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Ride the rough times

Options and futures can help you ride out the market’s volatility—and also profit from it.

Nitya Varadarajan | Print Edition: May 18, 2008

An Inflation scare in China or a rate hike in Japan can send stock prices tumbling in India. In an increasingly integrated global financial world, events like these have become common and trigger waves of panic selling.

Consequently, stock markets have become volatile—and there is no telling which way the tide will turn. Therefore, in today’s volatile market, it’s important for investors to ride the rough times and, where possible even, profit from them.

 Tools of protection

How futures and options work in a volatile market.

  • Two- or three-year options are a reality and could prove useful for the long-term investor

  • A long straddle, or a long strangle are good options to use in a volatile market

  • Learn the art of arbitraging.buy in the cash market, short-sell in the futures market

  • Due to intra-day volatility, there is a danger of a stop-loss trigger first in the cash market. Therefore, choose an option where the strike price premium equals the stop-loss. This will not only limit the losses but gives an opportunity to stay in the market and gain from the rise

  • Hedge about 60 per cent of your portfolio using Nifty futures, instead of averaging in the cash market
Sandeep Singal, Co-head, Institutional Derivatives Business, Emkay Share and Stock Brokers, has a novel suggestion for the riskaverse investor, and it is similar to a structured finance product fund houses are coming out with. If you have capital of, say, Rs 2.5 lakh, you can put Rs 2,12,500 in a bank fixed deposit, which will give a rate of return of about 8.5 per cent. This will ensure that the capital grows back to Rs 2.5 lakh over two years.

With the remaining Rs 37,500 you can buy long-dated (up to three years) option contracts. Says Singal: “Investors can buy option contracts (up to three years) on the Nifty, which SEBI has allowed,’’ he says. This will allow them to take a shot at the market over the long term, and also ride out the volatility.

Insure against volatility

Monal Desai, Vice President and Head of Institutional Equity Derivatives, Prabhudas Lilladher, recommends a different strategy— essentially a hedge to counter the market’s downside. “During selling sprees, if the investor holds stocks that trade in the futures and options segment, he can sell futures or call options, or buy a put option.

This is like buying insurance in a falling market.” Although hedging comes at a cost, for some investors, it can work better than averaging in a falling market. Suresh Kumar Iyer, Technical Analyst, Asit C. Mehta Investment Intermediates, agrees: “The medium- to long-term investor can hedge his portfolio by short-selling Nifty futures up to 50-60 per cent of his portfolio rather than averaging his purchase price stocks till a clear trend emerges or some reversal takes place.”

Another option is to use a covered call strategy if you are already holding a stock trading in the futures segment. A short-term neutral to bearish view on a stock you hold but don’t want to sell can fetch you premiums if you sell call options. This will reduce your cost of acquisition.

However, option sellers take a risk— they have to comply if buyers choose to exercise the option. But selling out of the money call options is your way out, as buyers will not exercise their option if the strike price is higher than the spot price.

 The future zone

What is the difference between futures and options?

  • An option gives the buyer the right but not the obligation, while the seller has an obligation to comply with the contract. In futures, both the buyer and seller have an obligation to honour the contract

  • A call or put options can lapse,
    but if you choose to exercise it, the counter-party (seller) must comply. A futures contract, on the other hand, is binding on both buyer and seller and it has to be settled on or before the expiry date

  • The purchase of a futures contract involves a larger cash outflow than options, where one pays the premium

  • A futures contract carries unlimited profit and loss potential, whereas the buyer of a call or put option has limited losses but unlimited profit potential

  • Futures are a favourite with speculators and arbitrageurs, while options are widely used by hedgers

Sandeep Singal, Co-head, Institutional Derivatives Business Emkay Share & Stock Brokers
Sandeep Singal
Another solution that works for investors is arbitrage. Says Desai: “As futures are short-term instruments, prices in the cash and futures market coincide on the day of expiry. Transactions can be offset in the cash and futures market. Buy in the cash market and short-sell futures at a higher price than your cash market purchase. At the time of expiry, sell the stocks in the cash market and buy the futures you sold earlier. This technique allows you to take advantage of any mis-pricing in the cash and futures market.”

One strategy that probably sounds like rocket science but is quite simple is going in for long straddles or strangles, as they are called. It works well in a volatile market, particularly when an investor is not clear about which way the market will move. In a long straddle, an investor buys both put and call options on the same stock at the same strike price that expire at the same time.

The investor makes a profit if the security moves either up or down, but after accounting for the option’s cost price. It works best if you think the market is highly volatile, but don’t know where it’s going.

Similarly, in a long strangle an investor buys both a put and a call option, but unlike a long straddle the options are bought at different strike prices. Says Anand Kuchelan, Senior Analyst, Derivatives Strategy, PINC Research: “A long strangle is created when calls and puts are bought at different strike prices.”

Investors can make money in a highly volatile stock, if the underlying stock moves significantly. At the most, an investor will lose the cost of the premiums, if there’s no movement in the stock. If for example, the current Nifty is ruling at 4,750, one could buy a 4,600 put @ Rs 45 and a 4,900 call @ of Rs 55.

The strategy becomes profitable if the Nifty goes below 4,500 or above 5,000, after including the option costs. All in all, investors have reaped benefits in a volatile market —all it takes is a bit of gumption. “For these strategies, a view is needed, but not the direction,” says Iyer. Rightly so.

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