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Advantages of Trading Options
Leverage - Option trading is very attractive for small pocket traders. By taking position in options, one can reduce their cost significantly. Let’s take an example, suppose you wish to buy 12,000 shares of ABC Ltd., which is currently trading at Rs 130 level. Rs 130 call option of the same company is quoting Rs 5. Lot size for the company is 6000. In case you decide to buy stocks, your investment would be (130*12,000) = Rs 15,60,000. But if you choose to go options way, to take the same exposure, you will have to buy two lots for which your investment would come to (5*2*6000) = Rs 60,000. This means your cost of investment in options trading is just 3% to 4% of the investment required in stock trading.
Limits risk – Another benefit of options buying is that the risk is limited to the investment you make. Suppose, in context to the above example, you buy shares of ABC Ltd. and on the next day, the company comes up with the news of closing one of its subsidiaries and aftermath the stock opens 15% below your entry price. Now, the stock price falls to Rs 110.50, while the 130 call becomes zero. In case of stock, you would incur a loss of Rs 2,34,000; while in options, you would lose Rs 60,000 - the entire investment amount, which is far less than the one incurred in stock trading.
Higher potential returns – By trading in options, one will experience higher percentage returns compared to stocks. Lets assume, the delta of ABC Ltd. is 0.80, which suggests that options price will rise by 80% of stock price. If stock moves up to Rs 13, you will earn 10% return. While your option position will gain Rs 10.40 on the investment of Rs 5. Here, the return on investment is nearly 208%, which is much better than the return on stock. On the flip side, if you are on the wrong side of trade, one may end up losing the entire investment amount.
If you have been a seller of an option and the stock moves in the opposite direction than you thought, your take home losses accordingly.
Works in different market scenarios - One of the key advantages of options trading is alter strategies as per different market conditions. There are various strategies for all kind of markets, whether bullish, bearish or sideways - Long call, Bull call spread, Long Put, Bear put spread, long straddle, short straddle, etc. One can switch his strategies as per market condition.
Hedging - Every individual trading in stock market is exposed to a certain risk. In the event of any adverse market movements, hedging simply protects your trading positions from incurring loss. Suppose, you picked a stock of ABC Ltd. for Rs 100 six months back and now it is trading at Rs 125; here, you are earning a return of 25% on your investment. Now due to result season, you realize that the markets may soon enter a turbulent phase, which may also result in losing the money you earned during this time frame. In such scenario, you can hedge you position by simply buying ATM put option for same quantity, which will limit your downside during adverse market condition.
Income from existing portfolio – Any long term investors, who would like to earn some return or who want to lower the cost of their existing portfolios, can opt for covered call writing. In this case, one can write call option of the stocks he holds, which may give him some income on investment. Suppose, you have 7000 shares of XYZ Ltd., which you bought for Rs 130. Now, this stock is giving you handsome returns and therefore, you wish to hold it further. Later, you witness that this stock has consolidated and foresee the 135 level as a hurdle for the stock. Hence, you write 135 call option of same series for Rs 4 due to which you will get Rs. 28,000 (4*7000), if stock closes anywhere below Rs135. Thus, the same money that you have blocked in your portfolio fetches you some income.
Futures and Options contracts:
Derivatives that are traded on the exchange are of two types - Futures and Options. Both are contracts, which are traded in the exchange. The contract buyer agrees to buy or sell the underlying assets (stocks, in this case) at a fixed price at a future date. Now, if this is a futures contract, then the buyer has to fulfil the agreement at all costs. If this is an Options contract, however, the buyer can let the contract expire without fulfilling the terms of the agreement.
What is derivatives expiry:
The future date by which the contracts have to be fulfilled is called the derivatives expiry. To avoid confusion, the exchange has decided that the contracts can only expire on the last Thursday of every month. If this happens to be a trading holiday, then the previous trading day would be counted as the expiry date.
On the expiry day, the contracts are settled (or simply get expired in case of Options). This can be done by two ways - you can buy another contract which nullifies your contract, or you can settle in cash. For example, suppose you buy a futures contract which allows you to buy 100 shares of ABC company, then to close the contract, you can buy another futures contract which allows you to sell 100 shares. You will then have to pay the difference in the price of the contract. Each contract is traded at a specific value. This is connected to the underlying stock's price in the secondary stock market (cash market)-where you buy and sell stocks directly. So, the settlement value of each contract is tied to the closing price of the stock on the last day.
Why it affects stock prices:
Futures and Options contracts derive their value from their underlying stocks or indices. However, over short periods of term, the derivatives contracts can affect stock prices too. For example, suppose investors are optimistic about the near future. So, the volume 'Buy' contracts increase in the derivatives market in comparison with the 'Sell' contracts. Now, looking at this, investors in the cash market could start buying shares in anticipation of higher prices. When this buying increases in large quantity, the stock price actually rises.
Arbitrage trading on expiry:
A few days or a week before the expiry, traders take stock of their derivatives positions-whether they are truly profitable or not. Often, these traders have stock positions in both the secondary stock market as well as the derivatives market. Sometimes, they may buy from the stock market and sell through the derivatives market to make profits. This is called arbitrage trading. Around the expiry period, such traders may decide to cancel or unwind their positions to avoid losses. In such a case, they may directly sell the stocks in the secondary market itself. There may be other traders who do the exact opposite. Either way, this sudden increase in trading causes price fluctuations. This leads to an increase in volatility in the secondary market. However, this is just for a short period of time. Markets often recoup their losses after the expiry.
Topics Covered :
What are derivatives?
Instruments in derivatives
Objectives of derivatives
Benefits of derivatives
Terminology for derivatives
- Lot size
- Span margin
- Maintenance margin(MTM)
Introduction to Options
- Option terminology
- Option payoffs
- Strategies in Options:
- Brief of Derivatives(in a table)
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