Thinking of investing in options but the risk of the derivative market scares you?
Here are tips for the beginners.
Option trading is an alternative way for investors to invest in the performance of a security such as a stock or an ETF. By trading options an investors attempts to capture the up or down movement of the security, while only investing a fraction of the cost it would take to own the actual security
Consider a stock that trading at Rs.100, if anyone purchase a share and the price went up by Rs.5 that means 5% return with the right option contracts, that person can get profit from the same jump in the stock price while only paying a small premium that cost significantly less in the price of owning the stock. The ability to make more with less is one of the benefits of options trading however the potential for greater profits comes with greater risk of losses.
Let’s take a closer look how an option contract look at how the contract an option contract works unlike a stock. When you buy an option contract you’re not purchasing the security itself instead you’re purchasing a contract but gives you the right to buy or sell a security at a certain price before a certain date consider.
There’s a coffee shop chain called CCD. CCD is trading at Rs.50/ share. An investor believes that the stock price of CCD will rise, the investor taking advantage of this anticipated price movement by buying 100 shares of the stock but now investor is concerned about the initial capital requirement. Now let’s assume that there is another investor who already hold 100 shares of CCD stock and plans to hold on to it for a while. Investor who have shares thinks the stock price will not increase much over the next few months.
Both investor can utilize a call option this type of option contract gives the buyer the right to buy shares of CCD at a set price called a strike price at a set time called Expiration. In this case it is Rs.55 per share in four weeks’ time typically each standard option contract represents 100 shares so this one contract would give the buyer the right to buy 100 shares of CCD stock AT Rs.55 per share. The buyer purchases the contract by paying the options premium. The premium or the price of the options is determined by several factors including the stock price.
Now we know how option trading works
Let’s look at the risk associated with Options trading
(If you’re a seller you are associated with different risk than if you are buyer)
If any individual buy a call, then that person buying the right to purchase that stock at a certain price. The upside potential is unlimited and the downside potential is premium that a person spent. An individual want the price to rise up so that he/she can buy the stock at a cheaper price.
If any individual buy a call, then that person buying the right to sell that stock at a certain price. The upside potential is the difference between the share prices and the downside potential is the premium that an individual spent.An individual want the price to fall down so that he/she can sell the stock at a higher price.
Call Seller (Writer):
Call Writers – If you sell a call, you are selling the right to purchase to someone else. The upside potential is the premium for the option; the downside potential is unlimited. You want the price to stay about the same (or even drop a little) so that whoever buys your call doesn’t exercise the option and force you to sell.
If you sell a put, you are selling the right to sell to someone else. The upside potential is the premium for the option, the downside potential is the amount the stock is worth. You want the price to stay above the strike price so that the buyer doesn’t force you to sell at a higher price than the stock is worth.