Options are Derivatives that let you but are not obligated tohonour a deal at a fixed price on a specific date. Derivatives are financial products that derive value from underlying assets like Commodities, Stocks, Indices, or Currencies. For example, if you buy a Stock Option for Rs. 1,000 and its price goes up to Rs. 1,200, exercise your right to sell the Option and make a profit of Rs. 200. But if the price falls to Rs. 800, you may choose not to exercise the Option, thus avoiding the loss.
But how do you know which contract to invest in? The answer is to go for the most-active contract in the market: Options with the highest trading volume over a given period. But how do you find the most active contracts? Here are some factors that will help:
Assume you have chosen the underlying asset for Options:Currency, Commodity, Stock, or Exchange-Traded Funds. Once you select this, the following are the steps to follow to find the most active Option Contracts:
Investment objective
Be clear of what you aim to achieve from this trade. Are you just speculating on the bullish or bearish view of the underlying asset? Or hedging a potential downside rise on which you have a significant position? These questions are important because your trading strategy depends on your investment objective.
Call or put
Now, decide whether you want to bet on falling or rising prices. If it is the former, you may want to go for the Put Option. If it is the latter, opt for Call Options. While Put Options gives the right to sell the underlying security at a specified price on a specific date, Call Options give you the right to buybut are not obliged to.
Risk-reward payoff
This is the prospective reward you earn for every rupee you risk on an investment. Consider this ratio to compare the expected investment returns and decide whether the rewards are worth the risk. This also determines your investing strategy.
Consider the premium
You need to pay a premium while entering an Options Contract. The premium depends on the underlying asset’s price, volatility, and expiry, among other factors. Premiums make up for a certain percentage of your transaction and affect your returns. Meanwhile, compare the underlying asset’s volatility with its historical volatility since it affects your premium and devises an investing strategy.
Identify events and timing
Events impact the prices of underlying assets. Market-wide events impact broad markets, such as Federal Reserve’s interest rate hike. Some are specific to the underlying security, like earnings report in the case of Stocks. Before and after they happen, such events impact the underlying security’s volatility. You may want to capitalise on such events. Options Trading also offers a variety of strike prices and periods. This way, you can decide which strike price to enter and when to do so.
Formulate a strategy
Now that you know the basicsdevising the right plan becomes easier.
Regardless of your underlying asset, the best options to trade are the ones that have high liquidity and volume. Some high liquidity Stock Options in the Derivatives Market in India are exchange indices like SENSEX and NIFTY. BANK NIFTY is another liquid index. Plus, the exchanges publish a list of the most active contracts you can consider.
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