Introduction – Best Option Trading Strategies For Beginners
As you know, there are two ways to trade in the stock market, through cash markets and derivatives. While most novice traders are familiar with trading stocks in the cash market, derivatives still remain a mystery. In this blog, we will discuss option trading for beginners through simple option strategies.
What are Derivatives?
Derivatives are financial contracts whose values are derived from the value of the underlying asset. These contracts generally have pre-defined parameters such as quantity (lot size), quality (in case of commodities), and expiry date. Derivatives make it possible for traders to take trades with indices as the underlying assets, which would not be possible through cash market trading. They are traded on the National Stock Exchange, which also allows trading of currency derivatives. Let us take a look at the different types of derivative contracts.
Futures Contract
A futures contract signifies an agreement between two parties for the purchase and delivery of an asset, where the price is decided at the time of entering the contract but the contract is executed at a future date. Futures are standardized contracts that are traded on an exchange. These contracts are often used for hedging and speculation rather than for delivery. It is traders of the contract are obligated to fulfill the commitment to buy or sell the underlying asset if the contract is not squared off before expiry.
Call Option Contract
A Call option gives the buyer of the contract the right, but not the obligation, to buy the asset at the selected strike price on the day of the expiry. The buyer can exercise this right irrespective of the actual price on the day of expiry.
Put Option Contract
A Put option gives the buyer of the contract the right, but not the obligation, to sell the asset at the selected strike price on the day of the expiry. The contract buyer can exercise this right irrespective of the actual price on the day of expiry.
What are Options Trading Strategies?
While it is possible to trade naked options, i.e. single option trade, it is safer to hedge your positions and reduce your risk by trading with option strategies. Most of these strategies ensure that loss is limited and the probability of booking profit is higher. Strategies employed by traders are based on their views about the expected price movement in the underlying asset. Thus, option strategies can be for bullish, bearish, range bound / sideways/sluggish, and volatile price movements.
Furthermore, to make it easy to understand, some important terms and facts are stated below:
The strike closest to the underlying asset’s price is called the at-the-money (ATM) option. In case of Call Options, all strikes less than ATM are considered in-the-money (ITM) and all strikes above ATM are considered out-of-the-money (OTM). The reverse is true for Put Options; strikes less than ATM are OTM, while strikes higher than ATM are ITM.
All strategies listed here require that each leg of the strategy should have the same expiry. Index Options generally have weekly and monthly expiry, while stock options only have monthly expiry. Whereas, futures of indices and stocks always have monthly expiry, usually on the last Thursday of the month. If that day is a holiday, then expiry is on the preceding trading day.
10 Best Option Trading Strategies for Beginners:
For ease of understanding, we will take an example of Nifty trading at 17000 points (ATM strike is 17000). Unless specified, the strategy must be executed with only one lot. Where more than one lot is required, number of lots is clearly mentioned.
- Bull Call Spread
Bull Call Spread is a strategy for moderately bullish markets. It involves buying one ATM Call and selling one OTM Call of the same expiry. This strategy will give profits when the increase in underlying asset’s price is more than the spread minus the net premium paid, where net premium paid is calculated by subtracting premium received from the premium paid. Loss is incurred when price of underlying asset decreases instead of increasing. But loss is restrained as we have carried out one call writing trade.
For example, if we apply Bull Call Spread on Nifty, it would be as follows:
Long ATM Call – Buy 17000 CE
Short OTM Call – Sell 17100 CE
- Bear Put Spread
Bear Put Spread is used when expecting moderately bearish price movement. It is executed by going long on an ITM Put and shorting an OTM Put. This strategy works on the same principles as Bull Call Spread but in the opposite direction of price movement.
For example, applying Bear Put Spread on Nifty, we would take the following trades:
Long ATM Put – Buy 17000 PE
Short OTM Put – Sell 16900 PE
- Bull Call Ratio Back Spread
This is a three leg strategy used when a trader has a strong bullish view. It gives unlimited profits if market goes in our favour and gives limited profits when market goes against us. Loss is only incurred if the market stays within a specific range. Thus, this strategy is profitable when market is volatile.
This strategy can be understood through the following example of Nifty:
Long Two OTM Calls – Buy 17100 CE – 2 lots
Short ITM Call – Sell 16900 CE
- Synthetic Call or Protective Put
This is a strategy used by traders who have a long term bullish view but are concerned that the stock may show bearish movement in the short term. It employees a combination of Futures and Options contracts, with an unlimited potential for profits and limited risk. To execute this trade, one must buy a futures contract and an ATM Put. In this case, the Put option acts as an insurance and protects the trade from a bearish move.
For example, in Nifty, this strategy would be:
Futures Contract – Buy Nifty Futures
Long ATM Put – Buy 17000 PE
- Synthetic Put or Protective Call
This is a strategy used by traders who have a long term bearish view but are concerned that the stock may show bullish movement in the short term. It employees a combination of Futures and Options contracts, with an unlimited potential for profits and limited risk. To execute this trade, one must sell a futures contract and buy an ATM Call. In this case, the Call option acts as an insurance and protects the trade from a bullish move.
For example, in Nifty, this strategy would be:
Futures Contract – Sell Nifty Futures
Long ATM Call – Buy 17000 CE
- Long Straddle
Long Straddle is a strategy which is used when market is volatile but one cannot predict which direction it will move to. This strategy has potential for unlimited profits once price crosses outside a specific range, on any side. It can be executed through going long on ATM Call and ATM Put.
For example, long straddle in Nifty would look like:
Long ATM Call – Buy 17000 CE
Long ATM Put – Buy 17000 PE
- Short Straddle
Short Straddle is a strategy which is used when market is range-bound. This strategy gives maximum profit if price stays at or near ATM strike but has potential for unlimited loss once price crosses outside a specific range, on any side. It can be executed through going short on ATM Call and ATM Put.
For example, long straddle in Nifty would look as follows:
Short ATM Call – Sell 17000 CE
Short ATM Put – Sell 17000 PE
- Strip
This is a bearish strategy which is executed by going long on one ATM Call and two ATM Puts. It gives unlimited profits when price is volatile and gives max limited loss if price stays near ATM Strike.
For example, on Nifty we can apply strip as follows:
Long ATM Call – Buy 17000 CE
Long 2 ATM Puts – Buy 17000 PE – 2 lots
- Butterfly
Butterfly is neutral options trading strategy which employees a combination of bull and bear spreads. This strategy has a fixed profit and limited risk. The strike prices on either side of the ATM options will be at the same strike distance.
A long butterfly call spread would consist of one long ITM Call, writing two ATM Calls, and one long OTM Call. The short butterfly spread strategy would consist of writing one ITM Call, two long ATM Calls, and writing one ATM Call. This strategy can also be executed in Put Options.
For example, if we apply long butterfly call spread on Nifty, then the trade would be executed as follows:
Long ITM Call – Buy 16900 CE
Writing two ATM Calls – Sell 17000 CE – 2 lots
Long OTM Call – Buy 17100 CE
Maximum profit would be incurred if Nifty closes at the ATM Strike i.e. 17000.
- Iron Condor
Iron Condor is a four leg, non-directional strategy with limited profit and limited loss. It consists of two Call Options (long Call and short Call) and two Put Options (long Put and short Put).
For example, on Nifty an Iron Condor Option Strategy would be executed as follows:
Long Put – Buy 16800 PE
Short Put – Sell 16900 PE
Short Call – Sell 17100 CE
Long Call – Buy 17200 CE
Maximum profit would be incurred if Nifty closed within the middle strike prices, between 16900 to 17100 on expiry. We hope this blog has succeeded in educating you so you can start using these strategies to gain profits. You can use online strategy builders to check the payoff charts and find out how much price needs to move for getting sufficient profits. This way, you will be able to decide which strategy is most suitable based on your view on price movement.
Also Read-
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Scalping Trading
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