Unlocking Potential: How Options Trading Can Enhance Your Investment Strategy
Level up your investing! Options trading lets you manage risk, boost returns, and adapt your strategy to any market.
Have you ever wondered how some investors effortlessly grow their wealth through stock market investments? It’s not just luck; rather, it's smart investing. While buying and holding stocks is a common strategy, it might not always deliver the returns you aim for.
This is where future and options trading comes into play. It offers flexibility and allows you to earn profits in both rising and falling markets. Additionally, options trading enables effective risk management while tailoring your investment approach to suit different market conditions.
Let’s discuss how options trading can enhance your investment strategy. But first, you must understand what options trading is, especially if you’re new to stock markets.
Understanding Options Trading
An option is a derivative contract that gives you the right to buy or sell an asset at a predetermined price within a specific period. As the name suggests, it is an ‘option’ so you are not obligated to execute the contract. It is called a derivative because it derives its value from the underlying asset that is being traded.
There are two types of options:
- Call options, which allow you to buy an asset
- Put options, which allow you to sell an asset
The underlying asset could be a stock, commodity, interest rate, or even a currency. Options contracts can be used to hedge or protect against potential losses. Thus, provides a safety net for your investments. You can also use these contracts to speculate or anticipate future price movements of the asset. This allows you to profit from price fluctuations. While dealing in options, you will come across two more terminologies, strike price and premium.
A strike price is the predetermined price at which you can buy or sell the underlying asset. For example, if you have a call option with a strike price of ₹500, you can buy the asset at ₹500, regardless of its market price.
Premium is the price that you pay for buying an options contract. It is the non-refundable fee you pay upfront to hold the option. For instance, if the premium is ₹20, you pay this amount to have the right to buy the asset at the strike price.
Flexibility In Various Market Conditions
Option trading gives you the ability to profit in different market conditions. Whether the market is up, down, or stagnant, there are option strategies that can help you make the most of the situation. For instance, if you think the market will go up, you can use call options to make money. If you think the market will go down, you can use put options.
Risk Management
Options can act as a hedge or protection against potential losses. You can use options during volatile markets where the risk of price swings is high.
For example, if you own shares of Infosys and are concerned about market volatility, you can buy a put option. This can help protect your investment by allowing you to sell the shares at a predetermined price and can limit your losses.
Enhanced Earnings
Options can also help you earn extra income. One way to do this is by selling call options on stocks you already own, which is called writing covered calls. This means you agree to sell your stock at a certain price if the buyer wants to buy it. In return, you get paid a fee, called a premium, right away.
For example, if you own shares of Tata Motors and sell a call option on them, you get the premium immediately. This gives you extra income, even if Tata Motors' stock price stays the same or goes up slightly.
Leveraging Investments
Options allow you to control more shares with less money, which can increase your potential profits. Instead of blocking a larger amount to buy more shares, you can use a smaller amount to buy options contracts. If the stock price moves as per your expectations, you can benefit from the price changes without the need for a large initial investment. This way, options provide a cost-effective way to fetch a good return on investment.
For example, if you think the stock price of Company ABC will go up, buying 100 shares at ₹1,500 each would cost ₹1,50,000. Instead, you can buy a call option for those shares, which might cost only ₹10,000. Now, if ABC company's share price rises to ₹1,600 (a 6.67% increase), the options contract allows you to benefit from this increase with a smaller initial investment.
While your total profit might be lower compared to owning the shares, your return on investment (percentage gain) can be much higher despite investing a smaller amount of money. In this example, if the option premium rises to ₹12,500 due to the increase in stock price, your investment has gained 25%.
Customising Your Investment Approach
Options trading can significantly enhance your investment portfolio by managing risk and potentially increasing returns. Options offer the flexibility to tailor your investment strategy as per your risk tolerance and market expectations.
You can employ various strategies to balance potential gains and losses. For instance, using a combination of Call and Put Options can protect your investments while allowing for potential profits. This way, you can stick to your financial goals while dealing with the ever-changing market conditions.
As you gain experience in options trading, you can explore various advanced strategies to further diversify your portfolio. However, it’s important to approach options trading with caution. According to SEBI's report, 89% of retail traders in equity futures and options suffered losses in FY22. This highlights the need for thorough research and a well-thought-out strategy.
Starting with options trading requires a solid understanding of strategies and the market. Therefore, make sure to educate yourself, start small, and learn continuously.
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