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Not much option for lay investors

This so-called self-teaching guide to the derivative markets is too dense for the lay reader and hardly demystifies the complex world of options.

Babar Zaidi | Print Edition: December 13, 2007

An option is an investment avenue that offers investors unlimited gains at limited risks. If the option call proves correct, the buyer makes a killing. If not, he loses only the premium he paid on the contract.

Options demystified
OPTIONS DEMYSTIFIED
Price: Rs 295
Pages: 252
By Thomas McCafferty
Published by Tata McGraw-Hill

Ever since derivative trading started in India in 2001, it has grown in leaps and bounds. So much so that today more money changes hand on the futures and options markets than in the cash segment of the stock market.

But options are very specialised investment products and one needs to do a lot of homework before stepping into this high-risk arena of leveraged buying. Therefore, any book that explains how options work and tells you how to use them to your advantage is more than welcome.

That’s why I picked up Thomas McCafferty’s Options Demystified hoping to convert my tentative knowledge and overbearing fascination with the concept of derivatives into a wealth creating opportunity.

The author first introduces readers to the concept of an option, explaining how the derivative gives the buyer the right to buy the underlying stock or index. Using charts to show how “calls” and “puts” work, he points out that “call option contracts offer bulls unlimited opportunities to gore the market profitably while put option contracts sharpen the bears’ claws to rip out opportunities that can break the bank”.

However, stock and index options are not the only derivatives dealt with in this book. Several other types of options, many of which are not available in the Indian markets, also find place in it. Real estate options, for instance, are only there in the informal property market.

THE RISK PYRAMID
NAKED SHORT SELLING: Short selling an option when you don’t have the underlying stock. If you sell a “call” and stock price goes up, loss is unlimited.
STRADDLES: Buying a call and a put option of the same strike price. If index or stock price moves in any one direction, loss from one will be offset by the profit from the other. If no movement, you lose the premium of both.
SPREADS: Purchasing an option of the next month against the sale of a similar option of the current month. If price falls, your loss is contained because you have sold as well. If it rises, you have also bought the next month’s option. Works in puts as well.
COVERED OPTIONS: Buying an option when you have a futures position or have the underlying shares. The option hedges the risk in the cash and futures market.

The bayana or earnest money you pay to buy a house is nothing but a real estate option, though it is one that works both ways. The reader is introduced to stock and index options only in the third chapter. The chapter on currency options may prove useful as last fortnight, Sebi proposed the introduction of currency options in India.

McCafferty has an engaging style and keeps the language conversational, though some chapters tend to be boringly lengthy. The short tests at the end of each chapter are interesting. At the end is a final exam of 50 questions.

The chapter on “Some Advanced Concepts” is useful. It tells about various combo strategies in which options can be used to hedge risk and maximise gains. For instance, if someone has taken a long position in the futures market or is sitting on a huge unrealised profit, buying a put option can help reduce the risk. In case the stock price slips, his loss in the cash or futures market will be offset by his profit from the put option.

This is also why the book has limited relevance to the Indian reader. The book cites US rules, regulations and tax laws. One would have expected that the Indian edition cite local tax laws and regulations.

For instance, the difference between American options and European options is dismissed in the space of three sentences. “American style options are excercisable any time prior to the expiration date. European style options permit the trader to exercise them only at the expiration date, not before. Some European style options are sold on US exchanges, so just be alert.” For a newbie trying to find his way around in the derivative maze, such a fleeting reference hardly explains the implications of this crucial difference.

Moreover, Indian readers should have been told that index options on the National Stock Exchange are European while stock options are American. You can exercise a stock option on any trading day but an index option can be exercised only on the date of expiry.

The book’s title too is misleading. This is not a book that can educate the lay reader about options. McCafferty does attempt to explain the basics but the message gets lost because there are not enough tables and charts to complement the text.

For a book that is meant to be a “self-teaching guide” for investors, there is just too much of text and too few graphs and charts to demystify this complex instrument. In fact, the real demystification happens when some terms are explained in the appendix.

But the book is not about options alone. It covers the futures market as well. This again is a lengthy treatise on leveraged buying without any tables and charts coming to the aid of the uninformed reader. Then there is a section on fundamental and technical analysis. There is also a chapter on various investor personality type.

Interesting, but what has that got to do with option trading? Maybe the book should be renamed “Everything I wanted to write about stock markets… but didn’t know where to stop”.

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