Options have the potential to make you more money in a very short period than any other listed investment. It is entirely possible to make ten times your money in a matter of weeks from a call option, for instance, if you understand them well and correctly anticipate a market move.
Why Everyone Needs Options?
This is because options employ leverage, which is to say that a comparatively small amount of money (the call option premium value) is in large part determined by the value of the underlying shares that the call option is purchased on, which is many magnitudes larger. Percentage changes in the price of the underlying shares are magnified many times over in the option premium value by this leverage.
However, this leverage is not the scary, wealth-destroying kind. Unlike buying a future (another kind of financial derivative) or buying shares through a broker using a margin account, where you can lose far more money than you invest, buying an option has limited loss. That is to say that it is only possible to lose the option premium value that you purchase, which is a comparatively small amount of money.
Buying an option also gives the owner convexity. This simply means that as the underlying shares increase in value, the call option premium increases in value at a much faster rate. And if the underlying shares fall in value, then the call option premium decreases in value at a slower rate.
Whereas a call option is bought when wishing to reap the rewards from the underlying shares (or share index) rallying, a put option is bought when wishing to profit from the underlying asset falling in value. As well as using them for speculation, put options therefore make extremely effective hedging instruments, when wishing to protect portfolios from large falls in markets. Not only do put options have the same intrinsic benefits outlined above that call options do, but all options increase in value as markets get more volatile. Because volatility tends to increase as markets fall, put options have the capacity to make even larger profits than call options.
Leverage, limited loss and convexity are encapsulated in one instrument when you buy an option, making them extremely powerful tools of wealth creation. Options historically were the favoured tools of hedge funds and other large investment funds, but the advent of more sophisticated broker platforms and the associated competition-driven reduction in trading costs has spurred an explosion in their use by retail investors in India and around the world.
Risk of Options
However, options also have their own unique types of risks, which are not found in other investments. It is essential to understand what these are and how options work before embarking on using them, so as not to experience the costly pitfalls that novices encounter. You cannot profit from options before thoroughly understanding them and these unique risks require understanding, monitoring and mitigation to harness successfully the power of options.
Furthermore, an understanding of option strategy is also necessary to thrive with options. Although at times just buying an option can be an exceptionally powerful strategy on its own, different circumstances, market conditions and regimes require different strategies. Just as a batsman selects his shot depending upon the pitch, the bowler he is facing and the position of the fielders, so an option strategy must be carefully selected to suit the conditions that the option user faces. Understanding your craft, practice, control and diligence will soon allow you to be hitting sixes and not just singles.
Content by – Benedict Maynard CFA worked as Head of Derivatives, Derivatives Specialist, and Global Multi-Asset Strategist for two of the top ten firms by assets under management in the City of London during his twenty-year career.
His newly published book, Happy Returns – Your complete guide to option trading for beginners to advanced and the actual strategies professional traders use to maximize profits and reduce risk is available on Amazon Kindle https://www.amazon.in/dp/B0C61BM26V