A Beginner's Guide to Options Trading: 5 Easy Steps to Get Started

Introduction

Options trading can complement your investment portfolio well, helping you leverage your position and potentially earn a good sum of money. But before you jump in, you must learn the basics. An option is a contract that gives you the right, but no obligation, to buy or sell an underlying asset at a specified price within a certain period of time. Indeed, this flexibility turns options into one of versatile investment instruments.

Step 1: Determine Your Objective

Identifying Your Goals and Risk Tolerance   

The first thing you must do before you start is to identify your financial goals. Do you need to generate an income, safeguard against other investments, or speculate on price direction? Your risk tolerance, which is your ability to bear possible losses, should align with these objectives.   

For instance, Rajesh, a 30-year-old engineer from Mumbai, wants to make money on the side through trading. He established a target of generating additional monthly income while being able to offset small losses.

Aligning Your Trading Strategy with Your Objectives  

Once your goals are set, you must align your trading strategy with these objectives. In Rajesh’s case, this meant strategies such as buying calls that could provide a steady income while lowering the risk. Make sure that your trading approach matches your objectives and risk tolerance. 

Step 2: Choose the Right Options Contract

Understanding the Different Types of Options Contracts

There are two primary types of options contracts: calls and puts. A call gives you the right to buy an asset, while a put gives you the right to sell an asset. Understanding these principles is vital in selecting a suitable contract for your trading plan system.

Selecting the Appropriate Strike Price and Expiration Date

The contract specifies the strike price at which an underlying security will be bought or sold. The expiration date is the last day when you can exercise your option. Select a strike price and expiration date consistent with your market view and risk management approach. For instance, Rajesh, who thinks that a stock will increase over a three-month period, would purchase a call option with a lower strike price close to the current price and an expiration date three months away.

Step 3: Analyse the Market and Underlying Asset

Conducting Fundamental and Technical Analysis

Fundamental analysis, like financial statements, industry conditions, etc., must be used to assess the intrinsic value (true worth based on analysis, not just its current price in the market) of an investment by studying financial statements, industry conditions and economic principles. On the contrary, technical analysis, like price trends, trading volumes, etc., disregards the intrinsic value and concentrates on price trends and trading volumes to predict future price movements.

Assessing Market Conditions and Trends

Understand general market situations and trends to make more informed choices. If the Indian stock market is on a bullish streak, you can buy calls, as this could be a good time. Rajesh inspects Tata Motors and Infosys shares, utilising basic and technical analysis before concluding.

Step 4: Calculate the Risk and Reward

Estimating the Potential Profit and Loss

Before you decide to trade, it is important to calculate the approximate amount you may earn or lose. This also means that you understand the payment structure of an option and how price changes in the underlying asset will affect your position.

Determining the Risk-Reward Ratio

The concept is the risk-reward ratio, which lets you compare what you can potentially gain from a trade against what you can potentially lose. It's important to find a risk-reward ratio that makes sense for your level of risk tolerance. Rajesh, for instance, looks at trades with the risk-reward ratio at least 1:2, i.e. he aims to make twice as much as his risk system offers

Step 5: Execute the Trade and Monitor

Placing the Order with Your Broker and Executing the Trade

Select a well-known broker with the necessary tools and resources for options trading. Execute your order and ensure it is in line with your trading strategy. Rajesh, for instance, trusts Sharekhan's advanced trading platform and instructional tools.

Continuously Monitoring the Position

Once you have placed your trade, monitor the status of that position. You know that market conditions can change rapidly, so you can successfully manage the associated risks if you act proactively. Rajesh monitors his positions daily and modifies his approach according to market shifts.