Options – The basic framework
Question: What are Options?
Answer: Options are derivative products which, if you buy, give you certain rights.
Question: What kind of rights?
Answer: Call Options give you a right to buy a share (at a certain specific price), while Put Options give you a right to sell (again at a predefined price). For example, if you buy a Satyam 240 Call Option, you are entitled to buy Satyam shares at a price of Rs 240 per share. This specific price is called as the strike price or the exercise price.
Question: What do I pay for obtaining such rights?
Answer: The cost you pay for obtaining such rights is the premium (also called price or option value). In the above case, if you had paid Rs 20 for the Option, that would be the premium.
Question: So do I actually get Satyam shares?
Answer: Most of the time, you do not even intend to buy Satyam shares. The option itself has a value that keeps fluctuating with the price of Satyam shares. For example the Satyam share price may have been Rs 242 when you bought the Call Option.
You expect Satyam price to rise. You accordingly bought the Call (instead of Satyam itself). Now if Satyam rises to Rs 270 (in 10 days time), you will find that that the Call would also have risen in price from Rs 20 to Rs 35. In that case, you would simply sell the Call for Rs 35. You would have made a profit of Rs 15 on the Call itself without getting into Satyam shares themselves.
You can get Satyam shares (through the Call) if you want to, but that we will discuss later.
Question: So when should I buy a Call?
Answer: You should buy a Call when you are bullish.
Question: Why should I not buy the share itself?
Answer: Well, you can. But in Options you will earn more. Take the above case. If you buy Satyam shares at Rs 242 and sell Satyam at Rs 270, you will make a profit of Rs 28, a 12% return. Now if buy the Option at Rs 20 and sell at Rs 35, you have earned 75% return.
Your view is on Satyam in both cases, for the same period of time and you earn far more in Options.
Question: What if my view is not correct?
Answer: Here again, Options are very useful. If your view is wrong, you will find that your Option value will decrease, as Satyam share price decreases. For example, you will find that the Option value is only Rs 10 if Satyam drops to Rs 225. In that case, you will sell off the Option at Rs 10 and bear the loss.
If you had bought Satyam, you would have lost Rs 17 per share, while here you lose only Rs 10. It is however higher in percentage terms.
If Satyam drops all the way to Rs 200, you will find that your Option carries virtually no value. Here again, you would have lost Rs 42 per share in Satyam. But in Options, your maximum loss will be Rs 20, i.e. the amount you paid for buying the Option.
The biggest advantage of Options is that your maximum loss is limited to the Option Price you paid. Hence, you have limited losses but unlimited profits as a buyer of Options.
The accompanying graph is very useful in understanding the profit / loss possibilities of an Option. The X-axis shows the price of Satyam and the Y-axis indicates the profits or losses you will make.
How can I enjoy such a wonderful profile of limited losses and unlimited profits? I mean, somebody must be paying for this, isn’t it?
Well, you are right. That somebody paying for this is the Option Seller (also called the Option Writer).
Question: Why does he pay for unlimited losses?
Answer: The Option Writer is usually a skilled market player with indepth knowledge of the market. He is willing to take unlimited risk in return for a limited profit. The premium you pay is his limited income, but if his view is wrong, he will pay you for the unlimited profits you might make.
In the above case, if Satyam share price rises the Option Seller will lose Rs 15 (he would have sold you the Option at Rs 20 only to buy it back at Rs 35). If Satyam rises further, the Option value will also rise and his losses will be that much higher.
Question: When will the Option expire and what happens on expiry?
Answer: Options will (like Futures) expire on the last Thursday of every month. On expiry, your Call Option will be settled based on the closing price of Satyam. For example, if Satyam share price was Rs 281 on the last Thursday, you will be paid Rs 41, i.e. the difference between Rs 281 and your strike price of Rs 240.
Your net profit will be Rs 21, i.e. Rs 41 that you receive on expiry less the Rs 20 premium that you paid for purchasing the Option.
Question: Who will pay this difference of Rs 41?
Answer: The Option Seller/Writer will pay this difference of Rs 41 to the exchange which will pay your broker who will pay you.
This settlement is called automatic exercise of the Option.
Question: What if the price of Satyam on the last Thursday is below Rs 240?
Answer: If Satyam closes at say Rs 237, you will receive nothing. In that case, your loss will be Rs 20 (your premium) which the Option Seller would have earned as his income.
Question: Can I also exercise before the expiry date?
Answer: In case of stock Options (31 stocks currently), you can exercise your Option on any trading day. You will receive the difference (if you are holding a Call Option) between the closing price and your strike price. Such Options which can be exercised at any time are called American style Options.
In case of index Options (2 indices currently), you can exercise only on the last day. These are called European style Options.
Question: Are American style Options more useful / flexible?
Answer: Yes, but only partly. The advantage of anytime exercise is useful for Option buyers. However, in practice, exercise is rare. You will find that it is more profitable to sell an Option (having bought it earlier) rather than exercise.
You will often receive more by sale than by exercise. If you are waiting in the Ground Floor of a building and want to go to the 21st floor, you have two Options – one – take a lift and – two – take the stairs. Which will you prefer? Obviously the lift. In a similar manner, having bought an Option, you can exit in two ways – one – sell the Option and – two – exercise the Option. More than 95% of buyers will sell the Option.
Question: So when should I exercise?
Answer: You will take the stairs only when the lift is not working. In a similar manner, you will exercise the Option only when the sale possibility is not working. If the market is illiquid and you find that there are no trades happening, you may try to exit through the exercise route.
How do I use put options?
Question: How do I use Put Options?
Answer: You would, in most circumstances, think of buying Put Options when you are bearish about a scrip. For example, if Satyam is currently quoting at Rs 262 and you are bearish about Satyam, you would buy a Put.
Question: What would happen when I buy a Put?
Answer: You would first decide a certain strike price, say Rs 260. It would carry a premium as quoted in the market, say Rs 11. When you buy this Put, it gives you a right to sell Satyam at the strike price of Rs 260. Thus, if Satyam were to go down to Rs 235 at expiry time, you can still sell Satyam at Rs 260 (your strike price).
Question: Do I need to have Satyam with me in the first place?
Answer: At the moment, transactions in Options are cash settled. Hence, you do not need to possess Satyam to buy Satyam Puts.
Question: What is the meaning of Cash settled?
Answer: Cash settled means the difference between the strike price (Rs 260) and the market price on expiry (Rs 235) will be paid to you. In this case, you would earn Rs 25 per unit. As you are aware, the lot size for Satyam is 1,200. Hence, you would earn Rs 30,000 on expiry. After deducting the premium of Rs 11 per unit (i.e. Rs 13,200), your net profit will be Rs 16,800.
The cash settlement process applies to calls as well.
Question: Is there any other kind of settlement?
Answer: Yes. There is delivery based settlement, which is expected to be introduced in India in the next 3 to 4 months. In that case, you, as a Put buyer, have to deliver Satyam on the day of expiry and you would be paid Rs 260 per share. Thus you would effectively make a profit of the same Rs 25 per share.
The physical settlement system would apply to calls as well. As a buyer of a call, you would pay the strike price and would get shares delivered to you at the strike price.
Question: What are Index Puts?
Answer: You would use Index Puts when you are bearish about the market as a whole. Thus you would buy Nifty Puts or Sensex Puts and if the market actually moves down, you can pocket the difference.
Question: How would these be settled?
Answer: Index Options (both Calls and Puts) will always be cash settled. Physical settlement of the index itself is impractical.
Question: How else can I use Put Options?
Answer: Apart from buying Puts on the basis of a bearish view, you can view puts as Insurance on shares. If you are already holding Satyam and you are nervous about Satyam in the short run, you should consider buying Puts on Satyam.
Question: I could sell the shares also?
Answer: Yes, you can sell the shares. But in many cases, your view could be wrong and you may find Satyam has actually up instead of down. In that case, having sold off Satyam, most people never buy it back at a higher price.
Secondly, there could be capital gains on such transactions.
Question: What happens if buy these Puts?
Answer: If Satyam goes down (as per your belief), you will find that your Put will generate a profit. This profit will compensate for your losses on Satyam. Let us take an example. The current price of Satyam is Rs 262 and you bought a 260 Put paying a premium of Rs 11. Satyam actually goes down to Rs 235.
You will make a loss of Rs 27 on Satyam shares and a profit of Rs 25 on Puts. Thus the net loss will be Rs 2. Adding the premium also, the total loss is Rs 13.
If Satyam actually goes up to say Rs 300, you will forget about the Put and write off the loss of Rs 11 on premium. In fact, you might even sell the Put at some low price of Rs 2 or so reducing your losses partly.
This strategy is called is ‘put hedge’.
Question: Which Puts should I buy?
Answer: At any point, several Puts will be quoted. You might find Satyam 300 Puts, Satyam 280 Puts, Satyam 260 Puts, Satyam 240 Puts and Satyam 220 Puts in the market. The higher strike prices will carry a heavy premium and the lower strikes will be cheaper.
If you buy lower strike Puts, your protection will start late. For example, if you buy a Satyam 220 put for Rs 3, you must be willing to bear losses till Satyam reaches Rs 220 (from the current level of Rs 262), i.e. Rs 42 per share.
If you buy a Satyam 300 Put (which might typically quote for Rs 50), your protection starts the moment Satyam quotes below Rs 300.
Question: So what should I do?
Answer: Consider this as a Mediclaim Policy. You can go for a higher coverage at a higher premium or low coverage at a low premium.
You should ask yourself the following questions:
What is the probability of Satyam going down to that level?
How much loss am I willing to bear myself?
How much value for money do I see in the premium?
What if I hold shares other than the 31 Scrips on which derivatives are allowed?
If you hold other shares, you should consider buying Index Puts if you are nervous about them. You would pay a similar premium for protection and make some profits if the market moves down.
Question: How much of Index Puts should I buy?
Answer: This is slightly tedious and you need to understand how your portfolio moves vis-à-vis the market index (say Sensex). The relationship between the two is called ‘beta’. Statistically the number is generally between 0 to 2. For example, if the beta of your portfolio is 1.2, it means your portfolio will move by 1.2 times the movement in the Sensex. If the Sensex were to move up by 10%, your portfolio will move up by 12%.
You should therefore work out the value of your portfolio and multiply it with the beta and buy Index Puts of that amount.
This will work out to be a good insurance.
There are more intricacies on Index Put insurance which institutions holding large equity volumes might consider, but for a retail investor, this strategy is generally good.
You should however note that your protection might not be as precise as in the case of individual stock Puts, as the past beta may not exactly match with future beta. You should, in my opinion, be happy if you are able to cover even 80% of your losses.
We have discussed Option Buying (Calls and Puts). In our next article, we will discuss Option selling which is high risk and more exotic.