This instrument certainly looks appealing and tantalizing for most of the traders; but, one has to understand the risk factor involved in it.
The market that is moving in one direction or another is known as trending market. A bull market is trending upward while a bear market is trending downward. In a trending market, option trading gives higher positional returns as compared to cash or futures segment and in addition with other benefits like highly leveraging and limited risk (via naked option buying) makes it a most lucrative product during trending market.
Let’s take an example to have clarity on how can a trader fetch higher returns using options
Assume stock ‘ABC’ is in uptrend and is currently trading at 1000 (Spot), while in futures it is trading at a premium of Rs. 5 and 1000 call option is quoting Rs.25 (Lot size=800).
Investment required for different products are as follows:For Cash segment,
Spot Price * Total Quantity = 1000*800 = Rs. 8,00,000For Futures Segment,
In this segment, we only have to pay the margin amount which consist of initial and additional margin (initial margin = 8% and additional margin = 5% post deducting initial margin)
Therefore,Total value (for 1 lot) = Future price * Lot size = 1005*800 = Rs. 8,04,000 Initial margin = 8,04,000*8% = Rs.64,320 Additional Margin = (8,04,000 – 64,320)*5% = Rs. 36,984
Total Margin = 64,320+36,984 = Rs. 1,01,304For Options segment.
The total investment reduced drastically as here need to pay only the premium of the particular strike you planning to buy. In this case, we are buying At-The-Money call option 1000, which is quoting Rs 25/-
Total investment = Call Premium*Lots size = 25*800 = Rs. 20,000Investment Summary
Here, the total investment is lowest for position taken in options segment. The investment in options is merely 20% of Futures and 2.5% of cash segment transaction. This is clear evidence how highly leveraged options is as compared to others.
Now, suppose on the day of expiry ‘ABC’ closes at 1070.
Profit on expiry for all segment-Cash segment – (1070-1000)*800 = 56,000 Futures – (1070 -1005)*800 = 52,000
Options Segment – (1070-1000)-25 = 36,000Returns Summary
Now, let’s see how much is the percentage gains for the investment made in each segment
|Market Segments||Investment (INR)||Return on Investment Absolute Term (INR)||Return on Investment in %|
In the above table, you can see the percentage returns of each segment. In case of equities, we have hardly made 7% of returns on the investment by blocking INR 8,00,000 and on the contrary in options with just by investing your small amount of Rs. 20,000, you made Rs. 36000/- which is 180% of the investment.This is a power of trading ‘Options’. This instrument certainly looks appealing and tantalizing for most of the traders; but, one has to understand the risk factor involved in it. Hence, it’s advisable to gather proper knowledge about it; because, half knowledge is dangerous than no knowledge. Mind you, if it is handled properly with understanding, it can make wonders to your trading career. (The writer is Equity Derivative Research Analyst of Angel Broking)