What are the uses of options?

An option is a right to buy without the obligation to buy or a right to sell without the obligation to sell. The former is the buyer of a call option and the latter is the buyer of a put option. Have you wondered why use options at all? What are the uses of options and how do they add value. Let us look at why use options and also how it adds value to the trader.

Uses of Options

The use of options is broadly for 2 main reasons viz for speculation and hedging. Hedging must be the actual reason to use options but most traders also use it extensively for speculation. Let us look at why use options and how the use of options can help to make profits and also manage risk.

Let us understand speculation first. As the name suggests, speculation is about betting on the movement of a security. The advantage in options is that you can make a profit when the price move is favorable, but more importantly, you can also make profits when the IV goes up or when the volatility pushes up premium values.

The word of caution is that speculation is the reason options have acquired the reputation of being risky. Buffett called them weapons of mass destruction. To succeed in speculating in options, you must correctly estimate whether a stock will go up or down and also whether the volatility of the stock will go up or down.

The only reason, people still speculate using options is the leverage and the flexibility. When you can trade a high-priced stock or index by paying just a fraction of the price, this leverage is just too attractive. The flexibility options speculation offers is concerning being able to trade price and volatility shifts, which is not possible either in futures or in spots.

The more important function of options is hedging or protecting the risk of adverse price movements. Hedging strategies like protective puts are very useful in limiting your downside risk in the markets. For example, if you want to take advantage of the banking boom but also want to limit losses, then options would be a wonderful hedging instrument. Options can help you to cost-effectively restrict your downsides.

What is implied volatility?

As the name suggests, Implied volatility is a metric that captures the market's view of the likelihood of changes in a given security's price. It is the volatility that is implied in the price of options. The higher the IV moves, the higher is said to be the risk in the market and that is positive for option buyers. Lower the IV moves, lower is said to be the risk in the market and that is negative for option buyers.

Implied volatility is different from historical volatility, which is based on past historical prices. It is also called statistical volatility. The historical volatility figure will measure past market changes but it is only implied volatility or IV that will give you results that are actionable from a trader’s perspective.

What are the charges for options trading

Options are also subject to brokerage and other statutory charges like GST, STT, stamp duty, exchange transaction charges, and SEBI turnover tax. Brokerage is normally charged on a per-lot basis at an approximate rate of Rs.10 per lot to Rs.20 per lot. Options tend to attract cash market STT if you leave in-the-money options to expiry, without reversing your position.