Trading in options comes cheap, but with risks

The Bombay Stock Exchange's (BSE) Sensitive Index, or Sensex, has shed a little more than 20 per cent since January 2011. In the past six months, the markets have made a meagre one per cent. Due to the uncertainty in the markets, the retail participation in the cash segment in stock markets is almost non-existent.

However, retail investors are trying their hands at trading in the derivatives segment, say market participants.

"Over the last few months, we have seen many retail investors taking part in index options, as they are not making any money in the equity cash segment. The equity market volatility has led to this shift.

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The investors are more comfortable with options than futures, as the margin money (a minimum prescribed amount for security) requirement is lower," says Alex Mathew, head of research, Geojit BNP Paribas Financial Services. Retail investors took solace in derivatives after the 2008 market crash, too.

In the first four months of this year, the total turnover in the cash segment on the BSE was Rs 2.29 lakh crore, while volumes in the options segment alone amounted to Rs 74.8 lakh crore. Though the volumes traded in the options segment dipped slightly in March, it rose in all other months.

The difference between buying shares and options is that shares give you an ownership in the company, while options are contracts that give you the right to buy or sell the stock at a specific price on a specific date.

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There are two types of options, call and put. When you buy a call option, you get the right to buy the stock. When you buy a put option, you acquire a right to sell the stock.

The buyer of an option cannot lose more than the initial margin paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is limited.

However, derivatives are complex and usually not advised for retail investors. Typically, traders and sophisticated investors participate in derivatives as they know how it works.

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Individuals trading in options need to keep in mind that there is a high possibility of losing all the capital.

"Do not leverage beyond a point. There are high chances that the premium (or margin) that you pay gets wiped out entirely in adverse market conditions. Make sure you invest just a fraction of your portfolio in options," says Alok Agarwala, head of research, Bajaj Capital.

Experts say investors taking to stock options are not aware of it. They say youngsters willingly take risks associated with derivatives as they can enter and exit the market in hours and don't need to wait for long to make money.

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Additionally, they earn heavily by paying just the margin money to the broker, about 10 to 25 per cent of the contract value.

While index futures are the safest among the derivative products, only an investor with spare money should look at these, because it involves predicting or timing the market. At best, it can be used for hedging in case the market is falling fast and your portfolio comprises shares bought at higher prices or for diversifying your portfolio.

Another problem with options is that these can be illiquid. Brokers suggest having a 'cover strategy' but caution against a 'naked position'.

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The latter refers to a situation in which a trader sells an option contract without holding a position in the underlying security (equity) as protection from an adverse shift in price.

This is risky because it can lead to heavy losses beyond the margin. A cover strategy needs an option holder to have a position in the underlying and this helps the investor to hedge his position.

Having said all this, if done with proper knowledge, one can profit from trading in options. However, financial planners say since these are highly complex in nature it is best that retail investors stay away from this segment.