Options – The Basics
What most people don’t know about options contracts is that they were originally created as a way to reduce risk of other investments. Therefore, it is bit odd that options now have such a bad reputation as being risky and a sure way to lose money. You can just as easily lose money in stocks also. It all depends on your ability to identify opportunities and seize them before they pass you by.
Options trading can be quite profitable. It’s not unheard of for an option to double in value in a single day. This doesn’t happen every single day, of course, but it’s enough to give you an idea of what can be done in this market.
Of course, things aren’t that attractive all the time. Where there’s earning potential such as this there is also a risk, and indeed Options trading is considered very risky by many people and in the general public. Is this really the case? Should you avoid trading options entirely? Is options trading really risky?
The truth is that option trading is just as risky as the person doing the trading: if the trader doesn’t know how to trade options, the risk can be enormous. But if you attain a proper options trading course, learn the ropes, and become familiar with the way this market works, you can and should eliminate most of the risk and be able to earn a very large sum of money.
Remember, this is only as risky as your level of knowledge. The more you know the less risky it will be and the greater your chance of earning big profits.
Options trading can be confusing and risky. Fortunately it can also be safe and profitable. Like most things in the investment realm, there are bad options trading strategies and good options trading strategies.
The main idea to remember when using an options strategy is it’s meant to increase your returns or lower your risk. Therefore you should stick to strategies that have been proven to do these things and ignore the ones that promise untold riches but expose you to absurd risks
The first thing you need to do before doing any options trading is to look at the underlying stock. A big mistake traders make is ignoring the underlying stock and just looking at the premium level hoping to make a quick short-term profit. That’s a HUGE mistake and has no place in an investor’s bag of tools. If you’re a speculator or like to roll the dice in the stock market, then perhaps you can ignore the underlying stock, but if you’re an investor, then don’t ignore it.
A very famous quote:
the difference between gambling and investing is education
In option trading, possibly more than anything else, this statement stands true.
Benefits of option trading
Finally, words like “risky” or “dangerous” have been incorrectly attached to options by the financial media and certain popular figures in the market. However, it is important for the individual investor to get both sides of the story before making a decision about the value of options.
Leverage is created by making your investments work harder for you. In other words, leveraging is creating potential for bigger gains using a smaller amount of capital.
For Example: Say you wish to buy Reliance Industries in Feb because you think it will be going up over the next several months. You want to buy 250 shares while RIL is trading at Rs. 860 this would cost you a total of Rs. 2,15,000. Instead of putting up that much money, you could have gone into the options market, picked the proper option that mimics the stock closely and bought the March call option, with a strike price Rs. 860, for Rs.50. This would bring your total investment to Rs. 12,500 as compared to Rs. 2,15,000. The difference could be left in your account to gain interest or be applied to another opportunity that provides better diversification potential, among other things.
Options will help you to completely hedge long-term stock positions at a low cost.In options trading, hedging means you can establish a position to offset an exposure to price fluctuations in some opposite position in Futures or Equities. This has the goal of minimizing your exposure to unwanted risk.
Options are a perfect tool for protecting your stock portfolio. You can buy options on your stocks like you buy insurance for your car. For a small amount of money you can buy options against a longer-term trade or investment and fully protect that trade or investment from market volatility (dramatic ups and downs).
Options are the most dependable form of hedge, and this also makes them safer than stocks. When an investor purchases stocks, a stop-loss order is frequently placed to protect the position. The stop order is designed to “stop” losses below a predetermined price identified by the investor. The problem with these orders lies in the nature of the order itself. A stop order is executed when the stock trades at or below the limit as indicated in the order.
Had you purchased a put option for protection, you would not have had to suffer the Unwanted loss. Unlike stop-loss orders, options do not shut down when the market closes. They give you insurance 24 hours a day, seven days a week. This is something that stop orders can’t do. This is why options are considered a dependable form of hedging.
Trading Up, Down and Sideways
Options give the trader plenty of extra scope to make leveraged bets on the direction of a stock; whether you believe the stock will go up, down, or move very little in any direction. This means that you can make money on stocks even when they are not making money.
This depends greatly on which brokerage you use. Online brokerages offer discounts on options as there is a great deal of competition. This helps to keep options trading costs low. Brokerage on options are very open- there are no hidden costs. The Brokerage are a lot less than those charged for trading stock.
Risk Is Limited
Options allow you to create trading strategies with limited risk of loss, but with high probabilities of success only if you have complete control over the exposure to risk.
Any Movement Can Be Good
You do not need to be ‘bullish’ all the time. (Bullish means that most investors would expect upward price movement in the stock market). An option trading allows you to establish positions that earn you money when the market moves up, down, or trades in a range. Owning shares only allows investors to profit when stocks move higher.
By selling someone else the right to buy your stock at a predetermined price, you are paid a premium that you can consider to be a special dividend through an option. But you have to be very careful while selling options as your risk is unlimited, if it not moves in your direction.
If you wish to trade a diversified portfolio rather than just shares, there are options available on all the major indexes e.g. Nifty, Bank-nifty etc.
Options are available in a wide range of instruments, such as currencies, interest rates, index products, Stock options etc. This leaves a wide scope for options trading opportunities at almost any time.
Transactions can be executed quickly and easily, so your money is not tied up for a long time as it is in trading shares. You can re-invest many times over in the same time that you might only trade once with shares. This means many more chances to make a profit!
There is a rule when trading options known as the ‘rule of opposites’ where if one thing isn’t true, then the opposite must be true. Thus, we can say that when options are reducing in time to expiry (increasing time decay), it is a good time for selling options and bad for buying options, the closer you get to the expiry time.
Having reviewed the primary advantages of options, it’s evident why they seems to be the center of attention in financial circles today. With online brokerages providing direct access to the options markets through the internet and insanely low brokerage costs, low transaction cost, better customer service, the average retail investor now has the ability to use the most powerful tool in the investment industry just like the prop’s and institutions do. So, take the initiative and dedicate some time to learning how to use options properly.
It is the dawn of a new era for individual investors. Don’t get left behind!