“The greatest ignorance is to reject something you know nothing about.”
If you are invested in equity markets or mutual funds, it is wise to at least be aware of a derivative product called options.
Options have seen a significant rise in popularity over the past few years. Business channels such as CNBC, NDTV Profit, and ET Now devote considerable airtime to option strategies. Investors and traders are often attracted to options due to the lower upfront cost involved and the possibility of higher returns.
However, it is equally important to understand that options also carry significant downside risk, and losses can occur just as quickly if not used carefully.
Let us look at some of the commonly discussed concepts related to buying options.
Types of Options
Call Options
Call options give an investor the right, but not the obligation, to buy shares at a pre-agreed price (strike price) within a specified time period. Call options can be held for a few days or for several months, depending on the contract. Investors who buy call options generally have a bullish view on the underlying stock.
Put Options
Put options give investors the right, but not the obligation, to sell shares of a stock at a predetermined price. Investors who expect a stock to decline may use put options to benefit from falling prices. Observing put option activity can also provide insight into market sentiment, especially during bearish phases.
Buying Call Options Is Cheaper Than Buying Shares
Call options allow investors to gain exposure to shares at a much lower initial cost compared to buying shares outright.
For example, assume you want to buy 125 shares of Larsen & Toubro (L&T) at ₹1,700. The total investment would be ₹2,12,500. The quantity of 125 shares is used because futures and options contracts are traded in lots, and L&T’s lot size is 125.
An alternative approach is buying a call option. You could buy one CALL option of the July 2010 series, strike price ₹1,700, at a premium of ₹50 per share. Your total cost would then be ₹6,250 (₹50 × 125 shares).
If the share price of L&T rises above ₹1,750 (strike price plus premium paid) by expiry, the option can generate gains. If not, the option can simply expire. In this case, the maximum loss is limited to ₹6,250, while controlling exposure to 125 shares.
Buying Put Options Can Limit Downside Risk
Buying a put option can act like insurance for an existing stock holding.
Assume you already own 125 shares of L&T at ₹1,700 and are sitting on profits. You are concerned about a possible decline but do not want to sell your shares.
You could buy one PUT option of the July 2010 series, strike price ₹1,650, at a premium of ₹50. If the share price falls below ₹1,600 (strike price minus premium) by expiry, the put option can generate gains. This helps offset losses in the underlying stock.
This approach is known as a protective put strategy. It limits downside risk while allowing you to retain ownership of the stock. If prices rise, the put option may expire, and the stock appreciation continues.
A variation of this approach is the married put strategy, where an investor buys shares and a put option on those shares at the same time. Since both positions are entered together, they are considered “married.”
If used appropriately, options can:
- Reduce initial capital outlay
- Help manage downside risk
- Provide leveraged exposure to price movements
However, many investors are unaware of how options actually work. The purpose of this article is only to explain the basic concepts. It is essential to fully understand the mechanics, risks, and potential outcomes before buying or trading options.
P.S.: The example of L&T has been used because the stock was on my radar after it moved above the 1,700 level earlier this month.
Selling options and their implications will be covered in a separate post.
Options are powerful derivative instruments that can reduce capital outlay and manage risk, but they require proper understanding before use.
Disclaimer
This content is provided for educational and informational purposes only and should not be construed as investment advice, research, or a recommendation to buy or sell any securities or derivatives.
Derivatives trading involves risk and may not be suitable for all investors.
Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully.
