Investment portfolios are often composed of diverse asset classes. These usually are stocks, mutual funds, ETFs, and bonds. Options are an additional asset class. If used appropriately, options trading offers numerous advantages that dealing in stocks and bonds alone do not. Before we address these benefits, what are options?
What are Options?
An ‘option’ is a contract that permits (but doesn’t necessitate) an investor to purchase or trade instruments like securities, ETFs or index funds at a pre-decided rate after a specified period. Selling and purchasing options are carried out in the options market. An option that permits you to acquire shares sometime in the future is referred to as a “call option.” On the other hand, an option that enables you to sell shares sometime in the future is a “put option.”
Difference Between Options Trading and Other Instruments
Options are considered lower risk instruments than traditional futures contracts used in stock, index and commodity trading. This is because of the fact that one can choose to walk away from or withdraw their options contract at any time. This also means that, unlike stocks, options do not represent having ownership in a company. The market price of the option (also known as its premium) is, therefore, a portion of the underlying security or asset.
How Does Options Trading Work?
When an investor or trader buys or sells options, they have the right to apply that option at any point before the date of expiration. Simply purchasing or selling an option doesn’t require one to actually exercise it at the expiration point. Due to this structure, options are considered ‘derivative securities’. In other words, the price is options is derived from other things like the value of assets, securities, and other underlying instruments).
Benefits of Options Trading
- Buying options requires a lesser initial expense than acquiring stock. The price of obtaining an option (premium and trading fee) is a lot cheaper than what a trader would have to spend to purchase outright shares.
- Options tradinglets investors freeze the price of their stock at a specified amount for a certain period. Depending on the category of the option used, the fixed stock price (also known as the strike price) guarantees that one will be able to trade at that rate at any point before the options contract expires.
- Options tradingimproves a trader’s investment portfolio through added income, leverage, and even protection. A common way of using options to limit one’s downside losses is in the form of a hedge against the declining stock market. Furthermore, options can be used to produce a recurring source of income.
- Options trading is inherently flexible. Before their options contract lapses, traders can employ various strategic moves. These include using options to buy shares to add to theirinvestment portfolio. Investors can also try buying the shares and then selling some or all of them at a profit. They can also sell the contract at a higher rate to another investor before it matures and expires.
How to Use Call Options
A call option enables a trader to acquire a certain quantity of shares in either bonds, stocks, or other instruments like indexes and ETFs at any point before the contract expires. When purchasing a call option, to make profits, you would prefer that the asset or security price increases. This is because your call options contract enables you to purchase that underlying asset or security at the predetermined rate which is lower. Hence, in this case, you receive a discount when you use your call options contract to make a purchase.
However, do keep in mind that you will have to renew your call option (usually on a quarterly, monthly, or weekly basis). This is why options are known to continuously experience a ‘time decay’, which essentially means that they decay in value over time. When it comes to call options, look for lower strike prices, as this suggests the call option has more intrinsic value.
How to Use Put Options
A put option contract gives the investor the opportunity to sell a specific quantity of shares of some underlying security, asset or commodity, at a pre decided rate before the contract expires. With such contracts, one can make profits in case the asset or security prices drop in the future. This is done by selling underperforming shares at a predetermined price closer to the original price using the put option.
It’s also possible to reduce one’s net loss with put options. Suppose you buy stocks worth Rs 2500 with a put option worth Rs 2250 as you are predicting that their market price will drop. Within a few months’ time, assuming these stocks underperform at Rs 2000, you can sell them for Rs 2250, which reduces your net loss to Rs 250 instead of Rs. 500. Similar to call options, put options undergo time decay. However, to find an intrinsically valuable put option, look for initially higher strike prices.