Use derivatives for protection

Stock options. A brave new world, the introduction of which in the capital markets has given investors a longer leash where their portfolios and trading strategies are concerned.

But not just flexibility and freedom, stock options have also changed the rules of the game drastically, which in other terms means a whole new learning experience for investors.

As an example of how the rules have changed, market gurus point out that even those who are familiar with the trading mechanism and understand the basic of these instruments will find it more challenging then ever.

So what to say of the people who are making a foray into the capital market for the first time. So, one is forced to warn the new comers that one needs proper education and also needs to exercise due caution while experimenting with these instruments.

Don't go in for the hardcore money spinners with multiple risks first. Start with simple strategies by taking position in the cash market and counter position in the options market.

In the good old days, a longer view on the market could be taken by resorting to carry forward mechanism, now the same objective can be achieved by taking a position in the derivatives market. Also, since a naked position in the cash market is vulnerable to unfavourable price movements, one can also cap returns and losses by judiciously taking positions in this segment.

For example, if an investor is bullish about a particular stock he can take a long position in the cash market. And in order to lock his gains at a particular price, he can take a long put option in the stock. Since the buyer acquires a right to sell, he pays option premium. In order to understand the risks and the gains involved in this new game let me give you an example.

Let's say that an investor buys HLL in the cash market at Rs125. In order to fix a ceiling on selling price, he takes long put for April at a strike price of Rs140 by paying a premium of Rs10.

Strike prices change with movement in the prices of the underlying and therefore position in the cash market may not be covered in the options segment instantly. After paying a premium of Rs10, the cost of the buyer effectively comes to Rs135.

Since he has a right to sell the stock at Rs140 by April end, the minimum profit will be Rs5.

If fortunately for the investor the price of HLL moves above Rs140, then he can let the option expire without exercising and sell in the cash market at a higher price. On the other hand if the price falls below Rs140 he can exercise the option and make a profit of Rs5.

The other way to cover long position in the cash market will be to short call, which is also called writing a covered call. Here the buyer of stock becomes a writer in the option market and hence receives premium.

Now if the investor sells the April call option at a strike price of Rs140 and receives a premium of Rs5. Since the writer already has shares bought at Rs125, this will reduce his cost to Rs120. Now if the price of HLL moves above Rs140, the buyer will exercise the option. Option writer will sell the shares at Rs140 and earn a profit of Rs20.

If the price falls below Rs140, the buyer will let the option expire. In such a case, option writer can set a price target when he can exit from the cash market to avoid and in some cases to minimise losses.

Now conversely, the short position in the cash market can be covered by taking long call option or short put option. For example, by taking a bearish view on the underlying security, an investor shorts in the cash market at Rs105.

To cover that position he takes long April call option at a strike price of Rs100 and pays a premium of Rs2. Now the realisation price is at Rs105 less the premium of Rs2. Thus he stands to gain if he buys the stock at a price less than Rs103. If the price of share moves below Rs100, he will buy it from the cash market and let the option expire without exercise. On the other hand if the price moves above Rs100, he will exercise the option and buy the share at Rs100.

Now in order to understand the risk-return profile in case the position is covered by selling put option (short put) we will continue with the same example.

The seller (in the cash market) takes short April put at a strike price of Rs100 and receives premium of Rs6. Now his effective realisation price becomes Rs111. If the price of underlying security moves below Rs100, the buyer will exercise the put option.

Conversely, if the price moves up the option will expire. If this is the case then the seller will have to set a price limit at which he will exit from his position in the cash market to avoid or minimise losses.

While deciding a strike price and devising strategies, one has to consider other costs such as interest on borrowing stocks in case of short sale, margins to be paid to the exchange in case of short option positions, etc.


R. Dyes is a journalist based in New Delhi.