To trade Options one should have a trading plan. A trading plan, first of all includes technical analysis of trend of the underlying whose option is to be traded. It is very important to decide the trend of the underlying – upside, downside or sideways. Once we have decided on this trend it becomes easier to choose an option strategy and move forward with the trading plan. For trading any option strategy like trading any underlying stock we need to have a stop loss so that if the market moves against us we can minimize our losses by exiting our position at that point. Along with deciding the trend of the underlying and the stop loss we need to choose a scrip or stock which has high trading volumes, because trade are possible in only those options where there are high trading liquidity in their underlying.


Even though option prices are determined by market demand and supply, their prices are influenced by the following factors: the underlying price, the strike price, the time to expiration, the underlying asset’s volatility, and the risk free interest rate. Each of the five parameters has a different impact on the pricing of a Call and a Put. We have already discussed above the importance of knowing the trend of the underlying stock’s price, which can further explain the importance of choosing the options with the right strike prices for the chosen strategy.


While buying or selling any option we must calculate time remaining to the option’s expiration, as the time remaining in an option’s life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time to exercise it reduces. The time value of both call as well as put option decreases to zero as the time to expiration approaches zero. Therefore we should try to trade in options which have sufficient time remaining to expiration. As far volatility is concerned, it can be defined as the movement of returns. The more volatile the underlying stock higher is the price of the option on the underlying stock. Whether it is a call or a put, this relationship remains the same.


With all the above factors we also need to calculate the break even points of our strategies, and risk-reward ratios, the brokerage or the commission to be paid to the broker and margins to be paid to the exchange. As we know that in the spot market, the buyer of a stock has to pay the entire transaction amount (for purchasing the stock) to the seller and the settlement take place on T+2 basis; which means two days after the transaction date, but in a derivative contract, if some one enters into a trade today the settlement happens on a future date. Because of this, there is some possibility of default by any of the parties. Option contracts are traded through exchanges and the counter party risk is taken care of by the clearing corporation. In order to prevent parties from defaulting, the corporation levies a margin on buyers and sellers. This margin is a percentage (approximately 20%) of the contract value.


Finally we need to know how the option trades are finally settled in the exchange. There are basically three types of settlement in stock option contracts at NSE: daily premium settlement, exercise settlement and interim exercise settlement. In index options, there is no interim exercise settlement as index options cannot be exercised before expiry. In Daily Premium Settlement buyer of an option is obligated to pay the premium towards the options purchased by him and the seller of an option is entitled to receive the premium for the options sold by him. The premium payable and the premium receivable are netted to compute the net premium payable or receivable for each client for each options contract at the time of settlement. As for Final Settlement on the day of expiry, all in the money options are exercised by default. An investor who has a long position in an in-the-money option on the expiry date will receive the exercise settlement value which is the difference between the settlement price and the strike price. Similarly, an investor who has a short position in an in-the money option will have to pay the exercise settlement value.


So keeping all the above factors in mind we should come up with a set strategy – a trading plan, where we should manage our position according to predefined rules (like stop loss, breakeven points, Hedging techniques time of expiry etc.) defined in the trading plan. Greed tends to take a grip of most investors in the market, especially in F&O space. Hence, it is advisable that traders do not get too greedy and book profits when their target return is achieved.


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