BAJAJ BROKING
August 20, 2024
6 mins read
There are various investment techniques and strategies that are framed to reduce risk and bring ease to investors and traders. A basket option is an investment technique which is fundamentally rooted in the concept of options trading, where traders have a right, though not an obligation, to buy or sell an asset at a predetermined price.
Read on to explore in detail what is basket option, its types, benefits, characteristics and the challenges that it can pose to a trader.
A basket option is a trading technique which lets traders buy or sell the underlying asset at a specific price, by or before the stipulated time period. Here the underlying asset is a group or basket of securities, commodities, or currencies. Though the basket option gives the trader a right to buy or sell the basket before the stipulated time, it does not make it an obligation on the trader.
The basket option comes with lots of advantages for traders including the element of cost-efficiency as trading costs are considerably reduced. There is also reduced risk as multiple assets are clubbed into being a single asset, thus providing a hedge against losses.
The working of a basket option is mainly based on a common trading procedure with a few alterations that eventually sets it apart. Here is all you want to know about how basket option works:
First you would need to thoroughly research the financial derivatives available on the Indian stock market and then select the stocks, bonds, currencies, commodities that you want to buy or sell. This you should do keeping in mind your investment objectives.
You then need to place the selected contracts in a basket, and henceforth they will be treated as a single investment product. You can customise it as a commodity basket option, or a currency basket option, or an equity basket option.
You would then need to inform the stock broker, via app or website, about the selection of your basket option, and proceed with the completion of form.
Once you want to trade in Basket Options, you will have to decide which type of basket options you want to select for your investment. There are several types of basket options which you can create. Here are some basic types of basket options.
Equity basket option
This basket option is made up of shares of different companies that belong to a single sector, such as energy, or technology, or large-cap companies.
Currency basket option
This basket type is made of currencies of different countries.
Commodity baskets option
As is evident from its name, this type of basket option is made of assets belonging to the commodity sector, like rice, cotton, gold, oil, or steel.
Cross-asset basket options
This basket type is made by clubbing together assets belonging to different classes and sectors, but are tied together by some common feature.
The key characteristics of the basket option is that it is an efficient method to manage the risk across multiple assets. In technical terms, the basket option has an excellent hedging effect. This is because multiple assets in the basket tend to balance each other, thus lowering the risk of loss.
Other key characteristics of basket option include:
Since basket options can be customised, they can be made to meet the financial objectives of the investors.
The trading charges in case of basket option are on the lower side as multiple assets are considered to be a single investment.
There is a similarity between basket options and traditional options and both can be purchased as call options and sold as put options.
Liquidity can be an issue if the investor wishes to close the investment before the stipulated time.
Basket options is an investment technique which comes with loads of benefits. Some of the key benefits that make basket option an attractive strategy for investors are listed below:
Offer of diversity: As investors can handpick and select different assets from within sectors or classes, it provides them with a diversity in investment.
Risk Management: There is a reduced risk of loss in the basket option trading as investing in different assets creates a hedge. In other words, by investing in different assets, the loss is balanced between loss-making asset and profit-making asset.
Flexibility: The basket options trading provides investors the flexibility to choose and build a basket of assets, thus providing an opportunity to gain from the collective performance of multiple assets and increase the potential for profit.
Cost saving: Since the basket option lets a trader purchase multiple assets but involves only one trade transaction, it becomes a cost-efficient trading method.
An investor would first need a trading and a demat account if intending to trade in basket options. Then the process is similar to any other trading process. In the case of basket option, a trader would require to select different assets from within or across sectors and classes. The investor is then asked by the stock broker, via app or website, to complete the formalities, which may include registration, filling of details, and submission of fee or premium. Then the trade is confirmed.
Now that you know all about what is basket option, here are the differences between basket options and traditional options so that you would be able to distinguish between the them with ease:
Basket Option | Traditional Option |
This is not an investment product in itself, rather it is an investment technique in which various assets are clubbed together into a single investment. | This is an investment product in which a trader agrees to buy or sell an asset at a specific price by or before the stipulated time. |
It involves multiple assets from within or across sectors and classes. | It involves a single asset. |
The risk is reduced here as investing in multiple assets creates a hedging effect. | The risk is considerable as the investment is made in an individual asset. |
There is a concern for liquidity as multiple assets are involved in the investment. | The liquidity is of limited concern as only individual investment is in the focus here. |
The key challenge faced by the traders and investors in basket options remains that of liquidity. As multiple assets are part of the basket options, which will be having varying degrees of liquidity, it may become difficult to close or exit the trade before the stipulated time. This restricted liquidity is one of the major challenges of the basket options.
The other challenge that comes with basket options is that it limits the profits gained by the individual assets that are doing good and balances them with the losses suffered from the assets that are bearish. While this hedging effect reduces the overall loss and limits the risks, inversely this effect also cuts down the profit.
A basket option is a good way to diversify your investment portfolio and manage the risks. You must be fully aware of the advantages offered by the basket option to maximise the benefits offered by this strategy. At the same time, you must carefully weigh the risks and disadvantages associated with basket options, so you can invest according to your risk tolerance.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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A basket option is an investment technique which lets an investor create a basket of assets which are then treated as a single investment product. In the case of basket option, the underlying asset is the basket of assets which can be traded at a specific price by or before the stipulated time.
A basket option works on the two principles of:
Here, the underlying asset is the group of different assets which are considered one investment;
investor has a right to sell the basket on a specific price even before the stipulated time.
There are several benefits of basket options including reduced trading cost, hedging effect, and ability to customise the basket.
The different types of basket options include equity basket, commodity basket, currency basket, and crypto basket.
A basket option is made of different assets which are then considered a single investment product, however, a single-stock option is exclusively structured around one asset.
As basket option is made of multiple assets, it creates a hedging effect as the losses incurred from loss-making assets are balanced by the profit made by other assets.
The key risk associated with basket options is that of limited liquidity.
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