Option trading is often considered risky. But for a trader who understands options thoroughly, it offers a range of advantages which can be used according to one’s need and situation. In this article, I would like to share the reasons why an individual would put money in options. Reasons can vary as per individual but here are top 5 for me-
1. Leverage – Enables you to control large investments but with small capital. For example, to buy 500 shares of Reliance Industries at Rs. 1500 each, an investor would need 7.5 lacs. On the other hand, investors could buy a call options by just paying a premium of Rs 20 each that would be Rs 10000 only. By using leverage, an investor can hold stock worth a couple of lacs by paying a few thousand.
2. Hedging – Option can be considered as a good hedging tool to safeguard your portfolio in adverse or uncertain times. Consider an investor with a 10 lacs worth portfolio of blue-chip stocks but you are not certain about the upcoming event like budget, election results, RBI event, etc so in order to safeguard the value of your overall portfolio, the investor can go Put long and in case of any event that is not favorable, that investor can off-set his losses on portfolio against the gains on Put long.
3. Higher Profits – On 31st Oct 2019, there was an article in one of the leading newspapers that stated like “Yes Bank 60- call option trader make a killing in a few minutes”. That was true. On the news of a binding offer for a $ 1.2 Billion investment, the stock price surged by over 30 percent and a premium of 60-Call rose from 10 paise to over Rs 18. An investment of Rs 10000 would have been over Rs 18 Lacs.
4. Strategies – Options trading offers a range of strategies for its traders. One can choose the best fit for himself but understand options well before getting your hand into this. Options strategies allow traders to profit from price movements based on market sentiments like bearish, bullish, or neutral. It refers generally to a combination of an option position
5. Limited Downside – Option buyers have this convenience rather than confidence at their disposal. No matter how much a trade turns adverse or stock moves in the opposite direction, option buyers’ losses are limited to the premium paid whereas option writers (sellers) will have to bear huge losses. To understand this better, if you allow me to go back to example shared above, the investor with 7.5 Lacs of RIL bought at Rs 1500 each will lose 1.5 lacs if stock prices fall by 20 perc but an option(call option) buyer will only lose the premium paid by him(Rs 10000).
Conclusion – As seen, options can be our best friend but there are risks associated with any investment. Options when not understood correctly, they can lead to huge losses. Understand them properly and once you do, it’s always good to have 5-10 percent of that in your portfolio to get an edge. Know your risk profile beforehand.