Business Today

The right option

As markets zoom higher, volatility increases and so does risk. But options offer a hedge against risk.

By Nitya Varadarajan        Print Edition: July 1, 2007

Worried about stock market volatility? Concerned that a downturn in the stock market will wipe out your gains? Well, worry not. A simple hedging strategy in the stock market could save you lots of money. Despite the seemingly rocket science-like appellation, options are a lot easier to understand and use than rocket science itself. And thanks to the rapid use of them, investors can protect their portfolio for a fraction of the cost.

 

Of late, the volumes in the futures and options segment have increased to more than three times the turnover of the regular cash market. For regular long-term investors, a continuous use of options purely for hedging could become an expensive affair. Yet, once in a while, when market forces are aligned on the downside, these can turn into handy hedging tools. Here's a primer on options.

What are Options?

But before you go on to hedge that risk, what really are options? True to its term, stock market options essentially give you an option to buy or sell a stock or index like Nifty at a pre-determined price. You don't have to compulsorily buy or sell. In stock market lingo, you are not obligated to buy or sell. You can back out of the deal at expiry. Since all option contracts have to be settled at one time, they have a pre-determined expiry date. In Indian markets, there are one-, two-, and three-month expiries on options. Not all of them are liquid, though.

Options expiring earlier are traded more frequently than ones of longer duration. Besides, index options, which are derivatives of indices such as Nifty, are more liquid than individual stock options, which are essentially derivatives of individual stocks. For investors, hedging with options provides an alternative solution to otherwise liquidating a portfolio. Says P.L. Lakshmanan, Proprietor, Prognosis Consultancy Services, a boutique stock broking firm: "For the retail investor, options are better as they cater to a variety of requirements."

What's your option?

A primer on the world of options. 

Call option:
A contract that gives the investor the right (but not the obligation) to buy a stock or index at a specified price within a specific time period

 
Amitabh Chakraborty
Amitabh Chakraborty
President (Equities)/ Religare Securities:
"People with idle assets, who have no intentions of selling the same, could write an out-of-money call option"
  


Put option:
A contract that gives the investor the right (but not the obligation) to sell a specified amount of a stock or index or an underlying security at a specified price within a specified time. This is the opposite of a call option

European option: This is an option that can be exercised only at maturity. You must ride the volatility of the market. All the index options trading in India are European options

American option: This one can be exercised anytime during its tenure. All company-specific stock options trading in the country are American options

Strike price: It is the price of the option fixed by the exchange for a specific underlying asset such as Nifty. It could be higher, lower or equal to the spot market price of the same. Typically, there are many options with different strike prices

Premium: It's the price at which the underlying option is traded in the market
 
The Option Advantage

How do options help? 

  • Options have slightly low risk, as the outcome is pre-determined

  • Help in effective trade management as they discipline trading due to expiry

  • The option prices have a low initial cash outflow

  • They also help harness the power of leverage and get more exposure for less

  • When can you use it?

 

  • If you want to speculate with low risk

  • To manage portfolios effectively

  • When you want downside protection with buying put options

  • When you want to invest in stocks without risking entire capital

What is strike price?

But what one must remember is the strike price. A strike price is fixed by the exchange for the underlying asset of the option which could be higher, lower or equal to the spot market price of the same. These would be favourable to the buyer (in the money) if the current market price is higher than the strike price; not favourable to the buyer (out of money) if it's lower, or neutral (at the money) at the same level.

Who is writer?

If you have to buy, say, a call option, someone has to sell it. These sellers are called option writers. This is a very risky exercise and usually high networth or financial institutions use this tool as it can lead to unlimited losses. Option trading is possible between the 'writer' of the option or the seller and the 'buyer' of the option. Premium is paid by the buyer to the 'writer' or seller.

What is a call option?

There are two types of options: call and put options. In the former, the buyer has the right but not obligation "to buy" an agreed quantity of shares from the seller before the expiry date at the strike price for a premium that is market driven. Should the buyer decide later, the writer or the seller is obligated to sell. Buyers make money if the stock price increases more than the premium paid. On the other hand, if the spot price falls below the strike price, the buyer of the option will not be bound to exercise the option, but he forfeits the premium. Calls are bought when the underlying index or stocks are expected to go up.

What is a put option?

On the flip side, in a put option a buyer expects the stock market to go down. Here, the buyer is given the right (by paying up a premium) but not the obligation to sell the option on or before expiry date. The writer is obligated in "buying back" that option at the strike price if the buyer chooses to exercise his option. In this case, the buyer benefits if there is a substantial drop in spot price of the asset against the strike price. So when he is exercising his option, he buys the stock at a lower price in the spot market after factoring his premium, and sells it at the 'contracted strike rate' to the writer, pocketing the profit.

How do writers profit?

 
P.L. Lakshmanan
P.L. Lakshmanan
Proprietor/ Prognosis Consultancy Services:
"For the retail investor, options are better as they cater to a variety of requirements"
  

There are various ways in which a seller or writer can profit. If he expects the price of an asset to fall, he could place a "call" option. He gets a premium and gets to cushion his asset at the strike price. The premium which is paid upfront is his profit, provided the market does not move upwards and the price crosses the premium paid over and above the strike price. After this point, the seller makes a loss, which could be unlimited.

Some high networth individuals try and profit from this if they have idle assets by writing or selling calls with a strike-price that is way above that of the market. "People with idle assets, who have no intentions of selling the same, but desirous of generating some returns out of them, could write an out-of-money call option," says Amitabh Chakraborty, President (Equities), Religare Securities.

When is a put option Profitable?

  • Puts are profitable when the current market price falls below the strike price 

  •  You break-even when you recover your premium from the fall in current market price
     
  •  You lose the premium when the current market price is higher than the strike price 

  •  Loss is restricted to the premium paid  
     

When is a Call option profitable? 

  •  A call bought by you makes money when the current market price goes above the strike price

  • The current market has to go above your premium paid for you to break-even

  • You lose premium when the current market price is lower than the strike price

  • Loss is restricted to the premium paid   
     

The Hedge Strategy

How to hedge with Put options.

  •  When you buy a Put option, you get downside protection for a premium

  • If the market falls, the Put option becomes profitable

  • But if the market rises, you will lose the premium

  • Regular hedging is a costly affair and negates the gains made on the portfolio

  • Usually, most pros hedge only a part of their portfolios when there's extreme volatility

  • Buy Puts judiciously by looking at the premiums and how much it will cost you

If the writer expects the asset price to go up, he could place a 'put' option. If the price indeed goes up, he has his premium, and the buyer is unlikely to exercise that option. However, if the price goes down, and the buyer exercises his option, the writer's loss is to the extent the price has gone down, which could be substantial, wiping out the premium cushion, and more. He has to make good the difference between spot price and strike price to the buyer. Usually, writing options is very risky, as mentioned earlier, and is best left to the financial institutions or high networth individuals.

How to Gain?

On the other hand, if you expect the market to go up from the current levels, a simple strategy is to buy a call option. In case the market falls, at worst you lose the premium. But one gains if the market rises over and above the premium paid.

How to Hedge?

Retail investors can, however, protect their assets with a simple strategy. They can buy put options and cover the risk of the falling market. Simply put, when one buys a put option, one locks-in the portfolio at the current market. If the market falls, there's no loss on the side of the buyer. Usually, hedges such as this tend to be more costly in a falling market, but in a rising market, the cost of a put option tends to be cheaper. Of course, options have their risks, and it will cost you the premiums. So if you hedge all the time, you continue to lose premiums. But when the downturn comes, you will have saved yourself a bundle.

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