Options Investment: Meaning, Types, Strategies, Benefits & Risks

Options contracts grant you the right, but not the obligation, to buy or sell an asset at a fixed price by a specific date. Options investment refers to purchasing these contracts to either speculate on short-term price movements or protect existing investments from downside risk.

Options are highly complex instruments that investors use to gain exposure to assets without committing the full capital required for direct stock ownership. While the potential for high returns exists, you must be aware of the various options investment risks that include losing your entire premium if the market moves against you.

In this article, we will break down the meaning of options investment and explore the various types. We will also look into the key benefits and risks associated with this type of investment.  

What is Options Investment?

An option is essentially a financial contract between two parties regarding the future price of an asset. It allows you to speculate on the future direction of a stock or a market index without actually owning it.

An options investment gives the buyer of the options contract the right to buy or sell an asset at a pre-determined price on a future date. In exchange for this right, the buyer pays a fee known as a premium to the seller of the options contract. The buyer has the right to choose not to exercise the right, in which case, the contract simply expires worthless.

The seller of the options contract receives the premium and is financially obligated to buy or sell the asset at the pre-determined price on the said future date. The seller cannot avoid their obligation.

How Options Differ from Stocks 

When you buy a stock, you become a part owner in a company and hold it indefinitely until you decide to sell the stock. When you purchase an options contract, you do not become a part owner, get voting rights or receive dividends. Moreover, it has a set expiration date. Once it expires, the contract ceases to exist, and you lose all the rights and obligations that come with it.

An Example 

Here is a real-life example to help you understand options investment better. Imagine paying a non-refundable deposit to hold a house price for two months. If property prices rise within the two months, you still get to buy the house at the agreed lower price. If the prices fall, you can choose not to go through with your purchase and lose the deposit instead. This is exactly how a call option functions in the financial markets.

How Options Investment Works

Now that you are aware of options investment, let us look at the key components of an options contract. Understanding these components is essential before you enter into a position.

• Underlying Asset

The underlying asset is the financial instrument upon which an options contract is based. It could be a stock, an index like the Nifty 50, a currency pair or a commodity. The value of the options contract fluctuates based on the price movements of this underlying asset.

• Strike Price 

The strike price is the specific price at which you can buy or sell the underlying asset on a future date. It remains fixed throughout the life of the contract. The profitability of an options investment depends on the difference between the current market price and the strike price at the expiration date.

• Expiry Date 

Every options contract has a limited lifespan with a fixed expiration date. After the expiry date, the option ceases to exist and is settled between the two parties. You must decide whether to exercise your right or sell the contract before this deadline.

• Premium 

The premium is the price you pay to purchase an options contract. It is determined by factors such as the current price of the underlying asset, volatility and time remaining until expiry. 

• Buyer vs. Seller 

The buyer of an options contract holds the right to exercise the option and pays the premium. The seller receives the premium and is obligated to fulfil the contract if the buyer chooses to exercise. In an options investment, the seller usually faces a higher potential risk compared to the buyer.

Types of Options Investment

Options investment types can be categorised into two: call options and put options. Let us explore them in detail.  

• Call Options 

A call option gives you the right to buy the underlying asset at a specific strike price. You generally purchase call options when you expect the price of the asset to rise. If the market price exceeds the strike price, your call option premium gains value.

• Put Options 

A put option gives you the right to sell the underlying asset at the strike price. You typically buy these when you expect a decline in prices. If the market price falls below the strike price of the put option, the option premium gains value. 

American vs. European Options 

American options and European options are currently the only two options investment types that are used across the world. American options allow you to exercise the contract at any point before the expiry date. European options, which are the type used in the Indian financial markets, can only be exercised on the specified expiration date.

Options Investment Strategies

Successful traders and investors use specific options investment strategies to manage risk and optimise returns. Let us look at four simple yet often-used strategies. 

• Buying Calls 

A very simple options investment strategy that involves purchasing a call option when you are bullish on a stock or index. This strategy offers unlimited profit potential, with the risk limited only to the premium paid. 

• Buying Puts 

An options investment strategy that is often used when you are bearish on a stock or index. By buying put options, you can profit from falling prices without short-selling the stock directly.  

• Covered Call 

A covered call is an options strategy that involves holding the underlying stock and simultaneously selling a call option against it. The strategy generates income from the premium received but limits your upside potential. However, this strategy is ideal only for situations where the stock is not expected to rise sharply. 

• Protective Put 

A protective put is an options investment strategy used for hedging risk. Here, you own a stock and buy a put option for the same asset, which acts as an insurance policy against a potential decline.

Benefits of Options Investment

Understanding the various options investment benefits is important. Here are some of the advantages that equity stocks cannot offer.

• Leverage 

Options allow you to control a large amount of stock with a relatively small amount of capital. This leverage can significantly amplify your returns. A small percentage move in the stock price can result in a large percentage gain in the option value.

• Hedging 

Options investment is the most effective tool for hedging. You can use it to protect your stock portfolio from downside risk. For example, you can insure your investments against market crashes by using put options without selling your long-term holdings.

• Income generation 

Options investment strategies like covered calls allow you to collect premiums, which act as a source of income and can enhance the overall yield of your portfolio. Selling options contracts can be a useful strategy in range-bound or sideways markets where stocks are not moving much.

• Flexibility 

Options offer a high level of flexibility. You can structure trades in such a way that you gain profits from any market condition, whether prices are rising, falling or staying flat. You can even trade based on volatility, profiting when the market expects large moves irrespective of the direction.

Risks of Options Investment

While the benefits may seem appealing, options investment risks are often very substantial and require careful management. Let us look at four key risks in detail.

• Limited Lifespan 

Unlike stocks, options contracts have a fixed expiration date. If your predicted price move does not happen within the specified timeframe, the option can expire worthless. This is because of a concept called time decay, which erodes the value of your option every single day.

• High Volatility 

Another one of the options investment risks you should keep in mind is volatility. Options prices are extremely sensitive to sudden changes in market sentiment as they can drastically alter the value of your position. While high volatility can lead to gains, it can also result in rapid losses if the position moves against your expectations.

• Complexity 

Options are complex financial instruments that require a deep understanding of pricing models and Greeks (Delta, Gamma, Theta and Vega). Beginners often struggle to grasp how these variables interact, which can lead to mistakes in trade execution or strategy selection.

• Potential Loss of Premium 

Among the many options investment risks, the potential loss of premium is often the most important. For buyers of options, the risk is limited to the premium paid. For options sellers, the risk of potential losses can theoretically be unlimited.

Options Investment for Beginners

If you are considering options investment for beginners, you must approach it with discipline and focus on proper risk management measures. Here are some things you must keep in mind. 

• Capital Requirements 

While you may not need a lot of capital to start options investment, you should have enough to withstand losses. Remember, the capital requirements vary depending on the options premium, the lot size and how close the options contract is to the expiration date. 

• Risk Management Tips

Let us look at some simple tips that can help you manage risks effectively when making options investments.

1. Never invest more than 5% to 10% of your total capital in a single trade.
2. Always use stop-loss orders to limit downsides.
3. Avoid holding short-term positions overnight to skip gap risk.
4. Understand the maximum loss potential before initiating an options position.
5. Start with paper trading to practice without real money.

• Common Mistakes to Avoid

Since options contracts are highly complex financial instruments, traders and investors leveraging them often make certain mistakes. Here are some of the common mistakes that you should avoid when making options investments. 

1. Buying deep out-of-the-money (OTM) options due to their low premiums. 
2. Holding losing options contracts until the expiration date, hoping for a miracle reversal.
3. Trading options contracts during earnings announcements or other key market events without a proper strategy.
4. Ignoring the impact of implied volatility (IV) when making options investments.

Options Investment vs. Stock Investment

There are quite a few differences between an options investment and a stock investment. Comparing these two helps clarify the role options play in a portfolio.

1. Risk Comparison 

Although equity stocks carry the risk of price decline, you rarely lose your entire capital unless the company goes bankrupt. With options contracts, however, there is a risk of total loss of premium if the contract expires worthless. Therefore, an options investment is often considered much riskier than an equity investment.

2. Cost Comparison 

Buying options contracts requires significantly less upfront capital compared to buying the equivalent amount of stock. However, brokerage and other trading costs can be higher for options investment due to frequent turnover. Equity stocks, on the other hand, are more cost-effective to hold for the long term.

3. Return potential 

Stocks offer linear returns. For example, if the stock rises 10%, your profit would also be 10%. Meanwhile, options offer non-linear returns. For instance, a 10% stock move could result in a 100% option gain due to the power of leverage. 

Frequently Asked Questions (FAQs)

1. Is options investment safe? 

No. Options investment is not safe. In fact, it carries a very high level of risk. However, when used for hedging your investments, it can increase the safety of your portfolio.

2. Can beginners invest in options? 

Options investment for beginners is not advisable. This is because options contracts are highly complex financial instruments and involve significant risk. It is more suited for experienced traders and investors. 

3. How much money is needed for an options investment? 

The amount of capital required varies depending on the premium, the lot size and the expiry of the options contract. 

4. Is options investment better than stocks? 

No. Neither of the two investment options is better than the other. Options investment is more ideal for short-term speculation and hedging, while equity stocks are more suited for long-term ownership and wealth building.

Conclusion

Options investment is a powerful way to hedge risks and generate income through short-term price movements. While the flexibility and potential returns are attractive, the complexity and time-sensitive nature require you to adopt a disciplined approach. If you intend to leverage options, you should first master the basics and learn to manage the various risks carefully to succeed in this dynamic market.