Equity Options: 5 reasons These can Bring a Change to your Investment Strategy

Summary

• Investors are facing tough time in sustaining returns during COVID-induced volatile market scenario.
• Regardless of the market conditions, Options as an investment avenue can be considered, and they can, not just diversify your portfolio but also protect and grow your investment.
• Options provide an investor (buyer of options) right but not the commitment to buy and sell an asset/security at a set strike price before the contract ends.
• Options have their benefits, but there is a risk with any investment. It is imperative to understand one’s risk-taking abilities before investing in the ever-so lucrative Equity Options.

Markets are facing extreme volatility, and investors are watchful of their investment moves and portfolio performance during these unprecedented times. Can we blame them? Certainly not! Its all about tapping the attractive investment avenues, driven by thorough analysis and return assessment.

Due to the ongoing spat between the US and China over the trade deal and virus origins, along with the havoc created by the novel coronavirus pandemic, the global markets are under pressure, not just to improve but to sustain this year. Investors are struggling to stay afloat and retain returns amidst volatile commodity scenario, sinusoidal equity market trends and weak macro fundamentals. Diversification, smart analysis and awareness of market trends and alternate investment avenues is critical here.

Amidst the uncertainties, the opportunists have found a way to keep their investment portfolio diversified by taking exposure to the Equity Options.

In simplified words, Equity Options, commonly known as ‘Options,’ are the derivative contracts for a month or more that provide the buyer the right (not the obligation) to purchase or sell a fixed number of shares at a set price in the future.

Options have been around in financial markets for more than 40 years. With the battered markets and crushed investors’ sentiments amidst challenging scenario, they have started gaining increased attention from the investors. They are used in various strategies adopted by the investors, from a conservative strategy to a high-risk strategy.

If one understands the concept of Options in addition to pricing and correct value determination, trading in them can be very successful. The basic rule is to make up an Options price. In more straightforward terms, one would need to know its actual value which can yield decent returns viz-a-viz market value.

Investors can take exposure to options of over 71 individual ASX listed shares, with strategies including simple call and put options or some advanced strategies such as Split Strike, Butterfly, and Condor. Given the virus-induced volatility, a prudent options strategy can yield reasonable results. Buying call can generate returns from capital appreciation if the market goes up, while put options will be beneficial if the market goes down.

The five major reasons why Equity Options can bring changes to an investor’s strategy are as follows:

1. Higher Leverage with Low Investment. The amount of finance required to invest in Options is considerably small. This is significantly attractive given the financial crunch faced by households and businesses during COVID-19 crisis. This low investment, in turn, gives higher leverage to control a significant asset.

For instance, an investor can secure a call option position with very less capital which may reward after the price appreciates. An investor will have to pay $12,000 to purchase 200 shares at $60 each. However, he/she can pay $30 on those shares for a call option position and spend only $6000. This cost-effective strategy in equity options is also called a stock replacement strategy. By using this strategy, an investor could buy a high number of options with reduced capital. Though it is not as simple as it sounds, it does give the investor an option to buy and assess a correct call to ape the stock position.

2. Less Risk Exposure. Most of the time in dealing with stocks, investors consider several risk factors first, along with fundamental and technical analysis. The option buyer has loss capped, max loss in the trade could be the amount invested. However, it is important to note that for an option seller/writer loss could be infinite.

3. Hedging. If investors do not want to sell their long-term stock investments, it becomes important to safeguard their holdings against the price fluctuations. This condition is particularly relevant, when the investors do not want to change or modify their underlying position. For example, at times, when the market takes a downturn and investors want to protect their profit, investors can purchase put options to secure their investments for the future.

4. Higher Returns Compared to Equity Investment. A well-studied investor can always profit using a befitting option strategy. This strategy can be better explained with the help of an example.

Let us suppose shares of company 'A' are currently trading at $55, and an investor is expecting the market to rise, and share price to grow to $70 at the end of the month. Now, he/she can buy these shares at $55 and hold them until the end of the month as he/she is expecting the rise.

Alternatively, he/she can buy a strike price of $65 for the premium of $3 and lock the selling price. If the share reaches $70 at the end of the month, the investor can exercise the call option and buy the shares at $65 and simultaneously sell the shares at $70 in the market. With this option strategy, the investor is earning the profit of $2 per share with an initial investment of $3 per share.

The investor would have made 27% profit with buying shares at $55 and holding them till the end of the month. However, with the option strategy, total returns investor will earn will be around 67%.

5. Flexibility in Buying and Selling. Options can also be customised to different end-results than depending on ‘stock will go up’ and ‘stock will go down’ situation. Not all investors have enormous risk tolerance. Options can, therefore, be tailored to suit the requirement of an investor by tailoring his/her risk-taking ability and accomplishing different returns. They are called synthetic derivatives. Furthermore, as explained above, options can be purchased and sold in various integrated ways with less capital, while earning similar or more profit.

Bottomline

Some people may say that Options have caused devastating losses in the past, while used for naked calls to make extremely high returns. Notwithstanding, if the options strategies are used prudently with due assessment combining calls and puts and measuring payoffs and risk, they can give satisfying results.

Options have their benefits, but there is a risk with any investment. Notable, risks associated with options include potentially unlimited losses in writing options, the possibility of fall in option value, margin calls/additional funds to secure your position, complexity while adopting offsetting positions.

However, if options are used smartly with due-diligence, risk profile and return expectations, the investment portfolio may look very versatile. It is imperative to understand one’s risk-taking abilities before investing in the ever-so lucrative Equity Options. Besides, an understanding of various strategies is important, including bullish strategies, bearish strategies, neutral strategies and strategies for price-breakouts.