Part 6 Learn Institutional Trading

1. The Mechanics of Option Trading

Option trading involves two primary participants: buyers and sellers (writers).

Option Buyer: Pays the premium upfront. Has limited risk (only the premium can be lost) but unlimited potential gain (in case of call options) or substantial downside protection (in case of puts).

Option Seller (Writer): Receives the premium. Has limited potential gain (only the premium) but carries significant risk if the market moves against the position.

Trading mechanics also include:

Margin Requirements: Sellers need to deposit margins since their risk is higher.

Lot Size: Options are traded in lots rather than single shares. For example, Nifty options have a standard lot size of 25 contracts.

Liquidity: High liquidity in options ensures tighter spreads and better price execution.

Settlement: Options can be cash-settled (index options in India) or physically settled (individual stock options in India post-2019 reforms).

The actual trading process involves analyzing the market, selecting strike prices, and deciding whether to buy or sell calls/puts depending on the outlook.

2. Option Pricing and the Greeks

One of the most fascinating aspects of option trading is pricing. Unlike stocks, which are priced directly by supply and demand, option prices are influenced by multiple factors.

The Black-Scholes model and other pricing models take into account:

Intrinsic Value: The real value of an option if exercised today.

Time Value: Extra premium based on time left until expiry.

Volatility: Higher expected volatility raises option premiums.

The Greeks

Option traders rely heavily on the Greeks, which measure sensitivity to different market factors:

Delta: Measures how much an option price changes with a ₹1 change in the underlying asset.

Gamma: Measures how delta itself changes with the price movement.

Theta: Time decay; options lose value as expiry nears.

Vega: Sensitivity to volatility.

Rho: Sensitivity to interest rates.

Understanding these allows traders to manage risk more effectively and structure trades in line with their market views.

3. Types of Option Strategies: From Basics to Advanced

Options allow for simple trades as well as complex multi-leg strategies.

Basic Strategies:

Buying Calls (bullish).

Buying Puts (bearish).

Covered Call (own stock + sell call).

Protective Put (own stock + buy put).

Intermediate Strategies:

Bull Call Spread (buy lower strike call, sell higher strike call).

Bear Put Spread (buy put, sell lower strike put).

Straddle (buy call + buy put at same strike).

Strangle (buy out-of-money call + put).

Advanced Strategies:

Iron Condor (combination of spreads to profit from low volatility).

Butterfly Spread (low-risk, low-reward strategy).

Calendar Spread (buy long-term option, sell short-term).

Each strategy has a defined risk-reward profile, making options unique compared to outright stock trading.