The ups and downs of a stock market, be it BSE or NSE can create a situation of panic for even the most experienced investor. After all, it is your hard earned money which is at risk. Fortunately, there are some investment risk management strategies that allow you to trade in the stock market without actually having to buy or sell stocks. This can be done through ‘Options’. Let us understand more about it.
Meaning of Options
An option is the right to buy or sell a security at a particular price within a specified time frame. This essentially means that you don’t have to outright buy or sell a stock, but you can make a calculated bet on the future price of the stock within the specified time period of the option. Options can be of two types – Call Option and Put Option.
Meaning of Call Option
A call option gives an investor a right to buy a stock at a specified price within a specified time period. It is important to note here that the investor is not under an obligation to buy the stock. If the price at the end of the specified time period is not suitable for the investor, he can simply let the option expire without buying any stocks. Let us look at an example.
Example of Call Option
Suppose the shares of A, are selling at INR 90 in January. You are of the belief that the share prices will go up over a course of few months. In that case, you can buy a six-month call option to buy 100 shares of A for INR 100 by 31st July. For this call option, you roughly pay INR 200 i.e. (100 shares x INR 2 per share) assuming that the cost to buy the call option is INR 2 per share. Bear in mind that when it comes to options each lot is for 100 shares.
Situation 1: On 15th June, if shares of A are trading at INR 110, you can exercise your call option and gain a profit of INR 800 i.e. (INR 10 profit x 100 shares – 200 original investment).
Situation 2: However, if the prices of share A don’t go up as per your expectations, and fail to reach INR 100 during the six months option period, you can let the option expire and save your money. The only loss you have to bear is the original investment of INR 200.
Meaning of Put Option
A put option gives an investor a right to sell a stock at a specified price within a specified time period. It is the exact opposite of a call option. Investors use put option to protect themselves against any sudden market crashes or drops. Let us look at an example to see how put options work.
Example of Put Option
Suppose you own some shares of B that you purchased for INR 50 per share. As of January, the stock is trading at INR 70 per share. You want to protect yourself against possible price drops of the stock and limit your risk. In such a case, you can buy a six-month put option at a strike price of say, INR 70 to be exercised by 31st July.
Situation 1: Suppose the price of the stock B takes a beating and is trading at INR 60 per share on 15th June. You can exercise your put option and sell your shares at INR 70 even though the shares are currently trading at a lower price.
Situation 2: However, if the price of B keeps climbing and goes even more than INR 70 per share, in such a case, you can let your put option expire and still reap the benefits of the increased value of your own shares that you bought for INR 50 originally.
Thus, call and put options are a great way to gain bigger without putting yourself at too much risk up front
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