Options provide safety net for investors

Financial derivatives started with the purpose of managing and transferring risk. Those who were more willing and able to take more risk would get it transferred from those who were bearing the risk but could not face it.

With that thought let us dive deeper into the basic utility of Options that of managing risk associated with making some adventurous moves in special marketconditions. While braveheart investors will still be making such moves without any help, I feel when you have such beautiful instruments why not use them?

Let us look at a few such moves and see how Options can create safety nets.

While there is a possibility that the stock would turn itself around immediately and recover back to a more reasonable level, equal chances are that there could be much more left to lose.

Relief comes in terms of Buying a Call. Instead of Buying a stock at 100, buy a 100-strike Call. If the view is right, one would get all the benefits. But, in case things were to deteriorate further from there all that is at stake is the Call Premium. Essentially, a cost paid to get the pair of gloves. On a later date when expiry nears, the same can be converted to delivery as the chaos settles.

Move #2 Buying into Expected Quick Recovery (Too Much Damage is done in a single day).

Holders of a similar view as Case #1 but the class of participants here would be more tactical investors. The only difference here is the fall that shatters the stock in a single day and it seems too much.

In such cases, the premiums are up across strikes (EG 110 Call of Rs100/- stock would be trading at 15 in volatile times instead of 5 in normal times). To fight this, pair up the Call Buy with a sell position in a few strikes higher call.

While the Call sold would cap the profits, it would give that much-needed funding when the premiums have increased multifold.

Move#3 Abrupt move for an Investor Holding stock for Long Term

This is more wealth preservation technique, instead of a wealth creation. I know the investors would not be tracking the stocks on a daily basis, but it wouldn’t hurt to have an alert mechanism in place. (not that difficult in this digital era). Just a simple drawing of attention would do when the stock starts behaving out of the ordinary on the lower side.

In such a situation, when there is an above-average move, Buy a Put Option just till the price stabilizes and shows you signs of firm ordinary behaviour. Sort of like Buying Medical Insurance at the first sight of health irregularities. God forbid if anything unfortunate were to happen, the pockets would not be drained.

So, gain all there is to gain if you win but using Options in adventurous moves do not lose if you lose.