How investors can use 'options' to build their portfolio
Options is a segment of financial instrument called derivatives. It's a contract that gives its buyer the choice of executing or not executing the deal. The seller, also called the underwriter, has the corresponding obligation. The buyer of options pays a fee to get the privilege of deciding on implementing the contract.
Here's how it works. Suppose you strike a deal to buy a house for Rs 50 lakh, but need six months to raise the money. So, you request the owner for more time. As the owner has to wait more for money, to make the deal fair, you pay him a fee, say, Rs 5 lakh, for getting the option of buying the house within six months for Rs 50 lakh. In the next six months, two situations may arise- the government announces that it will connect the locality with a metro line, while a builder says it will build a premium shopping mall nearby. This pushes up the value of the house to Rs 75 lakh. Since the owner has agreed to sell the property for Rs 50 lakh, all you need to do is buy the house, making a profit of Rs 25 lakh within three months. In the second scenario, you find out after two months that the property has other claimants, who are fighting over its title in a court. This means the house is worthless for you. In such a situation, instead of Rs 50 lakh, you lose just the Rs 5 lakh that you had paid to get the right to exercise the option to buy the house.
The other point to understand is that an option is merely a contract dealing with an asset. This is why options are called derivatives (deriving value from the underlying asset). It is used mostly in stocks and commodities.
CALLS AND PUTS
There are two types of options- call and put. A call option gives the buyer the right to buy the asset at a pre-determined price before or on maturity date. When investors buy call options, they expect that the underlying stock/index will rise by the time the contract expires.
A put option gives the buyer the right to sell the asset at a pre-determined price before or on maturity. Investors use this option when they expect the stock/index to fall by the expiry period.
SHOULD YOU USE OPTIONS?
Kiran Kumar Kavikondala, director, WealthRays, says, "Most investors are scared of using options due to lack of awareness about the instrument and ways it can be used." He says investors and traders should understand the terminology and ways options (both call & put) can be used to hedge investments and make money. "Time decay applies to most options. In this, as the contract nears expiry, the premium start falling," says Kavikondala.
Sahaj Agrawal, deputy vice president, Derivatives Research, Kotak Securities, says, "In the Indian context, index options account for most of the activity in the options trading segment." Thus, investors should stick to index options, he says.
Hedging - Options help investors manage risk Leverage - Options allow investors/traders to use leverage, as the amount of investment required is considerably lower. They enable investors to take high exposure by paying a small premium.
Risk-reward payoff - Options provide an opportunity for unlimited upside with limited downside (risk of losing premium).
Lower investment - Options allow taking of a large position with a small investment.
Flexibility of strategy - Options allow investors/traders to create unique strategies to take advantage of different market characteristics such as volatility and time decay. They can be used in a wide variety of strategies to profit from the ever fluctuating market.
PITFALLS OF OPTIONS
Risk in short selling - Selling options attracts margins similar to futures contracts, increasing the investment and risk. One should not venture into short-selling options until & unless one is aware of the risks involved.
Lower liquidity - Options in many individual stocks don't have much volume. The fact that each covered stock will have options trading at different strike prices and expiry dates means there is a strong chance that the option you are trading will have low volumes unless it is very popular.
Higher spreads - Options have higher spreads due to lack of liquidity. This means more indirect costs because you will be giving up the spread when you trade.
Complicated - Options are complicated for beginners. Most beginners, and even some advanced investors, think they understand them when they don't. In case of unfavourable market movement, the risk to capital is high. Options are affected by various factors and, hence, the risk matrix is multidimensional.
Time Decay - You lose the time value of options as you hold them. There are no exceptions to this rule. Time decay in options is the ratio of the change in price to the decrease in time to maturity. As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable keeps falling as time passes.
Non-availability - Although options are available on a good number of stocks, this still limits the number of possibilities that are available to you.
Risk - Selling options in akin to assuming the position of an insurance company, whose risk is unlimited but gain is limited to the premium earned.
SOME BASIC STRATEGIES?
"The bull call spread and the bull put spread are the most common strategies if the investor's view of the market or stock is moderately bullish. Mildly bullish trading strategies make money as long as the underlying stock does not fall by the option's expiration date. These strategies may provide a small downside protection as well. Writing out-of-money covered calls is a good example of such a strategy," says Kavikondala.
Out-of-money is a call option with a strike price that is higher than asset's market price or a put option with a strike price that is less than the asset's market price.
Agrawal says, "The simplest strategies involve buying a call and buying a put option. Buy call is a bullish strategy and adopted when the trader expects an upmove. Similarly, buy put is a bearish strategy and is executed when the outlook is negative."
General elections in India will be held in less than six months. Keeping this in mind, how can individuals use options to protect their portfolio?
Ankit Swaika, head, Investment Advisory & Research, Religare Private Wealth, says, "To protect the portfolio, an investor can buy a put option for six months or 12 months. This can be their simplest strategy to hedge the portfolio. Evolved clients can become a call underwriter."
Since an option is a specialised product, he says the best strategy is to take help from an expert in the derivatives market or a technical derivatives expert.
"Investors can also check for structured products or derivative investments provided by alternative investment funds and portfolio management services," says Swaika.
There are many different strategies for trading options, and it is a field that is still evolving. Therefore, it's best to take the help from an expert before investing.
