Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details
Are you scared of options because of the risks but want to profit from the flexibility of options to make profits, irrespective of market directions? In this article, we explore the low-risk option strategies, which can kick-start your options journey with well-defined risks.
What are options?
Options are contracts between buyer and seller to transfer a particular number of shares at a given price during the period of the contract. If you want to learn more about options basic, please check out our option primer.
Should you get into Options?
Unlike stocks, options can increase or decrease in price for any market condition, so you can use options to make money when the markets go up when markets go down, when markets are range bound when markets are volatile. Essentially you can create option strategies for any market condition depending on your outlook on the market.
What are risks associated with Options trading?
Options are contracts that expire after a certain period, so if the markets do not move into your favorable position by the end of the expiry, you would lose the premium of the option.
Let us assume you buy a weekly NIFTY Put option at 19000 strike with an expiry of 7 days. Now if the market goes below 19000 in 7 days, your position would be profitable, however, if at the end of 7 days, NIFTY stays above 19000, then you lose your premium.
When you buy an option, your risk is always limited to a premium amount only.
If you are an option writer/seller, then the risk is even higher. In the same example, if we assume you sold a weekly Put option of NIFY at a strike of 19000 and NIFTY goes down to 18000. In this case, you would need to pay the buyer of Option Rs 50000 ((19000-18000) *50), whereas the premium you would have received for selling that option would be in the range of Rs 1000 or even lower, depending on how close is the expiry date.
How to reduce the risk in options?
Option buying is a relatively low-risk strategy for beginners, however, the likelihood of options expiring in the money or being profitable is statistically less than 30%. 70% of the options expire worthless as per the market data.
For option buying to be profitable, the market needs to make a big move towards the strike of your option in a very short period, otherwise, the decay in premium is going to negate the profits due to market movement. This is one of the main reasons why most beginners start with buying options, instead of selling options.
For option sellers, the risk is very high while the rewards seem to be very low, but 70% or more times the options expire worthless. This means more than 70% of the time, the options seller is making a profit.
Options sellers use hedging to protect them from the unpredictable market movement against their position. Let us assume that we sell a Put option of strike 19000PE, but we create a hedge by buying 18800PE. So if the market stays above 19000, we are profitable. If the market goes below 19000 but above 18800, we would have losses, however, if the market goes below 18800, our losses get capped at 18800.
Low Risk Option Strategy
Bull Put Spread
A bullish Put spread is created when you sell a Put option of a higher strike and buy a Put option of a lower strike. This strategy would be profitable if the market moves higher which is why it is called a Bull Put spread, while the risk is limited with the hedge if the market were to move lower.
Bear Put Spread
A bear Put spread is created when you sell a Put option of a lower strike and buy a Put option of a higher strike. This strategy would be profitable when the market moves lower, if the market were to move higher the risks are limited because of the hedge.
Bull Call Spread
A bull call spread is created when you sell a Call option of higher strike and buy a Call option of lower strike. This strategy would be profitable when the market moves higher, if the market moves lower then the losses are capped because of the hedge you created by buying lower Call option.
Bear Call Spread
A bear call spread if created when you buy a Call option of higher strike and sell a Call option of lower strike. This strategy would be profitable when the market moves lower, if the market moves higher then the losses are capped because of the hedge you create by buying a higher Call option.
Conclusion
If you are worried about the risks arising due to unpredictable nature of the stock market but you still want to take advantage of option trading for making money even when market is not going higher, you can utilize these option strategies to make regular income.
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