After my last post, I got several queries from fellow Happionaires asking me to explain a bit more about what Options are. I find it great that so many people are not hesitant to ask questions and learn about new things. Options are something which very few people understand well. Not because they are difficult to understand, but because very few people who know about them explain it in a simple and easy way. By now I’m sure all of you who have read our blog as well as ITHW must be knowing how The Happionaire Way is about making everything fun, simple and interesting.
I remember several years ago when I asked one of my brokers to explain what options were, he told me so many things which made no sense at all to me at that time. Talks about option premiums, calls and puts can be extremely confusing for somebody who has no idea at all about all these things.
Before I explain it to you, let me clarify once again that personally I don’t trade in Options now. In the past as soon as I learnt about options, I got tempted and traded in them. Since the returns possible are quite high, a lot of us get very tempted. We all have greed in us. Sometimes I made huge profits trading in options and sometimes I made losses. In the end I don’t think I made any substantial amounts of money trading in options. Luckily though I didn’t risk too large an amount and learnt a lot from the mistakes I made. By the grace of God, I continue making mistakes and I continue learning from them.
Now let me try to explain in a very simple way about options. Let me share a small story with you, which will help you understand what options are.
Let us say you want to buy an apartment. After searching a lot you find a nice apartment that costs Rs. 10 lakhs. (I know many of you might be wondering where we can get Rs. 10 lakh apartments. I don’t know where we can get them either, but the way the real estate market is behaving I won’t be surprised to find several such apartments.)
Since you like the flat so much, you speak to the builder and tell him to block the flat for you. You want to consult with your family and will tell him for sure in one month. The builder tells you that you will have to give him Rs. 10,000 to block the apartment. You can either pay him the entire Rs. 10 lakhs after one month and take the property or alternatively in case your family doesn’t like it you can let it go but you will lose your Rs. 10,000.
You think about it, and decide Rs. 10,000 is not too big an amount to pay for the flat. You pay the amount and the builder blocks the apartment in your name for a period of one month. Anytime you can pay him Rs 10 lakhs and the apartment is yours.
Now before you can consult with your family you find out that Shahrukh Khan, Aamir Khan, Salman Khan, Kajol, Rani and Preity Zinta have all ended up buying flats in the same building where you have blocked your apartment. This has caused a lot of excitement amongst people and the demand for the apartment you blocked has gone up.
In fact you have fans offering you Rs. 15 lakhs for the same apartment. You have blocked the flat for yourself at a price of Rs. 10 lakhs. This means if you sell the flat you will make a profit of Rs. 5 lakhs. However you have not invested Rs. 10 lakhs but only Rs. 10,000 to block the flat in your name.
You decide to sell the flat at Rs. 15 lakhs. From that you give the builder Rs. 10 lakhs and keep the remaining Rs. 5 lakhs for yourself. This means you have invested Rs. 10,000 and in return got Rs. 5 lakhs in a period of less than a month.
This is a very simple example which try to help understand how options work. Your maximum risk in the above case was Rs. 10,000 but maximum profit potential was unlimited. Unlike futures where the risk can be more than the capital invested.
The above example can be called a “Call Option”. This type of option increases in value when things go in the positive direction. If you buy a call option for the NIFTY, it will rise as the NIFTY rises. In the stock market too options can be used as tools to minimize risks as well as trading tools.
Options can be traded in a similar way like stocks. For instance you can tell your broker to buy a call option if you are bullish or alternatively you an tell him to buy a put option if you are bearish.
Even though I know how they work and I know the basic theory behind it, I have professionals handle them for me. Options need you to be more aware and alert about things happening in the short term and I have trained myself over time to be a long term investor. Very few people can do both trading and investing together. Rakesh Jhunjhunwala is one of the few rare people who does both successfully.
You can usually find a professional options trader to handle everything with the lowest capital base being of Rs. 5-8 lakhs with a profit sharing percentage of 30-35%. So if you get a profit of Rs. 1 lakhs on an investment of Rs. 5 lakhs. You would need to pay around Rs. 30,000 to your trader, so your profit would be Rs. 70,000. However please remember that even though returns can be spectacular, the losses too can be high. The maximum loss that can be made is you losing the entire amount you have invested.
Never let greed take control and always stay sane. I have seen Option traders make amazing amounts of money, however with time a few of them become over confident and greedy and end up losing whatever they had made. I will share more details regarding options in my future posts as I find that it is one area still several people are unaware of.
Aniket Waghmare also shared some interesting details on options here. Rediff also has a fairly exhaustive article on options here. Spend some time trying to learn and understand things better. It always helps.
Irrespective of whether you trade in options, invest or run a bank too much greed is never good. I would suggest all of you look at the results of companies which just came out in the past few days and look at the currency losses incurred by a few. These aren’t too good and one of the reasons for these losses are aggressive people blinded by greed. A major private sector bank in India has made huge losses due to this, and the only thing to blame is greed and a lack of knowledge.
Stay calm, sane and smile. It is great to be aggressive and ambitious, but at the same time be sane and have the knowledge to fuel the aggression and ambition.
Happy wealth creation!