If used properly, options can generate returns which are far higher than the dividends. Let us discuss the same in detail.

Often, long-term investors think that derivative products such as options are meant only for speculators. In fact, it is the other way round. Trading in options is a way to protect individual shares or an entire portfolio against any unexpected and sudden downturn. If used properly, options can generate returns which are far higher than the dividends. Let us discuss the same in detail.

Understanding options
An option is a contract that gives its holder the right to either buy shares at a fixed price (a call option) or to sell shares at a fixed price (a put option). The price at which a person can either buy or sell the underlying shares is the strike price, and the price of the contract is nothing but the premium. You pay a premium to purchase an option or you will earn the additional premium if you simply sell a contract to someone else.

Generally, option contracts are available in ‘market lot’ of the underlying shares and contract expires on a fixed date. The holder may exercise an option on or before that date. Options trading is similar to that of buying and selling of shares. Let us look at popular ways of using options to generate income or to protect your portfolio from market fall.

Sell a covered call
This popular options strategy is primarily used to enhance earnings, and still it offers some protection against loss. It is used to generate income from investors who think stock prices are unlikely to rise much further in the near-term. Let us see how it works. You buy 100 shares of ABC company on January 1, 2020 at Rs 50, then on the same day you sell one call option (which is equal to 100 shares) for a premium of Rs 4 which expires on June 30, 2020, with strike price of Rs 55. Actually, on June 30, 2020, ABC shares closes at Rs 60, so option is exercisable because it is above Rs 55 and you receive Rs 55 for your share.

So, as on July 1, 2020, you make a profit as follows: Rs 5 as capital and Rs 4 as premium which you have already collected on January 1, 2020 from sale of the option. Thus, you got a gain of Rs 9 per share or 18%. Contrary to the previous scenario, let us see what happens if the stock closes at Rs 40 on June 30, 2020. Option is not exercised, as the stock is available in the market for Rs 40, so he will not buy from you by paying Rs 55. So, you book a loss of Rs 10 per share minus the premium which you have collected Rs 4. So, you net loss is Rs 6 or 12%.

Buy puts
A put option works in a way just opposite to how a call option does. Put option grants the right to sell an underlying asset at a fixed price through a predetermined time frame. Put option gains value when the price of the underlying share decreases. This is almost comparable to short selling of shares, making profit from falling prices. But, in short selling the risk is unlimited.

Conversely, a put option loses its value if the underlying stock price increases past the strike price, and the option will simply expire worthlessly. Investors could buy put options when they are concerned that the stock market is likely to fall.

To conclude, Covid-19 has impacted all investors and theirportfolios. In this juncture, options —which is a part and parcel of derivative products of exchanges —is another fantastic tool for generating income as well as protecting your portfolio from a sudden market sell-off.

The writer is a professor of finance and accounting, IIM Tiruchirappalli