Whether you’re hedging, looking for income, or speculating, you can put options to work for your portfolio. Although options may not be suitable for everyone, they’re among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many kinds of investors in rising, falling, and neutral markets.
Reducing your risk
Many options are useful as tools of risk management, acting as a way to protect your portfolio against a drop in price of underlying. For example, if an Investor is concerned that the price of his shares in LMN Ltd. is about to drop, he can purchase puts that give him the right to sell his stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, the investor has protected himself against losses below the strike price. This type of option procedure is also known as hedging. While hedging with options may help you manage risk, it’s important to remember that all investments carry some risk, and returns are never guaranteed.
Investors who use options for risk management look for different ways to limit a potential loss. They may choose to purchase options since the loss is limited to the price paid for the premium even if the price of underlying does not fall/rise as per their expectation. In return, they gain the right to buy or sell the underlying security at an acceptable price (Strike Price of Option) for them. They can also profit from a rise in the value of the option’s premium if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling the stock at an unfavorable price, the risk associated with certain short positions may be higher.
Conservative Investors with a conservative attitude can use options to hedge their portfolios or provide some protection against possible drops in the value of underlying. Options writing can also be used as a conservative strategy to bolster income. For example, say you would like to own 250 shares of Reliance Industries now trading at Rs.2300 and are willing to pay Rs.2200 per share. You write a Reliance Industries 2200 PE (Put option, European Type), and pocket the premium. If prices fall and the option is exercised, you’ll buy the shares at Rs. 2200 each. If prices rise, your option will expire unexercised. If you still decide to buy Reliance Industries, the higher cost will be offset by the premium you received.
Bearish Investors who anticipate a market downturn can purchase puts on stock to profit from falling prices or to protect portfolios—regardless of whether they hold the stock on which the put is purchased.
NOTE:
If you buy a call, you have a bullish outlook and anticipate that the value of the underlying security will rise. If you buy a put you are bearish and think the value of the underlying security will fall.
Modest profits
Most strategies that options investors/traders use have limited risk but also limited profit potential. For this reason, options strategies are not get-rich-quick schemes. Buying generally requires less capital than equivalent stock transactions, and therefore return profit figures—but a potentially greater percentage of the investment—than equivalent stock transactions.
Long-term
Investors can protect long-term unrealized gains in stock by purchasing puts that give them the right to sell it at a price that’s acceptable to them on or before a particular date. For the cost of the premium, a minimum profit can be locked in. If the stock price rises, the option will expire worthlessly, but the cost of the premium may be offset by gains to the value of the stock.
Bullish
Investors who anticipate a market-moving higher can purchase calls on stock to participate in gains in that stock’s price—at a fraction of the cost of owning that stock. Long calls can also be used to lock in a purchase price for a particular stock during a bull market, without taking on the risk of a price decline that comes with stock ownership.
Leverage
Options buying allow buyers to benefit from changes in a stock’s price at a fraction of the cost of owning that stock. For example, Investors A and B think that stock in company ABC, which is currently trading at Rs.100, will rise in the next few months. Investor A spends Rs.10,000 on the purchase of 100 shares. But Investor B doesn’t have much money to invest. Instead of buying 100 shares of stock, she purchases one ABC call option at a strike price of Rs.115. The premium for the option is Rs,2 a share, or Rs.200 a contract since each contract covers 100 shares. If the price of ABC shares rises to Rs.120, the value of her option might rise to Rs.5 or higher, and Investor B can sell it for Rs.500, making an Rs.300 profit or a 150% return on her investment. Investor A, who bought 100 ABC shares at Rs.100, could make Rs.2,000, but only realize a 20% return on her investment.
Aggressive Trading: Investors with an aggressive outlook use options to leverage a position in the market when they think they know the future movement of a stock. Options holders and writers can speculate on market movement without committing large amounts of capital. Since options offer leverage to investors, it’s possible to achieve a greater percentage return on a given rise or fall than one could through stock ownership. But this strategy can be a risky one, since losses may be larger, and since it is possible to lose the entire amount invested.
What Are the Risks?
The risks of options need to be weighed against their potential returns.
Many options strategies are designed to minimize risk by hedging existing portfolios. While options can act as safety nets, they’re not risk-free. Since transactions usually open and close in the short term, gains can be realized very quickly. This means that losses can mount quickly as well. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.
RISKING YOUR PRINCIPAL: Like other securities—including stocks, bonds, and mutual funds—options carry no guarantees, and you must be aware that it’s possible to lose all of the principal you invest, and sometimes more. As the buyer of an option, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise.
However, since the initial capital requirement is usually less capital for options buying than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you’d bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage: Percentage returns are often high, but it’s important to remember that percentage losses can be high as well.
Understanding Premium
As discussed in the early chapter, the value of an equity option is composed of two separate factors. The first, intrinsic value, is equal to the amount that the option has gone in-the-money with respect to the underlying. Options that are at-the-money or out-of-the-money have no intrinsic value. But all unexercised and unexpired contracts still have time value, which is the perceived—and often changing—the price of the time left until expiration. The longer the time until expiration, the higher the time value, since there is a greater chance that the underlying stock price will move and go in-the-money.
Premium = intrinsic value + time value
The entire premium of an at-the-money or out-of-the-money option is its time value since its intrinsic value is zero. In contrast, the entire premium of an in-the-money option at expiration is its intrinsic value since the time value is zero.
WASTING TIME
One risk particular for an option buyer is time decay because the value of an option diminishes as the expiration date approaches. Therefore, options are considered wasting assets, which means that they have no value after the expiration date. Stockholders, even if they experience a dramatic loss of value on paper, can hold onto their shares over the long term. If the company exists, there is the potential for shares to regain value. Time is a luxury for stockholders, but a liability for options buyers. If the underlying stock or index moves in an unanticipated direction, there is a limited amount of time in which it can correct itself. Once the option expires out-of-the-money it is worthless, and you, as the holder, will have lost the entire premium you paid. Options writers take advantage of this and are usually intended for the contracts they write to expire unexercised and out-of-the-money.
Since options are wasting assets, losses and gains occur in short periods. If you followed a buy and hold strategy, as you might with stocks, you’d risk missing the expiration date or an unexpected event. It’s also important to fully understand all potential outcomes of a strategy before you open a position. And once you do, you’ll want to be sure to stay on top of changes in your contracts.
• Since an option’s premium may change rapidly as expiration nears (Gamma effect, will be discussed in the subsequent chapters), you should frequently assess the status of your option, and determine whether it makes financial sense to close out a position.
• You should be aware of any pending corporate actions, such as splits and mergers, that might prompt contract adjustments. (Website: https://www.bseindia.com/corporates/corporates_act.html)
KNOW WHAT YOU WANT…
Before you begin trading options it’s crucial to have a clear picture of what you hope to achieve. Options can play a range of roles in different portfolios, and picking a goal narrows the field of appropriate strategies you might choose. For example, you may want an additional income from the stocks you own. Or maybe you hope to hedge your portfolio from a market downturn. No one reason is better than another, just as no one options strategy is better than another—it depends on your goals.
AND HOW TO GET IT
Once you’ve decided upon an objective, you can begin to explore options strategies to find one or more that can help you reach your objective. For example, if you want more income from the stocks you own, you might deploy strategies such as writing covered calls. Or, if you’re trying to hedge your positions from a market downturn, you might think about purchasing puts, or options on an index that tracks the type of stocks in your portfolio.
Rule of Thumb: The more time until expiration, the higher the option premium, because the chance of reaching the strike price is greater.