Part 4 Institutional Trading

1. Introduction to Option Trading

Options trading is one of the most fascinating, flexible, and powerful segments of the financial markets. Unlike traditional stock trading where investors directly buy or sell shares, options provide the right (but not the obligation) to buy or sell an underlying asset at a predetermined price within a certain time frame. This right gives traders immense flexibility to speculate, hedge risks, or generate consistent income.

At its core, option trading is about managing probabilities and timing. Stocks may only move up or down, but with options, traders can structure positions that benefit from multiple scenarios—rising prices, falling prices, or even a stagnant market. This is what makes options such a versatile tool for professional traders, institutions, and increasingly retail investors.

The roots of options trading go back centuries, even to ancient Greece where contracts were used for olive harvests. But the modern options market took off in 1973 when the Chicago Board Options Exchange (CBOE) was launched. Today, options are traded globally on exchanges like NSE (India), CBOE (US), and Eurex (Europe), covering not just equities but also indices, currencies, and commodities.

Why are options popular? Three main reasons: leverage, hedging, and strategy flexibility. Leverage allows traders to control a large position with a relatively small premium. Hedging allows investors to protect portfolios against adverse market moves. And strategy flexibility lets traders design trades that fit their market view precisely—something simple buying or selling of stocks can’t achieve.

In essence, options trading is about trading opportunities rather than assets. Instead of owning the stock itself, you trade its potential movement, giving you multiple ways to profit. But with this opportunity comes complexity and risk, which is why a deep understanding is crucial before jumping in.

2. Types of Options: Call & Put

The foundation of option trading rests on two types of contracts: Call Options and Put Options.

Call Option: Gives the buyer the right (not obligation) to buy the underlying asset at a specified price (strike price) before or on expiry. Traders buy calls when they expect the underlying to rise. Example: If Reliance stock is ₹2,500, a trader may buy a call option with a strike price of ₹2,600. If the stock rallies to ₹2,800, the call buyer profits from the difference minus the premium paid.

Put Option: Gives the buyer the right (not obligation) to sell the underlying asset at a specified strike price. Traders buy puts when they expect the underlying to fall. Example: If Nifty is at 20,000, and a trader buys a 19,800 put option, they benefit if Nifty drops to 19,000 or lower.

Both calls and puts involve buyers and sellers (writers). Buyers pay a premium and enjoy unlimited profit potential but limited loss (only the premium). Sellers, on the other hand, receive the premium upfront but carry unlimited risk depending on market moves. This dynamic creates the foundation for strategic option plays.

Another key distinction is European vs American options. European options can only be exercised on expiry, while American options can be exercised anytime before expiry. Indian index options are European style, while stock options used to be American before shifting to European for standardization.

Ultimately, every complex option strategy—iron condors, butterflies, straddles—derives from some combination of buying and selling calls and puts. Understanding these two instruments is therefore the first step in mastering option trading.

3. Key Terminologies in Options

To trade options effectively, one must master the essential language of this domain:

Strike Price: The fixed price at which the option buyer can buy (call) or sell (put) the underlying.

Premium: The cost paid by the option buyer to the seller.

Expiry Date: The date when the option contract ceases to exist. Options can be weekly, monthly, or even long-dated.

In the Money (ITM): When exercising the option is profitable. Example: Nifty at 20,200 makes a 20,000 call ITM.

Out of the Money (OTM): When exercising leads to no profit. Example: Nifty at 20,200 makes a 21,000 call OTM.

At the Money (ATM): When the underlying price is equal or very close to the strike.

Intrinsic Value: The real economic value if exercised today.

Time Value: The extra premium based on time left until expiry.

Greeks: Key risk measures (Delta, Gamma, Theta, Vega, Rho) that tell traders how option prices react to changes in market factors.

Understanding these terms is non-negotiable for any trader. For example, a beginner may get excited about buying a low-cost OTM option, but without realizing the impact of time decay (Theta), they may lose the entire premium even if the market slightly favors them. Professional traders carefully balance these variables before entering trades.

4. How Option Trading Works

An option contract is essentially a derivative, meaning its value depends on the price of an underlying asset (stock, index, commodity, currency). Every option trade involves four possible participants:

Buyer of a call

Seller (writer) of a call

Buyer of a put

Seller (writer) of a put

When an option is traded, the exchange ensures transparency, margin requirements, and settlement. Unlike stocks, most options are not exercised but are squared off (closed) before expiry.

For instance, suppose a trader buys a Nifty 20,000 call at ₹200. If Nifty rises to 20,300, the premium may shoot up to ₹400. The trader can sell the option at ₹400, booking a ₹200 profit per unit (lot size decides total profit). If Nifty remains stagnant, however, time decay will reduce the premium, causing losses.

In India, index options like Nifty and Bank Nifty weekly options dominate volumes, offering traders fast-moving opportunities. Stock options, meanwhile, are monthly and useful for longer-term strategies. Settlement is cash-based for indices, and physical delivery for stocks since 2018 (meaning if held till expiry ITM, shares are delivered).

The mechanics of margin requirements also matter. While option buyers only pay premiums upfront, option writers must keep margins since their potential losses can be unlimited. This ensures systemic safety.

Option trading, therefore, is not just about direction (up or down), but also timing and volatility. A stock can move in the expected direction, but if it does so too late or with too little volatility, an option trade can still fail. This is what makes it intellectually challenging but rewarding for disciplined traders.