Benefits & Risks of Options Trading- Pros n Cons Explained

Published on Wednesday, April 4, 2018 by Chittorgarh.com Team | Modified on Monday, February 12, 2024

Trading options is a little more complicated than trading shares. So why should investors trade options? Options trading offers some important advantages that are not present when trading shares, such as:

Advantages of Options Trading (Benefits of Options Trading)

Small investment, higher profits

Called leverage in trading parlance, trading in options offers you the opportunity to make higher gains with a small investment. This is because when you buy options, you don't pay for the value of shares but a premium amount which is much smaller than the value of shares. And the profit you make is the change in the value of the shares.

Let's understand this with an example:

Say you purchase a TATA MOTORS Option available at a strike price of Rs 2000 at Rs 200 premium for a lot size of 100 shares. To buy this option, you pay Rs 200 (premium per share) X 100(lot size)= Rs 20,000. If the share value of TATA MOTORS moves up to Rs 2500 within the expiry period, you will earn Rs 500 X 100= Rs 50,000. The net profit after deducting the premium amount paid Rs 20000 will be Rs 30000.

Now if you had traded in shares during the period, you would need to invest Rs 2000 (share price) X 100= Rs 2,00,000 and you would have made a profit of Rs 500 (price movement) X 100 = Rs 50,000.

So, options offer you the opportunity to earn more profit per rupee invested than shares.

Benefit of earning profits in both, rise and fall in the price of the underlying instrument:

At times, as an investor, you're not sure which way a particular stock or an instrument will move but are sure that some event will definitely cause significant movement in the share price. This happens during the time of the announcement of quarterly results, budget, policy changes, etc. In such times, you can make use of 'Long Straddle Option Trading Strategy'. The strategy involves buying both, a call and a put option, at the same strike price and expiration. This allows you to make a profit when there is a significant price movement in the share of the company, irrespective of whether it moves up or down.

Let us understand it with an example-

Just ahead of its quarterly results, Reliance Options is available for

Call option at a strike price of Rs 2,000 at a premium of Rs 200 for a lot size of 100 shares.

Put options at a strike price of Rs 2,000 at a premium of Rs 210 for a lot size of 100 shares.

You buy both by paying Rs 20,000 for the call option and Rs 21,000 for the put option.

If the share price of Reliance rises to Rs 2500, you exercise the call option and earn-

Profits = [(current price- strike price)X(lot size)]-(premium paid)]

Profits = [(2,500-2,000)X(100)]-(20,000)] = Rs 30,000

But you would also lose the premium amount of Rs 21,000 paid for the put option and hence your net profit would be Rs 9,000.

If the share price of Reliance falls to Rs 1500, you exercise the buy option and earn-

Profits = [ (Strike price- current price) X (lot size)]- (premium paid) ]

Profits = [ 2,000-1,500) X (100)]- (21,000) = Rs 29,000

Here again, you would also lose the premium amount of Rs 20,000 paid for the call option and hence your net profit would be Rs 9,000.

Acts like insurance against your current investments:

We buy insurance to protect ourselves from financial loss as a result of an unfortunate event. Options can also be used as insurance to protect your investments. As we all know, a put option gives you the right to sell at a certain price within a certain time. Buying a put option when you also own the underlying assets is like buying insurance against a potential loss in the value of your investments.

Let us say you own 1000 units of BAJAJ AUTO which is currently trading at Rs 5000. The put option for BAJAJ is available at the strike price of Rs 5000 for a premium of Rs 300. You buy the put option by paying a premium of Rs 3,00,000. Even if the share price falls to Rs 3000 in the next few months, you can exercise the put option and sell at Rs 4700 (strike price - premium) and limit your losses. On the other hand, if the share price rises to Rs 6000 in the next month, your insurance may not have much value anymore, but you are protected till the expiry date. Also, your investment has increased due to the rise in the share price. With a put option worth Rs 3,00,000, you can protect an investment of Rs 50,00,000 from price loss.

Less expensive than the underlying itself:

In terms of cost, options are much more efficient, and this is one of the main advantages of options trading. Due to options, the trader can acquire an option position with a low margin. Sometimes the underlying asset itself can be very expensive compared to its derivative. The trader can buy/sell options instead of investing in the underlying asset. In this way, he can profit from the price movements of the underlying asset at a lower cost.

Disadvantages of Options Trading (Options trading risk)

If options trading has so many advantages, why are some investors reluctant to invest in them? Like any investment, options trading involves certain risks:

• It requires a good understanding to make profits: Many investors rush into options trading because it offers leverage, which allows for higher profits on small investments. However, options are a little complicated to understand. Therefore, investors need to spend some time understanding options in detail before taking the plunge into options trading.
• Short-term investments: Options are short-term investments with a maturity of a few months. The shorter the term, the less time the price has to recover. The probability of losing money is therefore just as high as the probability of making a profit.
• Prices can fluctuate considerably: Since options are a derivative of stocks, indices, etc., a small movement in the underlying stock or index price can result in a large movement in option prices.
• The possibility of losing all your capital: In unfavourable market conditions, you may lose all of your capital paid in premiums.
• Fees and commissions: Complex strategies are associated with costs on several levels. In addition, there are legal costs, exchange rate costs, tax costs, etc., all of which must be taken into account.

Options are high-risk, high-reward play. However, if done with proper understanding and strategies, one can minimize risks and profit from trading in options.