Benefits & Risks of Options Trading
Published on Wednesday, April 4, 2018
Modified on Monday, May 28, 2018
Trading in options is a little more complicated than trading in shares. So, then why would investors trade in options? Options trading offers some major benefits that are not available in stocks trading like:
Small investment, higher profits
Called leverage in trading parlance, trading in options offers you the opportunity to make higher gains with a small investment. This is because when you buy options, you don't pay for the value of shares but a premium amount which is much smaller than the value of shares. And the profit you make is the change in the value of the shares.
Let's understand this with an example:
Say you purchase a TATA MOTORS Option available at a strike price of ₹ 2000 at ₹200 premium for a lot size of 100 shares. To buy this option, you pay ₹200 (premium per share) X 100(lot size)= ₹20,000. If the share value of TATA MOTORS moves up to ₹ 2500 within the expiry period, you will earn ₹ 500 X 100= ₹ 50,000. The net profit after deducting the premium amount paid ₹ 20000 will be ₹30000.
Now if you had traded in shares during the period, you would need to invest ₹ 2000 (share price) X 100= ₹ 2,00,000 and you would have made a profit of ₹ 500 (price movement) X 100 = ₹ 50,000.
So, options offer you the opportunity to earn more profit per rupee invested than shares.
Benefit of earning profits in both, rise and fall in the price of the underlying instrument:
At times, as an investor, you're not sure which way a particular stock or an instrument will move but are sure that some event will definitely cause significant movement in the share price. This happens during the time of the announcement of quarterly results, budget, policy changes, etc. In such times, you can make use of 'Long Straddle Option Trading Strategy'. The strategy involves buying both, a call and a put option, at the same strike price and expiration. This allows you to make a profit when there is a significant price movement in the share of the company, irrespective of whether it moves up or down.
Let's understand it with an example-
Just ahead of its quarterly results, Reliance Options is available for-
Call option at a strike price of ₹ 2,000 at a premium of ₹ 200 for a lot size of 100 shares.
Put options at a strike price of ₹ 2,000 at a premium of ₹ 210 for a lot size of 100 shares.
You buy both by paying ₹ 20,000 for the call option and ₹ 21,000 for the put option.
If the share price of Reliance rises to ₹ 2500, you exercise the call option and earn-
Profits = [(current price- strike price)X(lot size)]-(premium paid)]
Profits = [(2,500-2,000)X(100)]-(20,000)] = ₹ 30,000
But you would also lose the premium amount of ₹ 21,000 paid for the put option and hence your net profit would be ₹ 9,000.
If the share price of Reliance falls to ₹ 1500, you exercise the buy option and earn-
Profits = [ (current price- strike price) X (lot size)]- (premium paid) ]
Profits = [ (1,500-2,000) X (100)]- (21,000) = ₹ 29,000
Here again, you would also lose the premium amount of ₹ 20,000 paid for the call option and hence your net profit would be ₹ 9,000.
Acts as an insurance against your current investments:
We buy insurance to protect ourselves against financial losses arising out of an unfortunate event. Options can also be used as an insurance to protect your investments. We all know, a put option gives you the right to sell at a set price within a certain period. Buying a put option, when you also own the underlying instruments, is like insuring your investments against a possible decline in its value.
Suppose you own 1000 units of BAJAJ AUTO, currently trading at ₹ 5000. The put option for BAJAJ is available at the strike price of ₹ 5000 for a premium of ₹ 300. You buy the put option by paying a premium amount of ₹ 3,00,000. Now even if the share price falls to ₹ 3000 in next couple of months, you would be able to exercise the put option and sell at ₹ 4700 (strike price- premium) and limit your losses. On the other hand, if the share price moves up to ₹ 6000 next month, your insurance won't have much value but still, you are protected till the expiry date. Also, your investments have gained from the rise in share price. A put option of ₹ 3,00,000 helps you protect an investment of 50,00,000 from downside price movement.
Risks in Options trading
One may wonder - when trading in options has so many benefits then why some investors shy away from investing in it? Like every investment, trading in options has its share of risks like:
- Requires good understanding to make profits: Many investors jump into options trading looking at the leverage it offers for higher gains with small investments. But options are little complicated to understand. So investors need to spend some time understanding options in detail before taking the plunge into options trading.
- Short-term investments: Options are short-term investments that run for a few months. The shorter time gives less time for price recovery. So the chances of losing money is also as high as earning profits out of it.
- Prices may move sharply: Options being a derivative of stocks, indexes etc., a small movement in the underlying stock or index price can cause sharp movement in the options pricing.
- A possibility of losing all the capital: In adverse market conditions, you may lose all the capital paid in premiums.
Options are a high risk, high reward play. However, if done with proper understanding and strategies, one can minimize risks and profit from trading in options.
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