What’s the best option?

There are several ways of making or losing money in the financial and commodity markets, either through trading or investing. You can either trade or invest in stocks, commodities like gold and wheat, fixed income instruments, real estate etc. But there’s one choice that many people are unaware of, i.e. derivatives. Derivatives are instruments whose values are derived from an underlying asset. There are two kinds of derivatives — futures and options.

In this article, we will look at options, and ways of benefiting from them. Options are a type of derivative that gives you the right, but not the obligation, to purchase certain assets at a fixed price at a future date. When you buy a stock option at Rs 100, and the price goes up to Rs 120, you can exercise your option, and make a gain of Rs 20. If the stock price falls to Rs 90, you can choose not to exercise the option, and avoid losing Rs 10. Of course, options are not just available for stocks; you can get them for a variety of assets, including gold, stock indexes, wheat, petroleum, etc.

How does one go about finding the best options to trade in? What parameters do you have to look at while trading, and finding the top options for you? Do you just find the most active options to bet on in the market? Let’s take a look.

Trading objective

Well, the first thing you should look at while finding the best options to trade for you is the objective. There are a couple of reasons why people trade in options. One is to hedge risk. Another is to make gains by betting on movements in prices, or speculation. The strategy you adopt will depend on your objective.

Call options

Another thing that affects your trading strategy is whether you want to take bets on stock prices rising or falling. If prices are rising, the best options to trade are call options. A call option gives you the right to buy a certain stock at a specific price in the future. This will enable you to make profits if you get your bets right, and prices rise.

Within call options, there are two types. One is a naked call option. This is a strategy that involves selling call options without owning the underlying security, like stocks. This is a risky strategy, since the potential for loss is unlimited; there is no telling how high the price of the stock could rise. But it’s possible to buy back the option contracts when prices starting going beyond the strike price, or the price at which the options contract was concluded.

Another type is the covered call option. This could be among the top options if your risk appetite is on the lower side. This is a strategy used by those who already own some stocks, and want to make any gains from any price increase. Here the investor buys a covered call equivalent to the stocks in his portfolio. So if the price rises, the investor can make gains without selling the shares. This is a conservative strategy, and may not be very suitable for a bull market because if share prices move above the strike price, the investors stand to lose out on the gains from that increase.

Put options

Another type is the put option, which gives you the right to sell a particular stock at a certain price. This is a good choice if you expect share prices to fall. If you expect the share price of Company XX to fall from the current Rs 100 to Rs 90, you can purchase 1,000 put options of Company XX at the strike price of Rs 100. So when share prices of Company XX fall to Rs 90, you can exercise your right to sell the options and make a profit of Rs 10,000. If prices rise to Rs 110, you have the choice of not exercising your option, and avoid a loss of Rs 10,000. In that case, your only loss would be the premium you have paid to enter into the options contract. So, this, in essence, is a bearish option.

Put options can also be used as a hedging strategy. If for example, you have a stock portfolio, and expect prices to fall, you can buy put options. So if stock prices do fall, you can offset the losses in your portfolio by the gains you have made by exercising the put option. This has two advantages. One is the obvious advantage of avoiding any losses from a fall in price. Another advantage is that by not selling your stock, you get the benefit of any dividends that companies may declare, and other privileges like voting rights. This type of option is called `married put’.

The premium consideration

Another thing you should know while finding the best options to trade is the premium which you have to pay while entering into an options contract. Premiums are determined by various factors like the stock’s price, volatility, the time to expiry and so on. One important factor is `moneyness’ — whether or not the option would make money if sold at the moment.

Premiums are a percentage of the transaction, and affect the returns you could make and the leverage you can get. Leverage is the extent to which you can purchase options, and is a multiple of the premium. For example, if the premium is 10 percent, you buy put options worth Rs 10 lakh by paying a premium of Rs 1 lakh.

Getting the timing right

When you trade in options, you get a variety of choices at different strike prices and different time periods. Premiums go up when the options contract is in-the-money. That is when the options contract is expected to make profits at the moment. In a call option, this would be when the price of the stock is above the strike price. In a put option, this would be when the strike price is above the market price. Out-of-the-money is when profits cannot be made on an options contract.

When options are in-the-money, premiums will go up. The reverse happens when they are out-of-the-money. In that case, premiums will fall. So it’s important to get the timing right while purchasing options. If you buy options while they are in-the-money, you won’t stand a chance of making much money.

There’s another factor that could affect premiums, and those are events happening around the world. Government policy announcements, for example, could lead to big changes in stock prices. This will lead to increased volatility, pushing up premiums. In that situation, selling or `writing’ an option could be a better choice than buying one. So the best options to buy today may be different from tomorrow or yesterday.

Risk appetite

The top option for you will also depend on your risk appetite. If you are averse to risks, you shouldn’t go in for deep out-of-the-money options. Sure, premiums are low and you could make good money if they get in-the-money, but it’s a risky proposition as well. You should also avoid going in for naked call options, since the potential for losses is also quite huge.

Conclusion

Options trading can be rewarding for those who are prepared venture into relatively unknown waters. However, this plunge involves far less risk than trading directly in shares or even buying futures. If you trade in shares, the downside is unlimited. If share prices go into a freefall, you lose to the maximum extent. This is also true for futures contracts, which unlike options, do not give you a way out if prices don’t go your way. However, in the case of options, the downside is low, restricted to the premium that you have to pay.

There is a small downside to an options contract that you should consider. Unlike shares, you don’t have any ownership of the company, so you don’t get any benefits like dividends. Options are a purely speculative instrument where you bet on prices falling and rising. It’s also a zero-sum game. There’s no win-win situation. If you win, someone else loses, and vice versa.

But the downside of options is quite small and benefits huge. You can get exposure to much more stocks with options through leverage, and increase your chances of making profits. What’s more, you don’t lose big when your hunches prove wrong.

All you need is patience, and keep up with the latest developments to make money from options trading. It would be a good start to study the most active options so that you get an idea of what’s the most popular with investors.