India being home to one of the biggest option trading communities (considering the volumes we do), it makes sense to look into other utilities of Equity Option as an instrument apart from the risk management a.k.a. hedging.
Options being priced at a fraction of the price of the underlying equity or index to which it belongs, does attract a lot of attention from traders. Traders look at options as an economical way to trading the same equity or index.
Option premiums are sensitive to price of its underlying. Thus, during the course of the expiry premium of an option bought with bullish perspective (Call) will rise if the price of the underlying rises. This factor creates an amazing trading opportunity.
Typically, when one Buys a Call Option the driving force is that Premium which is the maximum loss and the Profits are unlimited.
However, error here is that while we do affirm availability of the profit potential, we hardly sync it with longevity of our own view as well as potential of the underlying to go up during such time.
So, the most crucial thing to learn for trading Options beyond risk management is to gauge whether we will make money with the option trade given the longevity of my view. Because lets face it, trading views can have a life of a couple of seconds (There are few techies who do high frequency trading ) to a few hours to a few days.
Now let us take a trade. The stock is trading at 1,000. Our expectation is that it could go up to 1020 while on the downside could contain itself to 990. Typically, if I were to trade this view in Options I would go ahead and Buy a Call of 1,000 Strike.
This Call could be trading at 25. My view is that the stock can go up by 20. Now, the sensitivity to the price pushes up the premium during the expiry and brings it up possibly to 35 when the stock moves to 1020.
But to efficiently take a trade like this, we need to gauge which option my option trade will be able to make me money. Answer lies in the fact 3 crucial details: what is my Target and Stop-Loss in the underlying and Time by how long I am expecting this target to be achieved.
Given these 3 details I can easily translate my expectation in underlying into option premium. To do this, we have all other information but not the volatility figure. So, pick any calculator for Options to put the current stats (Underlying price, strike, premium etc.) we would get the volatility figure.
Plug in the expectation (Time and Target & Time and Stop Loss) along with volatility and figure out what the premiums of the option would be if the stock under consideration moves from current price to Target and Stop Loss after passage of Time. The answer (Target Premium & Stop Loss Premium) when compared to the Current Premium if makes sense to you economically only then take the trade.
The sweetest part of this trade is that the absolute money made by trading Options (Vs. Underlying) may not be that big but the Profitability (Profit Vs Investment) is very attractive. If we pre-calculate our Target and Stop Loss premiums ahead of the trade, Options could prove to be the best instrument to Trade.
Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.