markets by John Hull: Click Here to Buy Now