When an investor invests in a stock market, he makes a portfolio of investments including bonds, stocks and mutual funds. But investing in a variety of securities is not enough. In order to hedge the risk of a portfolio, investors usually purchase derivatives, such as options, futures, collar, cap, floor and so on. These derivatives hedge the risk of underlying assets and safeguard the investment of an investor. They protect the investor from the risk of loss and act as a shield for investments in a volatile stock market. However, you should always seek guidance of Your Personal Financial Mentor when you plan to invest in derivatives in the stock market because he can carefully observe the market and help you make a profitable investment that will be beneficial in the long run.
When an investor trade options in the stock market, he secures himself from the downside risk and get an opportunity to benefit from the profits. Options are versatile derivatives that enable you to adjust your position in the stock market according to the prevalent situation. These derivatives can be as conservative or as speculative as you want and therefore, protect you from downward trends and adverse movements in the stock market or index. But the versatility comes with the cost because these are complex securities and can expose you to a greater risk if you do not trade carefully. Moreover, there is a premium cost associated with the options that hedge the investors against the downside risk.
There are usually two types of options, call option and a put option. A call option gives the holder of the option, the right to buy assets at a specific price within a certain period of time, whereas put option gives the holder the right to sell the asset at a certain price within a given frame of time. Call options are very similar to having a long position on a stock and put options for short positions. Moreover, there are four participants in the stock market who trade options. A buyer of call options, a buyer of put options, a seller of call options and a seller of put options. Those who sell the options are known as ‘writers’ and the people who buy options are known as ‘holders’.
It is important for you to understand the terminologies that are used when you trade in Options. The price at which the underlying stock is traded in the stock market is known as the strike price. Then there is an exercise price, the price at which you can actually exercise the options. Moreover, option contracts also have an expiry date after which the option lapse. Volatility and time value are two most critical factors and are very hard to predict. Volatility shows the extent to which the return of an underlying asset will fluctuate between the current date and expiry date of the options. On the other hand, time value is the portion of the premium cost that is attributable to the amount of time remaining until the contract expires.
When you want to start trading in the options, it is necessary for you to keep the risk and costs of options in mind in order to secure your position in the stock market because options trading is speculative in nature and can increase the risk exposure if you do not trade wisely. However, investors prefer to use options in one form or another when they give employees a shareholding in the form of stock options or when they want to hedge the risk of foreign exchange transactions.
Categories: Stock Market