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Myths Vs. Reality of Option Trading

In both the Indian stock exchanges; NSE and BSE, there are many instruments or segments to trade; such as shares, bonds, currencies, commodities, derivatives, and many more.

Traders and investors can select the financial instrument based on their trading needs and goals. A Few traders are only concerned about the risk and try to invest in risk-free instruments, while others fall into the category of risk takers. Stock market trading is a completely random phenomenon, but if you know the right approach and take a little risk, you may make a handsome amount of profit.

Over the past decade, the options segment of the derivatives in the stock exchange has flourished significantly, and trading in futures contracts and options contracts has increased tremendously. NSE records the daily transactions of the options worth Rs. 4 lakh crores plus, and 80% is contributed by the index option only. If we check the transactions of Bank Nifty, it has surpassed 10 lakh crores by trading in Nifty weekly and Nifty Monthly basis.

Options trading is gaining popularity day by day. The reason is it provides a great opportunity to gain benefits in all market situations, such as bearish, bullish, highly volatile, and even low volatile.

We shall first briefly understand the concept of options and futures contracts and then move forward in understanding in detail the myths regarding the options and futures in the market. Besides the cash market, wherein the shares are bought and sold, there is another segment in which the futures and options are bought and sold. A future is a contract to buy or sell the underlying stock at a fixed date and price. Options are also a type of agreement in which the option holder has the authority to either buy or sell the underlying asset, but not the obligation.

For example, If I bought 1 lot (100 shares) of Nifty Feb at Rs. 1000, in the first week of Feb, by paying Rs. 100 as a premium. My profit or loss would be decided based on the price fluctuations of this Nifty. Suppose the price falls to Rs. 900, I will be at a loss of Rs. 100 + Rs.100 premium upon entry.

In another scenario, where the price increases, my risk will be limited to only Rs.100 paid as a premium, and I can earn a maximum profit minus the premium.

Let us see how the involvement in the options can be beneficial to the buyer of the contract and the seller of the contract.

Benefits to Option Buyers:

  • The option buyers can enter the contract by paying the premium amount, which is much less than any other financial asset.

  • The potential risk is limited only to the premium amount paid in the uncertain market.

  • Option buyers can hedge the portfolio for the long term by applying the protective puts strategy.

Benefits to the option sellers:

  • The option sellers have the advantage of receiving the premium.

  • Option sellers can lower the cost of the option contract by selling them out of the money.

So, by now, you must be clear on what options and futures contracts are, their working, and benefits to both; buyer and seller. Let us now move to get a clear understanding of the prevalent myths about option trading in the market.

  1. One of the major myths regarding options trading is "they are very risky to trade." It is partially true, as they can only be risky when you don't understand the right approach to use them in your favor. In options trading, the risk is limited to the premium amount paid only. If you have a proper understanding of various strategies to use in different market scenarios and a good judgment ability, you can make money out of it. With the proper understanding of hedging strategies, you can hedge your funds to prevent potential capital losses. Options trading is majorly used for hedging purposes only. The way to succeed in trading options is to apply customized strategies based on your goals.

  2. The next myth about options trading is that they are complex to understand; that's not true. The fact is options are very simple to understand, you have the right to sell or buy the stock, but you are not obliged to buy or sell. Moreover, there are only two types of options: call options and put options. Complexity can be in understanding various multi-legged option strategies, but you may start with single-legged strategies and move gradually to the complex ones. The strategies like a ladder, butterfly, iron condor, etc. may sound tough to comprehend, but we believe nothing is difficult, and with constant learning and practice, you can master them all.

  3. The next one is a little funny, though; some traders believe that by selling options, they receive the premium, which is free money. Nothing in this world comes for free. It is a completely wrong perception that selling the options and collecting premiums is risk-free. Before dealing with the options, you must be aware of the risk management strategies. Because though selling the options seems risk-free, if the market turns upside down, the trader may go bankrupt, and he would be devastated if the risk is not handled properly.

  4. Another interesting myth about options trading is that only the seller party makes the profit. If that's true, there would be no buyer; no buyers mean no marketplace. It is an incorrect statement; the truth is both the buyer and seller have the opportunity to make a profit in options trading. In scenarios such as high volatility, trending, or directional market, buying the options gives the buyer an added advantage of making money. It is quite often seen in Bank Nifty weekly expiring option contracts.

  5. Profiting from the options is very easy; it is yet another myth. In a theoretical sense, it's quite easy to profit with the options as you have the opportunity to profit from favorable and unfavorable market conditions. But you need to be smarter than the rest of the traders. In this trading style, one has to lose for the other to win; thus, it is difficult. Understanding when, where, and how much to invest needs a lot of focus, analytical thinking, and dedication toward your work.

Besides the above-listed one, there are more myths in the market regarding options trading, such as you need a lot of margin money to trade in options and Futures Contracts. The next one is you should buy the options and hold them. Some traders believe that only experts can make money in option segments. A few other traders believe that the price fluctuations are happening because investors trade highly in the options segment leading the stock market to crash.

To be successful in options trading, maintaining discipline is very important; you must consider your trading goals and your risk appetite, and most importantly, you must have a full-proof risk management strategy on hand to avoid any uncertain circumstances in the stock market.

The biggest myth about option training is it is risky. The risk largely depends on your risk-bearing capacity. Options themselves cannot be categorized into more or less risky. It's ultimately up to you how much risk you can bear on a trade.

Options can be used for many purposes apart from making money, such as hedging, speculating, and leveraging. That makes options trading so demanding in the Indian stock market, especially in the derivatives segment.

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