Risk mitigation part two options

The book – ‘Psychology of Money’ states that - “There is no reason to risk what you have and need for what you don’t have and don’t need”. The book significantly explains the importance of Risk Mitigation in everyone’s life.

The book lays a special emphasis on not risking the essential assets for something that is not really important for oneself. For example – You own a hatchback car sufficing all your needs of travelling. However, you wish to upgrade your car to a luxurious Mercedes/Audi Car and you already have a loan to pay off. Should you still go for a luxurious car? Or just settle with what you have? Here, it is not about settling with what you have and what you don’t! The primary thing that is usually overlooked – is to plan thoughtfully with an aim to upgrade and achieve what you wish to have!

To this, the author says that- If we had a magic wand, we could figure out how much of these outcomes were generated by repeatable acts vs the role of random risk and luck in swaying those activities one way or the other. But, we don't have a magic wand. We have brains that prefer simple solutions and aren't interested in intricacy. Therefore, mapping out how to mitigate the risks and maximizing capitals, can only be achieved by appropriate planning!

While we have already discussed about Risk Mitigation and how Futures Trading aids to mitigate the risks in the previous part, we will now chalk out how trading in Options can amplify the Risk Mitigation process. In case if you have missed reading the Part 1 of Risk Mitigation, please click here.

What is Options Trading?

Options are a type of derivative contract in which the contract's buyers (the option holders) are given the right (but not the obligation) to buy or sell a security at a predetermined price at a future date. The most popular contracts are for "call" and "put" options. A call option gives the contract buyer the right to purchase the underlying asset at a predetermined future price, known as the exercise price or strike price. A buyer who purchases a put option has the right to sell the underlying asset at a certain price in the future.

Options and Leverage:

There are two main definitions of leverage that apply to options trading. The first defines leverage as the application of the same amount of money to conquer a larger position. The risk of a rupee invested in a stock vs a rupee invested in an option is not the same. Leverage, according to the second definition, is defined as keeping the same size position but spending less money. A consistently successful trader adopts this notion of leverage into their frame of reference.

Pragmatically using options trading to mitigate the risk:

One of the simplest methods to reduce the risk of options trading is to understand the relevance of the underlying asset you own in the current market. This will assist you in determining which options to buy in and when an appropriate expiration date would be. There are various tactics that one may use to ensure that the risk associated with purchasing and selling options is minimized.

Managing Risks with Options Spreads:

Options spreads are significant and effective trading instruments for options. Basically, an options spread is when you aggregate multiple positions on options contracts with the same underlying security to produce one trading position overall.

For instance, you would have established a spread known as a bull call spread if you had purchased in-the-money calls on a particular stock and then sold cheaper out-of-the-money calls on the same stock. By purchasing the calls, you can profit if the price of the underlying stock increases, but you could also lose some or all of the money you invested if the stock's price doesn't rise. You may lower the maximum amount you could lose by writing calls on the same stock and thereby influencing some of the upfront costs.

Managing Risks Through Diversification:

Diversification is still useful when it comes to options, even though it isn't as crucial in the same way. In fact, there are many various ways to diversify. Although the fundamentals stay roughly the same, diversification is applied in options trading through a variety of techniques. You don't want to commit too much of your capital to one specific type of investment.

Utilizing a variety of techniques, trading options based on a variety of underlying stocks, and trading various option types are all ways to diversify your portfolio. Essentially, the concept behind diversification is that you can benefit in a variety of ways and are less dependent on a single event for the success of all your investments.

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