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A financial instrument known as a “chooser option” allows investors to select between two alternatives at a future date. Call it an “option on an option” or another exotic option type that allows the investor to exercise their right to purchase or sell the underlying asset later.
When using classic options, investors must choose whether to purchase or dispose of the underlying asset upfront. With chooser options, on the other hand, investors can select the option that would yield higher profits based on the state of the market. To know more about the chooser option, read on to: –
Chooser Option Meaning
As you are already aware, an option gives its holder the right to purchase or sell the underlying asset at the strike price at a later time. When the contract expires, the option holder has the choice to either exercise or disregard it. Whereas a put option permits you to sell the underlying asset on the expiration date, a call option grants you the right to buy the underlying asset. You can then buy a call option or a put option separately. A chooser option, which can be converted into a call or put option, is another product available to investors.
It provides investors with much-needed flexibility. Before it expires, it can be converted into a call or put option. Decisions must be made before the expiration date. It is impossible to see the flexibility provided by standard options and futures. However, their greater versatility makes them more expensive than conventional options. The put and call expiration dates are the same as those in the chooser option.
How does a chooser option work?
Let’s look at a situation where you have a chooser option on stocks of a particular company, say XYZ Ltd., which is now trading for ₹ 100 per share, to understand better how a chooser option operates. Assume that the call option has a strike price of ₹ 110, the put option has a strike price of ₹ 90, and the expiration date is in six months.
The stock price has risen to ₹ 120 per share in six months, and the market is bullish. In this case, you may prefer the call option to purchase shares at the discounted price of ₹ 110 instead of the stock’s ₹ 120 price. As a result, you receive ₹ 10 for each share you buy.
Now, you could exercise the put option, which enables you to sell the shares at its strike price of ₹ 90, which is higher than its then-market price, if six months from now, the market becomes negative and the stock price drops to ₹ 80 per share. You can, therefore, control your losses by using the put option.
Conversely, you may elect not to exercise any options and allow the contract to expire if the stock price stays steady and doesn’t fluctuate much.
Advantages of chooser option
Here are some of the benefits of chooser options: –
- Flexibility on offer
This is the chooser option’s most significant benefit. It provides you with the needed flexibility to adapt to the state of the market. Though no one can forecast the future behaviour of markets, owning a chooser option enables you to profitably and profitably manage your position.
- Build diverse strategies
You can create various strategies with a chooser option to fit your risk-reward profile. Giving you the option to select before the contract’s expiration date gives you more time to evaluate market trends and adjust your plan of action.
- Effective risk management
A knowledgeable investor understands the fine art of risk mitigation. Using a chooser option, you can reduce the risks of trading options. You can move from a call to a put option and vice versa based on the state of the market.
Cons of outright option
The chooser option has certain disadvantages in addition to its benefits. Among them are:
- More expensive than single options contract
A chooser option does not provide you the option at no cost. It costs more, which means that compared to a single options contract, a chooser option is more expensive. You could have to pay more significant premiums than regular call and put options.
- Complex to implement
Implementing a chooser option can be complicated, mainly if you are unfamiliar with options trading. This is because having to make judgments later may generate confusion and errors that could negatively impact your earnings.
- Potentially missed opportunities
Mistakes in selecting the incorrect option (call or put) may result in lost chances. The state of the market can shift quickly and dynamically. Delaying making a choice may result in lost opportunities to make money.
Why might investors choose to use chooser options?
- Risk Management: Chooser options allow investors to manage their risk exposure by allowing them to choose the type of option based on market conditions. This can be particularly useful in volatile markets where it may be difficult to predict the market’s direction.
- Tailor-Made Investment Strategies: Investors can create customised investment strategies with chooser options. They can exercise a call option if they are bullish on the market or a put option if they are bearish, depending on their risk appetite and investment goals.
- Cost-Effective Hedging: Chooser options can be used as a hedging tool to protect against potential losses in an underlying asset. For example, if an investor holds stocks that may decrease in value, they can exercise a put option and limit their losses.
- Opportunity for Higher Returns: With the added flexibility of choosing between two different options, chooser options can provide higher returns compared to traditional options. This is especially true if the market moves to the chosen option at expiration.
- Diversification: Adding chooser options to an investment portfolio can provide diversification and reduce overall risk. By having the ability to choose between a call or put option, investors can benefit from different market conditions and potentially offset losses in other areas of their portfolio.
The Bottom Line
Investors can select between a call and a put option at a later time with chooser options, a special kind of financial instrument. Although they provide more excellent investment strategy options, they also have additional fees. Despite their drawbacks, many investors still regard chooser options as a viable tool for profit-making and risk management.
FAQs
Imagine you wish to sell a barrel of wheat in three months but are concerned that the price may drop. You agree with a possible buyer that they will purchase your wheat barrel from you three months later at a predetermined price of X to hedge this risk.
Chooser option payouts are calculated using the same fundamental process as a standard call or put option. The distinction is that the investor can select the exact payout they want depending on whether the put or call option is more advantageous after expiration.
One advantage of chooser options is that they offer more flexibility in investment strategies, allowing investors to hedge against market volatility.
Yes, one downside is that they are generally more expensive than traditional options due to their added flexibility.
A call option gives the holder the right to buy an underlying asset, while a put option gives the holder the right to sell an underlying asset.