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Benefits and Risks of Option Trading

Benefits and Risks of Option Trading

Benefits & Risks of Options Trading- Pros n Cons Explained

The Options provides the investors more strategic and financial leeway than they usually receive simply by buying, selling or shorting the stocks. The traders usually use the options to protect against the portfolio losses, or an unexpected loss for a stock less than it sells on the open market or maybe sell it for more. The traders can increase the return on their existing new position and lower the risk on the speculative bets in any sort of market conditions. Trading in Options requires the customer to provide less capital to an investment rather than the investment in a stock or any other type of market trade. There are various benefits and the risks of Option Trading.

BENEFITS OF OPTIONS TRADING

Leverage:

Leverage basically refers to the usage of several strategies in order to increase the potential profit earned. Options Trading helps the traders to gain more profits with the small investments. The trader receives higher gains as at the time of buying options, the customer does not pay for the value of shares but a premium amount for the same is paid which is just the value of shares. The profit earned is just the change in the value of shares. Understand it in better way with an example:

Suppose you purchase a RELIANCE Option available at a strike price of ₹ 1900 at ₹100 premium for a lot size of 505 shares. To buy this option, you pay ₹100 (premium per share) X 505(lot size) = ₹50,500. If the share value of RELIANCE moves up to ₹ 2100 within the expiry period, then you will earn ₹ 200 X 505= ₹ 101000. The net profit after deducting the premium amount paid ₹ 50,500 will be ₹50500. Now if you had traded in shares during the period, you need to invest ₹ 1900 (share price) X 505= ₹ 9,59,500 and you would have made a profit of ₹ 200(price movement) X 505 = ₹ 10,1000. Thus, options provides you the opportunity to earn more profit per rupee invested than the shares.

Allows Trading Up, Down and Sideways:

In options trading, the trader gets the larger scope to earn leveraged benefits on the directions of the stocks. If the trader believes that the stock will go up, down or move even slight in any direction than the trader can gain profit. This simply mean that they can earn money on the stocks even at their significant movement in the share price. Understand it in better way with an example:

EXAMPLE
  • Just ahead of its quarterly results, ACC Options are available for-
  • Call Option at a strike price of ₹ 1,000 at a premium of ₹ 100 for a lot size of 500 shares.
  • Put Options at a strike price of ₹ 1,000 at a premium of ₹ 110 for a lot size of 500 shares.
  • The trader buy both by paying ₹ 50,000 for call option and ₹ 55,000 for put option.
  • If the share price of ACC rises to ₹ 1500, you exercise the call option and earn- Profits = [(current price- strike price)X(lot size)]-(premium paid)] Profits = [(1,500-1,000)X(500)]-(50,000)] = ₹ 2,00,000 But you would also lose the premium amount of ₹ 55,000 paid for the put option and hence your net profit would be ₹ 1,45,000. If the share price of ACC falls to ₹ 500, you exercise the buy option and earn- Profits = [ (Strike price- current price) X (lot size)]- (premium paid) ] Profits = [ 1,000-500) X (500)]- (55,000) = ₹ 1,95,000 Here again, you would also lose the premium amount of ₹ 50,000 paid for the call option and hence your net profit would be ₹ 1,45,000

Hedging:

This refers to establishing a position in the options market in order to offset an exposure to the price movements in some opposite position in the other shares. This aims at minimizing the exposure to the unwanted risk. In other words, options work as the insurance for your stock portfolio. The trader can buy options on his stocks as he buys insurance for the vehicles.

Understand it in better way with an example:

Suppose you own 500 units of TCS, currently trading at ₹ 2000. The put option for TCS is at the strike price of ₹ 2000 for a premium of ₹ 100. You buy the put option by paying a premium amount of ₹ 50,000. Now even if the share price falls to ₹ 1000 in next two months, you would be able to exercise the put option and sell at ₹ 1900 (strike price- premium) and limit your losses. On the other hand, if the share price moves up to ₹ 3000 next month, then your insurance won't have much value, you will still remain protected till the expiry date. Also, your investments have earned from the rise in the share price. A put option of ₹ 50,000 helps you protect an investment of 10,00,000 from downside price movement.

Opportunities

Trading in Options provides various opportunities to gain more regardless of the market conditions. The traders can buy and sell the options based on the wide variety of underlying asset. The options are available in various instrument such as metals, foreign currencies, agricultural products, interest rates, soft commodities, index products and much more. This provides a great scope for options trading opportunities at any time.

RISKS INVOLVED IN OPTIONS TRADING

Options Trading involves certain number of risks as any other investment. Some of the major risks involved are listed below:
  • Major losses: The Option seller may incur losses more than the price of the contract. The options are highly leveraged therefore, their prices may move very quickly. You can see the options price movements by huge amounts in a very short span of time say minutes or seconds of the usual hours or days like in stocks.
  • Complicated for the Beginners: Options Trading attracts many investors by looking at the leverage it provides for more profits with smaller investments. Trading in Options is quite complicated and thus an individual needs much knowledge and understanding to trade.
  • Short term Investment: Options are short term investment and thus it runs for days, weeks or months. Thus, there remains very less time to recover the losses incurred. Now, here the chances of losing money are equal to the chances of earning high profits out of it.
  • Quick and Sharp movement in the Prices: Options are the derivative of stocks and thus even a slight movement in the underlying stocks or index price may cause the sharp movements in the Option pricing.
An individual can minimize the risks if he has a proper and clear understanding about its strategies.