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Basics Of Options

Need for Options

Previously we have learned so many different types of derivative instruments like Forwards, Futures, etc. So what is the need for Options? Well, there are a few reasons why options are required in trading? The reasons are discussed below:

 

Less capital required

In option trading, less capital is required compared to stock trading, because option price is only a small fraction of the underlying stock price. When a trader is confident that a stock price will move in a particular direction within a short term, he can invest in option rather than in stock itself to take advantage of the expected movement, because of the limited risk, high potential reward and the smaller amount of capital is required to control the same number of shares of stock.

 

Protection

Investor’s protection is an important part of trading. An investor who invests in stocks, put options can be used as a hedging tool to protect your stock from a price drop. When the stock price drops, the put option will increase in value, hence offsetting the loss in the stock. When the stock rises the put option would simply expire worthless when the expiration dates come and you will only lose the amount you paid to purchase the put option. So, as if you buy a put option as an insurance policy to protect your stock from a price fall.

 

Leverage

You can potentially have a greater percentage of return on investment from option trading than stock trading.

 

For example:

A stock price of company XX. Ltd (currently trading at ₹96) is expected to increase significantly over the next few weeks. The call option price for that stock with strike price of ₹95 and 30 days to expiration is ₹6.

 

If you buy 100 shares of that stock, you need to invest ₹9600 to purchase the stock. Assuming the stock price increases to ₹105 within 15 days you would gain ₹900 (10,500-9,600) or 9% (900/9,600).

 

But if you buy a call option contract for that stock instead, the cost will only be ₹600. When the stock prices rises to ₹105, the option price may increase to ₹11 and you can sell the option with a gain of ₹500 (1,100-600) or 83% (500/600).

 

As we can see, given the same number of shares, we get much higher % return using option than stock.

 

We must understand that Leverage is a two-sided sword. In case of losses, the losses are also amplified in options.

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