Options Trading - Safe or Not?

This has been a question prevailing among the traders forever. Options market is a critical element of the derivatives market, especially in India. Risk is a core element of options trading but loss isn’t. Options may be risky, but you just risk a part of the amount that you pay as premium and not the entire trade value. Hence options are less risky in comparison to stocks.

Options trading does not guarantee you profits but neither does stocks, bonds, and mutual funds. But options can pay you higher profits than individual trading, if done correctly. By correctly, we mean you need to study the market or a stock for enough time, making reasonable predictions of the direction and the time of future price movements.

Options are parts of the derivative trade and are a financial arrangement between the buyer and the seller of the two parties. Options can also be used for hedging, and leverage, for speculation

Buyers of call options, buy paying the premium obtain the right but not the obligation, and hence the risk gets reduced irrespective of the change in the price, while profits can be unlimited if the market moves higher.

This premium is paid to the option sellers so their risk is infinite while benefit is limited to just the premium price they get for this option agreement.

Advantages of Option Trading

Unlimited profits and limited losses

Options trading has potential to offer unlimited profits and can be used to limit the losses. Options are much more leveraged than stocks. For instance, if the price of the option bought buy you goes beyond the strike price before the expiry date, you can make unlimited profits based on its rise in price.

Low cost of entry

The option trader need not pay the total options price to execute the trade. Options trading requires a certain part of the total amount, called premium, to book a trade. For example, to buy 100 shares of a stock at Rs.80, you need to pay Rs.8000 whereas if you were to purchase call options of equal amount, the premium required would be just a part of this amount. Hence, Options trading offers you advantage on the cost of entry.

Hedging against risks

Holding one investment position can be a bit risky for investors and hence options trading acts as a tool for them to hedge against such risk by allowing them to taking another investment position in the market. Options contracts prove to be an excellent tool to use to hedge against the risks in underlying stocks and it also protects an investor’s portfolio from loss. This strategy involves buying a put option with a higher strike price, then selling it on a lower strike price.

However, one must remember; hedging is a strategy of risk elimination and not profit generation. Options are a perfect way of securing your portfolio of stocks. Currently, purchasing options is like buying insurance for your stock portfolio and lowering your risk exposure. If, when the option expires, the price of the underlying security for a call option does not rise above the strike price, your choice becomes meaningless, and you lose all the money you paid up front. The premium you end up paying, though, is the maximum threshold for your risk. Otherwise, if the security price falls to Rs.80 from a strike price of Rs.100, in the case of the example above, you would have lost Rs.20 per share. You lose just the premium sum with the option, which is much lower.

To hedge in options or switch positions in the market, the 2 investments must have an indirect correlation. So, when one investment falls in value, the other investment must rise. Here options come in picture.

For example, assume an investor buys 100 shares of Reliance Industries at Rs.1000. The investor is bullish about the stock but is also nervous that the stock may drop by the near future. To hedge against a possible fall in the stock, the investor buys a put option for Rs.10 per share. The put option expires in three months and features a strike price of Rs.900. So now the investor can sell his Reliance Industries shares at Rs.9000 at any time within the next three months.

Assume that in three months, Reliance Industries is trading at Rs.110. The investor will not exercise his put option. He will gain Rs.100 from the rise available price from Rs.100 to Rs.110. However, he loses the premium of Rs.10 per share that he purchased the put option for. Therefore, his total gain are going to be Rs.9 per share.

Further, assume that Reliance Industries is trading at Rs. 60 in three months. If that happens, the investor would exercise his put option and be ready to sell XYZ shares at Rs.90 instead of Rs.60. By doing this, he loses Rs.11 per share instead of Rs.61 per share. The put option saves the investor from a considerable loss.

Options offer the investors an opportunity to switch flexibly for any possible change in the underlying security and generate profit from it. If the investor has a prediction of how a security's price will move in the near future, he can freely use an option strategy and bid or ask for a price in the options market. Just like, an investor will purchase a call option if he expects security price to increase to a certain amount and profit from the difference in strike price and price of options.

Disadvantages of options

Lower liquidity

Since options market has less participation from investors, they are less liquid. It is not easy to purchase and sell options due to low liquidity.

Risk and Unpredictability

The risk is limited to the option premium. However, if the options price movement is not favorable, the investor may lose the entire option premium. The options market cannot be always easy to predict and it requires a deep study of the market and strategies to lead in the right way.

Complicated

Options is not a piece of cake for beginners especially. Investing in options can be a bit challenging. Predictions pertaining to the market movement of a specific security and the time by which this price movement will occur must be called upon. Both the factors have to go/ be predicted right..

Taxes

The taxes gained from Options trading are generally taxed as short term capital gains and the rates are as high as personal income tax.

Commissions/ brokerage

The commission/ brokerage charges are comparatively high than stock trading.

Scope of Options traders

Option Buyers

• The premium to be paid by the option buyers to get an options contract is much lower as compared to the future contract

• Risk is limited and maximum to the premium amount whatever be the unfavourable market conditions

• Protective Puts can be bought in order to hedge the long delivery portfolio with a vertical put spread. A put spread provides protection between the strike prices of the bought and sold puts. A vertical spread is an options strategy that involves buying a call and selling a put and simultaneously selling another call and buying another put at a different strike price, but with the same expiration.

Option Sellers

• Sellers of the Put Options are profitable as long as the spot price remains at or higher than the strike price.

• Sellers of the options can reduce the cost of position which is already taken in portfolio or future contract by selling out of the money Calls

Myth and Reality of options and options trading

Options are too risky

Options is a complex concept and majorly feels risky due to its complexity feature. Though the risk in options is limited to the premium amount, this fear is built in the minds of the investors, mainly beginners only because it’s not easy to understand how to trade in them. Risk for buyer is only up to the premium amount while only high risk in option is when you are naked seller. Hence options trading demands market research, market judgement and formulating strategies which is in fact reduces risk.

Options needs strategies

Apparently there are only two options - Call and Put, and you can either buy or sell. But Options contracts can be traded in the most strategic manner. If you’ve just begun, it’s best to start from scratch, get into logic and stick to relatively simple strategies rather than going to Collar, Ladder Spread, Iron Condor, Strip, Strap, Butterfly, Calendar Spread, Box, etc.

Selling options is like receiving free money

This might sound exaggerated until you learn why. While selling options might look safe whereas uncovered options is a risky strategy because there is unlimited risk. Option sellers can win most of the time; the occasional losses can be devastating when inexperienced investors don’t manage risk properly with discipline.

Only options sellers make money

There is a myth that only option sellers can make huge gains and make money. And as you all know a trade is bound to have sellers and buyers and their own advantages and drawbacks, their own interest of trade. Both option buyers and sellers can make profit from option trading. If only sellers make money then there would be no buyers, with no buyers there would be no market. Sometimes option buying does have an edge in many cases especially at the scenario of high volatility, trending or directional market. We have seen many times that premiums have gone to multi fold especially in Bank Nifty weekly expiry too.

Trading options is a zero sum game

Derivatives is a Zero sum game but the truth is that options may be used as an insurance policies. It can be used as risk management tools. These are considered as zero-sum games because the contracts represent agreements between two parties and, if one investor loses, then the wealth is transferred to another investor. Most transactions are non-zero-sum games because the end result can be beneficial to both parties.

It’s easy to make money with options

Making money in market means you have to be smarter than other because it’s a zero sum game and one has to lose if the other has to win. To formulate your own successful ways of trading and investing requires a lifetime of work, dedication and focus. The secret to find and maintaining a high level of success in the markets is to trade and invest according to your own interest of traded, formulated strategies, risk tolerance, investment goals with proper management of risk and a disciplined approach.

Is option trading safe?

You cannot look for a one word answer to this question as options is featured with multiple concepts, advantages, disadvantages, exceptions. However we all know there can be no trade or investment that gives complete guarantee of safety and protection against risk. But since options offers you flexibility and strategy for all types of investors, we suggest you to study the market, observe the expert investors, consider each of its features and make your move without hesitation.