Use of Options
Options have various uses in the financial market, including:
- Speculation
- Hedging
- Income Generation
- Risk Management
Speculation:
Options can be used to speculate on the price movement of an underlying asset, allowing traders to potentially profit from short-term market movements.
Suppose an investor believes that the stock price of a particular Indian company will rise sharply in the near future. Instead of buying a large number of shares outright, the investor purchases call options on the stock. By using options, the investor can control a larger number of shares at a lower cost, while limiting potential losses if the stock price does not increase as expected. If the stock price does rise, the investor can then exercise the call options and profit from the price increase, resulting in a higher return on their investment than if they had simply purchased the shares outright.
Speculation using options can be a high-risk strategy, as the value of an option can fluctuate significantly based on changes in the underlying asset’s price, volatility, and time to expiration.
- Options can provide investors with significant leverage, enabling them to control a larger amount of shares for a fraction of the price.
- By using options, investors can increase their exposure to potential profits while limiting their potential losses.
- Leveraged options trades require a lower upfront capital investment, which can make them attractive to investors with limited funds.
- Options allow investors to speculate on market movements without actually owning the underlying assets, providing greater flexibility and diversification.
- Leveraged options trades can be a powerful tool for experienced investors looking to maximize their returns, but can also carry significant risks that should be carefully managed.
Option writers: Option writers are sellers who create new options contracts and sell them to buyers. They assume the obligation to sell or buy the underlying asset if the buyer decides to exercise the option.
Option holders: Option holders are buyers who purchase options contracts and hold them until expiration. They have the right, but not the obligation, to exercise the option.
Note on Nomenclature –
Generally, option buyers are known as option holders while option sellers are known as options writers.
Hedging:
Options hedging is a risk management strategy used by traders to reduce the potential losses of an investment.
- It involves buying or selling options contracts to offset the risk of an underlying asset.
- For example, a trader who owns a stock can use options hedging to protect themselves against a potential decline in the stock price.
- They can do this by buying a put option on the stock, which provides the right to sell the stock at a predetermined price.
- If the stock price falls below the predetermined price, the trader can sell the stock at a higher price, thereby minimizing losses.
- Alternatively, a trader can use options hedging to lock in potential profits.
- For example, a trader who has made a significant profit on a stock can use options hedging to protect their gains.
- They can do this by buying a call option on the stock, which provides the right to buy the stock at a predetermined price.
- If the stock price falls, the trader can still buy the stock at the lower price and sell it at the higher predetermined price, thereby locking in their profits.
- Options hedging can be a complex strategy that requires a deep understanding of options trading and risk management, but it can be an effective way to minimize losses and maximize gains in a volatile market.
- Options can be used as a form of insurance against potential losses in a portfolio. For example, a put option can be used to hedge against a decline in the value of a stock holding.
Income generation:
Options trading can be used for income generation through techniques such as volatility spread theory, max pain theory, options wheel theory, and delta order flow theory. These strategies allow traders to collect premiums and earn a steady stream of income with minimum risk.
However if things are not properly hedged, selling options contracts also exposes traders to potential losses if the market moves against their position.
Options trading provides traders with the ability to create custom payoff charts based on different scenarios, allowing for a range of potential outcomes. Traders can also make range-based bets, where they profit if the underlying asset stays within a certain price range. This flexibility is a key advantage of options trading, allowing traders to tailor their positions to their specific goals and risk tolerance.
Risk management:
Options can be used to manage risk by setting price limits for buying or selling an underlying asset, limiting the potential loss to a predetermined amount.
Let’s say an investor owns a significant number of shares of Infosys, an Indian multinational information technology company. The investor is worried about the possibility of a market downturn that could negatively impact Infosys’ stock price. To mitigate this risk, the investor could purchase put options on Infosys’ shares. If the stock price does indeed fall, the put option would gain value and help offset any losses incurred from the decline in the stock price.
Portfolio managers often conduct risk management ahead of major news events that can impact the market and use options. Here are examples of some such news events that can impact the Indian share market and prompt portfolio managers to conduct risk management:
- Union Budget announcements
- Corporate earnings reports
- Monetary policy announcements by the Reserve Bank of India (RBI)
- General elections and political developments
- Global economic trends and geopolitical events, such as trade wars or sanctions
- Natural disasters and unforeseen events that can disrupt supply chains and business operations
- Changes in regulations or policies related to specific industries or sectors, such as taxation or environmental policies.
- Mergers and acquisitions involving major Indian companies
- Corporate scandals or fraud allegations involving major Indian companies
- Changes in interest rates or inflation rates
- Union strikes or labor disputes affecting major industries
- Government policies related to infrastructure development or privatization
- Changes in foreign investment rules and regulations
- Major technological advancements affecting key industries
- Changes in oil prices or other commodity prices
- Outbreaks of epidemics or pandemics affecting economic activity
- Unexpected changes in currency exchange rates affecting import and export businesses.
Overall, options provide investors with a flexible and versatile tool for managing risk and generating returns in the financial markets. However, as with any investment, there are risks involved and it’s important to have a solid understanding of how options work before incorporating them into your investment strategy.