Option is a type of contract in which a trader (who buys the Option) has the right to purchase or sell the assets, but not the obligation, at a fixed price until the expiration of the contract. Options are traded in a lot of 100 each.
Types of Options:
There are two common types of options: Call Options and Put Options.
Call Options: Call options provide the opportunity for a buyer to buy a security (no obligation) at the strike price as mentioned in the contract. Options traders buy Call Options when they predict that the price of a security will go up and sell the Call Options if they assume the price will go down.
Put Options: Put options provide the opportunity for a buyer to sell a security (no obligation) at the strike price as mentioned in the contract. Options traders buy Put Options when they predict that the price of a security will go down and sell the Put Options if they predict the price will go up.
Benefits of Options:
- Trading options is cost-efficient as it needs a lot less money to purchase an option as compared to the underlying security.
- Options can be used to hedge an equity position. It will guarantee a certain buy price or sell price depending upon the type of Option used. This protects the investors’ wealth against sudden market fluctuations.
- Options can also be used for income purposes. There are a number of complex strategies, which can be deployed to generate income from selling, buying or complex positions of Call and Put Options. These strategies are very effective, at the same time very complex and risky. Novice traders should have deep understanding and education prior to trading Options for income. \
- Options trading is much flexible as an investor can implement options and purchase the shares and add them to their portfolio, then they can sell them, sell the call options to another trader.
- A trader can potentially get higher returns by trading options. The risk of losing money is also higher.
- Options trading can be exercised in various industries such as metal, agriculture, energy products, etc.
Options to protect Wealth:
Options is an excellent asset class to protect the wealth, such as retirement savings, significant long term stock portfolio etc. For example, if an Investor buys 1000 stocks of Tesla, it can buy 10 Put options with the set strike price to protect the 1000 Tesla stocks from unexpected market fluctuations. This strategy is also referred to as Covered Call. In another scenario, if a trader wants to book profit on its stock portfolio and re-enter into the stock at a lower price, a Call Option at lower strike price can be bought to have the option to buy the stock back at a lower price.
Options to regular Income
- The most common strategy to earn regular income from options trading is selling covered calls. For this strategy, the trader must own at least 100 shares of stock. The idea is to sell an out-of-money (in which the strike price is more than the market price) Call Options to earn money in the Premium. If the stock price never reaches the strike price, the Call Option expires worthless, and the trader retains the premium amount as the profit.
- Another strategy is to sell cash secured Put Options to generate income from the premium. In this strategy, the idea is to sell an out-of-money Put Option with the expectation that the stock price will remain above the strike price. If the stock price remains below the strike price at the expiry, the Put Option will expire worthless, and the trader will retain the premium as profit.
- The third strategy is to use credit spreads or debit spreads. Credit spreads can provide premium income, if the market moves in the expected direction. It can also be extremely risky, if the risk is not managed properly. Debit spreads can also provide profit, if the positions are closed for a profit prior to expiry. Once again, this strategy can also be very risky without proper risk management.
Risks in Options:
Options trading has higher inherent risks as compared to the underlying stock or instrument. Some Option types and strategies have lower risk than some other. However, understanding the risk in Options and how to manage the control of this risk is very critical prior to initiating Options trading.
- While buying an Option (either Call or Put), the risk is limited to the premium paid.
- However, while selling an Option, unless it is covered by the underlying stock position, the risk is unlimited. A proper analysis of Supply and Demand and identifying the right Stop Loss is extremely critical to avoid unlimited loss.
- In a Credit Spread, the risk is limited to the difference of strike price between the two Options minus the premium paid.
- In a Debit Spread, the risk is limited to the difference of strike price between the two Options plus the premium paid.
- There are risks in Calendar Spreads, Straddles, Strangles, Iron Condor and other Options strategies.
- The pricing of an Option is dependent on various parameters and can be complex to understand and estimate at times.
- Due to the time-sensitivity, a trader can lose money if the market does not go in the expected direction.
- There is also the risk of time decay in options.