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Why To Trade In Options


There are two primary drivers for stock options. They are speculation and hedging. Options primarily started with hedging tool but once its potential was realized as a quick money generator, it was started as a tool for speculation. As per a report, options are done more for trading than for pure hedging. There are complicated products created on options with objective of making lots of money.
While underliers like stocks can generate profits only when its value goes up, options can generate money when stock is in uptrend or downtrend or even in sideways market.

Unlike stocks, options can help you generate money irrespective of market movement.

Now lets understand why traders use options:
1. Trading(Speculation): As we have seen in previous tutorials that profit with options can be very high with limited risk. For smart traders who can predict market movement either up or down can buy options instead of stocks with much lesser capital for same amount of profit as stocks. Yet their loss is limited.

For example:
If value of a stock is 100
Capital required for buying 1000 stock is, 100,000
Movement of 10% will yield, 10,000 (brokerage and other charges included)
Maximum capital at risk -100,000.

For Options:
Capital required (only premium) - 2000 (with assumption of 2 per share)
maximum profit- with 10% movement. 10,000.
Net profit 10,000-2,000 = 8000 (brokerage and other charges included)
Profit% - 400%
Maximum capital at risk: 2,000
In the said example for a trader, stocks will return 10% while option will return 400%.

This scenario is extremely simplistic, there are various other factors. Please refer to advantage & disadvantage of stock option.

2. Block your requirement with limited capital: From definition of option explained in previous tutorials, it gives buyer an option to buy some thing at pre-agreed price without any obligation. By doing so, you are saved from any violent price fluctuation beyond strike price. However, if it moves against, then you always have choice to not exercise option with limited loss.

3. Hedging: It acts like a hedging tool and helps you to limit loss in case of unexpected movement of stock price. For example you hold some stocks and you like to limit the loss in case market crash, then you will buy put options. It acts as insurance to your capital.

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