Chooser option: What it means, its benefits and drawbacks
A chooser option allows you to decide between a call or put option before the expiry of a contract. While it offers flexibility to take calls depending on prevailing market conditions, it is more expensive than a single options contract.
Imagine you want to buy a new car a year from now. However, you are unsure if you want to buy a sedan or an SUV. You go to the car dealer who offers you the option to select the type of car when you need it in the future. Doesn’t this flexibility provide you with peace of mind as you know you can choose between the two different car types when the time arrives?
Similarly, in the financial world, a chooser option allows you to choose between the call or put option before the expiry date. In options trading, a call option gives you the right (but no obligation) to buy shares at a predetermined price, also called the strike price.
On the other hand, with a put option you have the right (but no obligation) to sell shares at the strike price.
How does a chooser option work?
To better understand the working mechanism of a chooser option, let’s consider a scenario where you have a chooser option on a certain company’s stocks, say company XYZ Ltd., currently priced at INR 100 per share. Suppose the expiry date is six months from now, and the strike price for the call option is INR 110, while for the put option, it is INR 90.
Suppose the market is bullish six months from now, and the stock price has increased to INR 120 per share. In this scenario, you might want to exercise the call option that allows you to buy shares at INR 110, which is lower than the stock’s price of INR 120. Thus, you get a benefit of INR 10 on every share purchased.
Now, if six months from now, the market has turned bearish and the stock’s price drops to INR 80 per share, you might want to exercise the put option that allows you to sell the shares at its strike price of INR 90, which is higher than its then market price. Thus, with the put option, you can limit your losses.
On the other hand, if the stock’s price remains stable and doesn’t show any significant movement, you can choose not to exercise any option and let the contract expire.
Advantages of having the chooser option
Now that you know the meaning and working mechanism of the chooser option, let’s understand its various benefits.:
Flexibility on offer
This is the biggest advantage of the chooser option. It gives you the much-needed flexibility to adjust to the prevailing market conditions. Nobody can predict how markets will perform in the future, but having a chooser option allows you to adjust your position accordingly, make profits, and limit losses.
Effective risk management
An intelligent investor is one who knows the art of risk management. A chooser option allows you to mitigate the risks associated with options trading effectively. Depending on the market environment, you can switch from a call to a put option and vice versa.
Build diverse strategies
A chooser option allows you to build a range of strategies to suit your risk-reward profile. By allowing you to choose before the contract’s expiry date, you get more time to analyse market developments and make decisions accordingly.
Drawbacks of the chooser option
While the chooser option has its advantages, there are some drawbacks too. These include:
More expensive than single options contract
The choice that a chooser option offers doesn’t come for free. In fact, it comes at a premium. A chooser option is more expensive than a single options contract. You might need to pay higher premiums compared to standard call and put options.
Potentially missed opportunities
Failure to choose the right option (call or put) can lead to potentially missed opportunities. Market conditions can change dynamically and rapidly. Waiting to make a decision can lead to missed chances of earning profits.
Complex to implement
Implementing a chooser option can be a little complex, especially if you are new to options trading. This is because the need to make decisions later can lead to confusion and result in mistakes that can adversely affect your profits.
Summing it up
While a chooser option has certain limitations, there’s no denying that it’s a powerful tool that allows you to make profits, hedge risks, and adapt to changing market conditions. If you seek versatility in options trading, a chooser option is a potent tool in your arsenal.