A Guide to Options: A Key to Expanding Your Investment Portfolio

A Guide to Options: A Key to Expanding Your Investment Portfolio

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Rashmi
Rashmi Karan
Manager - Content
Updated on Nov 24, 2023 15:24 IST

The term options may seem complicated to beginning investors. This type of financial derivative can be a great ally in any saver’s strategy since it allows multiple objectives to be achieved – ranging from reducing risk to enhancing volatility. Those interested in knowing how options operate to start investing through this financial instrument should familiarize themselves with key facts about options. This guide provides a comprehensive introduction to options, their types, and the factors that influence the prices of options. You will understand how options work and are used to enhance your investment portfolio.

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What are Options?

Options are contracts that give the holder the right, but not the obligation, to buy or sell quantities of underlying assets at a predetermined price before the contract’s expiration date. Option holders do not have to exercise their right to buy or sell if they do not want to.

Also, a currency option is an option contract that gives the holder the right, but not the obligation, to buy or sell a currency pair at a predefined price before a specified expiration date.

Must Read – What is Options Trading?

Types of Options

Types of Options

There are two types of options:

Call Options

A call option is a financial contract that gives the buyer the right, but not the obligation, to buy a certain amount of an underlying security (like a stock) at a specified price (the strike price) within a certain period (until the expiration date).

The buyer of a call option believes that the underlying asset will increase in value before the expiration date, and they can purchase it at the strike price, which would be lower than the market price. This allows them to profit from the difference between the market and strike prices.

At expiration, 

– If the value of the underlying asset (S) > Strike Price(K) 

  • The buyer makes the difference: S – K 

– If the value of the underlying asset (S) < Strike Price (K) 

  • The buyer does not exercise 

The value of a call increases as the value of the underlying asset increases, and the value decreases as the value of the underlying asset decreases.

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Put Options

A put option is a financial contract that gives the buyer the right, but not the obligation, to sell a certain amount of an underlying security at a specified price within a certain time.

The buyer of a put option believes that the underlying asset’s price will decrease before the expiration date. They would then be able to sell it at the strike price, which would be higher than the market price, profiting from the difference.

At expiration, 

– If the value of the underlying asset (S) > Strike Price(K) 

  • The buyer makes the difference: S – K 

– If the value of the underlying asset (S) < Strike Price (K) 

  • The buyer does not exercise 

Each option contract expires; you can exercise the options on their last date. If you do not exercise an option by the expiration date, it becomes worthless, and the holder loses the money paid to buy it.

Options can be traded on various exchanges around the world. They can be used for various purposes, such as – 

  1. Hedging (as a form of insurance against price movements)
  2. Speculation (making bets on future price movements)
  3. Income generation (through the selling of options)
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Factors Influencing Options Prices

Many factors influence the price of an option, also known as its premium.

Value of Underlying Asset

As the value of underlying assets increases, buying at a fixed price (calls) will become more valuable, and selling at a fixed price (puts) will become less valuable. 

Variance in that value

With increased variance, calls and puts will become more valuable because all options have limited downside. 

Expected dividends on the asset

The expected dividends on assets reduce the price appreciation of the asset and the value of calls while increasing the value of puts.

Strike Price

The relationship between the strike price and the current price of the underlying asset (whether the option is “in-the-money,” “at-the-money,” or “out-of-the-money”) can significantly affect the option’s price.

Time to Expiration

Options with a longer time until expiration are generally more expensive than those close to expiration.

Volatility

Higher volatility generally leads to higher option prices because there’s a greater chance that the option will move in the money.

Interest Rates

Although the effect is minimal compared to other factors, interest rates influence option prices. When interest rates rise, call options generally increase in price and put options decrease in price.

Dividends

If the underlying asset is a stock that pays dividends, those dividends can affect option prices. Because dividends lower the stock price, they can have a greater impact on the price of put options.

Market Demand

Like any traded asset, supply and demand dynamics largely influence the price of options. Products with high demand may witness an increase in prices.

Options pricing can be complex, and a combination of these factors influences it. Understanding these factors can help you make more informed decisions when trading options.

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How Can You Expand Your Portfolio Using Options? 

Expanding your portfolio using options is a strategic way to diversify your investments and increase returns. Here are some ways you can use them to expand your portfolio:

Income Generation: The purchase of options entails the payment of premiums, which are the price of the options. These premiums will reduce the potential returns of the portfolio and must be considered when evaluating the hedging strategy.

Hedging: An option spread involves combining call options and putting them to limit risk and the cost of protection. By combining different options, a price range can be created in which the portfolio is protected against adverse movements.

Leverage: These options help protect your portfolio against a general market downturn. If the market experiences a significant decline, putting options on the index may increase in value, offsetting losses in the portfolio.

Strategic Investments: Various strategies, such as spreads, straddles, and strangles, can be used to profit from different market conditions. You can earn profits if the asset’s price goes up.

Diversification: An option can be used to gain exposure to different assets and markets, helping to diversify your portfolio. For example, options are available on various underlying assets, including stocks, ETFs, indices, commodities, and currencies.

How Can You Use Options As A Hedge?

Investors use options as a hedge to limit potential losses on other open positions.

Suppose you own shares of a company, but you are worried that its price will fall short. You could buy a put option on your stock with a strike price close to its current level. 

If your stock price is below the strike price at the expiration, your losses are offset by the option’s gains. If the price of your shares increases, you will only lose the cost of buying the option initially.

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Key Takeaways

The buyer of a call option benefits from – 

  • Increase in the price of the underlying asset.
  • Increased volatility of the asset price.
  • Increases in interest rates.
  • Lower dividends

The buyer of a put option benefits from:

  • Fall in the price of the underlying asset.
  • Decrease in asset price volatility.
  • Lower interest rates.
  • Increases in dividends

FAQs

What are the options for investing?

Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. They are used to hedge risk, speculate on future price movements, and enhance portfolio performance.

What is the difference between a call option and a put option?

A call option gives the holder the right to buy an asset at a specified price within a specific period. On the other hand, a put option gives the holder the right to sell an asset at a specified price within a specific period.

What is the risk involved in trading options?

Options trading can be risky and is not suitable for all investors. The risk in buying an option is the premium paid for the contract, which is lost if the option is not exercised before expiration. Selling options can carry an unlimited risk if the market moves significantly against the position.

How can options be used in an investment strategy?

Options can be used in various ways in an investment strategy. They can be used to hedge against potential losses in other investments, generate income by selling option premiums, and speculate on the direction of price movements in underlying assets.

About the Author
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Rashmi Karan
Manager - Content

Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio