OPTIONS TRADING - Don’t be a Minimum Guy: By Payel Chowdhury

As Hank Azaria, an American Actor once said “I was hedging my bets by the time I got to college. I was interested in drama, journalism and psychology”. He understood that hedging is as important in life as it is in your finances. Talking about hedging in finance, what better financial tool to hedge your other investments than an option derivative. But what are options really?

Options are a type of derivatives whose value is derived from its underlying asset such as stocks. The options give the buyer or the seller the right but not the obligation to buy or sell the underlying asset. There are two types of options:

Call option- It gives the holder of the option the right to buy the stated asset within a particular time frame.

Put option- It gives the holder of the option the right to sell the stated asset within a particular time frame.

The one who sells an option for a premium is known as the option writer. The amount that the buyer of the option pays to exercise the right but not the obligation to buy/ sell the option at a future date is known as option premium. Each contract has a specific expiration date by which the holder ought to exercise their option. The stated price of the option is also known as the strike price. But the question is why would an investor go for options? The reasons being

• Options are usually bought for their leveraging advantages. It is also very cost-effective as an investor can obtain a position similar to a stock position but at a very reduced rate.

• It is less risky if used properly. Options are generally used for hedging. And also, less cost is involved because it requires less financial commitment than the equities.

• We are spending less money for almost the exact profit.

Options being a flexible tool offers more investment alternatives as they have an unfair reputation of being a significantly risky investment option. Although it is indeed a risky option when used for speculation, it is a great method of reducing risk when you are also investing in equity markets. When you buy/sell an option, you pay a premium for the right but not an obligation. If the said stock fails to increase or decrease depending upon the long/short positioning you are investing in, the only thing you would lose is the premium price. If you had invested the same in the stock market, you would have lost the entire investment. But apart from that, the risks associated with options if you are a writer or if you are a holder are a little different from each other. If you are a Put holder, the profit potential is the difference between the prices, but the loss potential will be only the premium amount. In the case of a call holder, the profit potential is unlimited, whereas the loss would be the premium you spent. But in the case of a call writer, the maximum profit would be the premium whereas the downside would be unlimited and for a put writer, the loss would be the amount the stock is worth.

FOR EXAMPLE

Let’s take the stock of HUL which is traded in the equity market at Rs 2000 per share. You have bought a call option with a strike price of Rs 2060 available at Rs 200 which expires in two months. If you predict that prices are going to rise in the future, you would have paid a premium of Rs 20,000 for a lot of say 100 shares. At the end of two months, you would only exercise your option, if the market price goes above the strike price plus the premium which would also be a breakeven point for you. Now, if the market share prediction goes in your favor, and the stock price reaches 3000, you would have a profit of Rs 740 per share (3000-2060-200). If the market share drops down to say Rs 1800 per share, you would not exercise the option and the maximum loss you would suffer would be the premium amount, i.e., Rs 20000.

CONCLUSION

Extensive research before buying an option mitigates the risk of price movements. It is less risky than trading in equity. If the research shows the future possibility of rising in the stocks, the investors should buy a call option. If the research shows a price decrease, he should buy a put option. The investor should also be aware of the market scenario and understand the reason for the upward or downward movement of the underlying asset. Also, investors should note that institutional trading tends to increase the price of the asset. So, the investor should decide on his position depending on the research and his requirement. Hence, in every portfolio, some percentage of investment should be set aside for trading in options that would mitigate the risk of a loss and the portfolio will be very well balanced.

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