Benefits of Options Trading
Options trading has surely come of age, at least in the equity markets in India. Options are not only liquid but they are many times larger than the cash market and the futures market in terms of daily volumes. Here we look at the advantages of options trading and the option trading benefits to option buyers and to option sellers. Here is a quick review of the benefits of options trading.
What is Benefits of Options Trading
There are many option trading benefits. Let us look at some unique advantages of options trading.
- Options trading allows hedging of risk. For example, if you are long on a stock and you bought a lower put option, then your risk is limited. For example, if you are long a stock at Rs.810 and you buy an Rs.800 put option at a premium of Rs.5, then your maximum loss is Rs.15. That is the power of options because that remains your loss irrespective of how low the price goes.
- Options help you to reduce the cost of holding a stock. For example, if you are holding stock and the price is just not moving then you can sell higher call options and earn the premium and reduce your cost of holding that asset.
- In terms of costs, the options are a lot more efficient, and that is one of the major benefits of options trading. Due to options, the trader can get an options position at a small margin. For example, to purchase 200 shares of a stock at a price of Rs.80, an investor requires to pay Rs.16,000. However, if he was to purchase call options of equal weightage, the premium required would be around Rs 4,000.
- Options offer the potential of high returns or you can say multiplier effect on returns. Here is how. As such, the option pays equal profit as the simple stock buying if had chosen the right strike. As we are getting options on a lower margin and getting the same profitability the percentage return would be much higher comparatively, at least if you look at it in terms of ROI or return on investment.
- One of the big advantages of options is that it allows the systematic transfer of risk from the person looking to hive off risk for a price to a person who is willing to assume that risk for a price. This is one of the biggest advantages of options trading as it gives a proper secondary market for risk, which is what makes the options market unique.
- An important aspect of options is that it provides liquidity and in the process, it also enables price discovery in the underlying market. This is an important function as the options are a good way of pricing complex risk parameters.
- A very important advantage of the options is that the options-related data normally acts as a lead indicator. For example, data points like option strike accumulation, Changes in options interest across strikes, sharp spikes in implied volatility in the options are all important leading indicators of the shape of things to come.
Risks involved in option trading
Broadly, there are five risks to trading in options and these are generic, irrespective of whether you are a buyer or seller of options.
- Potential Losses can be huge, especially when naked options are sold. Hence caution is warranted. Also, even if you are buying options and tend to see your options expire worthless on several occasions, it can spoil your trading capacity.
- Complexities in option pricing, option valuations, options trading, etc are what make this a challenging product. Many traders often do not understand the basic challenges with options and tend to jump into it.
- Liquidity may not be an issue with Nifty or Bank Nifty options options or even with very liquid stock options. But liquidity is surely an issue in mid-cap stocks where options are permitted.
- Costs are at multiple levels if you are doing complex strategies. Then there are statutory costs, exchange costs, tax costs, etc and all these needs to be factored in.
- Time Decay works to the advantage of the seller of the option but poses a risk to the buyer of the option as the option loses time to value with each passing day even if the price is not moving a lot.
How to trade in options?
Here are a few simple steps to options trading.
- Open a trading account and activate online trading
- Ensure that F&O trading is activated in your trading account
- Identify and make a list of stock options/index options you want to trade-in
- Ideally start with index options that are easier to estimate and more liquid
- Then limit yourself to around 10-20 very liquid stocks
- Don’t go for very deep OTM options. Stick to ATM or just OTM options
Frequently Asked Questions Expand All
Some of the key factors impacting the value of the option pricing include
- Stock price of the underlying in the secondary market
- Exercise price strike price based on which the option is being valued
- Volatility, which is the standard deviation of asset class returns
- Time to expiry which measures how many days are there to expiry
- Interest rates – since they impact the present value of the strike price
- Dividends, as they reduce the value of the company
Options are good and useful if predominantly used for hedging or protecting the risk. Otherwise, it is quite a risky proposition to try options on a speculative options trade.
It depends on how you value the option, whether you buy an under-priced of overpriced option, time to expiry etc. Globally, 85% of options expire worthless so sellers are surely making more money than option buyers.