Welcome to this edition of The Derivatives Show on CNBC-TV18. The basic rule of investing is being aware of one’s capacity for risk and the derivatives market offers a plethora of choices for risk profiles of every kind. Join Jitendra Panda, business-head broking, Capital First as he reveals some of the basic strategies that will enable you to harness the choices that Options offer.
Below is the edited transcript of the show on CNBC-TV18
Q: Let us start with Calls first. If you are going out to buy a Call, what is the view that you should be certain of?
A: When you are buying a Call, it means you are bullish in the market. Your view bets that the markets are going to go up. But then why you are buying a Call? because you want to limit your risk. Options are ideal instruments to control risk. So if the market doesn’t go up, you only lose the premium.
So this is the most basic strategy to begin with. First, you have to be bullish and you should be able to pay the current market premium.
Q: How do you decide on a strategy —the right price for a particular call?
A: The first factor that needs to be decided on is the timeframe. All options call for bets on the market reaching a target within a timeframe.
The next item on the agenda is the target level. If you are a buyer, you will have to set the targets. For example, Reliance Industries Ltd (RIL) is at Rs 900 and you believe that in the next 10-15 days, RIL will move up by another Rs 20-30. So you have set a target that in the next 15 days, Rs 30 is the targeted upside on RIL.
The last decision is to go and buy a Call option below the target of Rs 930 to allow you to make some returns if the market moves according to your forecast.
Q: When does one decide to exit a Call option? What is the break-even or the profit point that an investor should always keep his sights on?
A: Before an investor focuses on setting the target level, he has to be aware of the breakeven points. For example, you have bought a Rs 900 Call option with a target of Rs 930 and a premium of Rs 15. So you know till Rs 915 —if the market expires on last day at Rs 915 — you are going to get your premium back. If it expires at Rs 920, you get Rs 20. So breakeven is the strike price plus the premium that you have paid.
Now you have to set stop-losses as it is difficult to predict the market. So, you need to set a stop-loss, based on your risk appetite, if the target level falls below the premium you have paid. This will allow you to exit if the market is not moving as you have predicted.
Q: What are the strategies that a seller must adopt?
A: The Call writer or seller may get only the premium. That is the maximum profit he will make. However, his risk is unlimited. Now the question arises: Why does he sell? If a buyer was bullish, a seller is bearish. He believes that the chances of market coming down are very high. He wants to straightaway pocket the money and restrict his risk to the minimum.
Q: Tell us about Puts. What is the view that investors need to keep in mind and what are the strategies that need to be adopted?
A: What holds good for Calls, holds good for Puts too. The only difference is that the buyer instead of being bullish, is bearish. The risk is limited and returns are made when the market comes down.
Theoretically, profit is unlimited for a Call buyer but it is limited in the case of a Put buyer because the market cannot go below zero.
Q: At what level should a Put buyer set his stop loss if the market does not take the direction on which he has bet on?
A: Whenever you buy a Put or Call option, you need to keep your stop loss according to the value and time. If the market does not move as estimated in five days, then an investor must exit to avoid incurring losses.
Q: What is the maximum extent of risk involved for a Put writer?
A: Risk is unlimited for the Call and Put writer. He can exit during the market hours and shift his position to somebody else. But most writers wait till expiry.
Straddle and strangle are two popular Option strategies where an investor needs to buy the same number of Puts and Calls with the same expiry date. But what are the differences and how does an investor decide what is right for him? But first things first, what is a straddle?
A: Straddle is when an investor simultaneously buys Calls and Puts of the same strike price and same expiry. This strategy allows an investor to reap benefit in whatever direction the market moves.
Q: Obviously all straddles are intended to minimise risk in a volatile environment. What is the maximum risk that an investor faces if he goes in for a long straddle?
A: In a long straddle, an investor buys a Call and a Put for a premium on expectation of continued market volatility. But if the market remains flat on expiry, the premium paid on the Call and Put are lost. That is the maximum loss that an investor will have to bear.
Q: What is the difference between a long and short straddle?
A: A short straddle is just the opposite of a long straddle. Instead of buying a Call and a Put, the investor is trying to sell a Call and Put with the same expiry and same strike price. When you expect the stock or market is not going to be volatile you sell straddle. When you are selling straddle, you get premium because you are selling Calls and Puts.
Q: What strategy would you advocate?
A: Investors must use a long straddle only for an event such as corporate results. And invest only if you expect the results to have an explosive impact either upside or downside. Also look at your breakeven points very carefully. If the stock moves after the announcement of results, go for a long straddle. If you know the stock is not going to move another 15 days in the beginning of the month, then you go for a short straddle.
Q: What strategy would you deploy on high beta stocks vis-à-vis low beta stocks?
A: Use a long straddle for highly volatile stocks with an added event. This also necessitates investors to look at implied volatilities (IV) and set the breakeven points. For stocks with very low volatility, investors should sell the straddle whenever there is an opportunity despite the inherent risk.
Q: What is a strangle?
A: You buy an OTM (Out of The Money) Call option and an OTM Put option on the same day, with the same expiry. When the markets are very volatile then the OTM Call option will become ATM or At The Money (ATM) if market moves in the estimated direction, then there is a chance of making money. So your cost is low because you are buying OTM options. Overall, premiums and risk are low if the market does not move. So the difference between a straddle and strangle is on the risk.
Q: In terms of risk and reward, if the risk is limited or reduced in a strangle, what about the upside, the maximum profitability that you can have?
A: In case of a long strangle, you buy a Call and a Put and you are expecting market to be very volatile and your risk is low, so naturally your returns could be also lower if the market volatility is not very high. If it is very high, you will make money but again if you had bought the straddle your money would have been much higher, it could be possible when the markets are very volatile.
So it depends on the different strike price you are buying. Generally people buy a little OTM, so that the premiums are low, risk is lower.
Q: For a short straddle what should the investor's mindset be?
A: In case of a long strangle — look for volatility. In case of a short strangle, you are selling OTM Call and OTM Puts. Same example of Reliance:- I expect Reliance will not go above Rs 920 in the next 15 days and I do not expect it to go below Rs 880 also. Current price is Rs 900 for example. So what do you do? You sell the Rs 920 call and you sell the Rs 880 Put.
You get lower premiums, but then that is where you are pocketing. So, who are the sellers? They those who believe that they do not see Rs 920 or Rs 940 on Reliance, so they will sell those Call options and market will go any one direction. So even the risk comes it will come on the Call side, not on the Put side, so the money is covered at least one side to take care of the risk.
Investors who are moderately bullish or bearish on the markets but don't want to pay high premiums have the choice of sharing the premium i.e the cost as well as the reward. Jitendra Panda explains how investors could use bull and bear spreads to their advantage. Let's start with bull spreads first?
A: If you are moderately bullish and say for example, believe that in the next 15 days Reliance which is currently at Rs 900, will move up and buy a money call option at Rs 20. Now this will mean that you have to tale a risk of Rs 20. Now this is how the bull spread strategy works– an investor buys at the money call option and sells out of the money call option.
In our example, the Rs 900 call option was bought at a premium of Rs 20. Now I believe that since I am moderately bullish, Reliance may go upto Rs 930. So why should I pay only Rs 20? I would like to go and sell at the higher call option of Rs 930 or Rs 940 call option which is available in the market and pocket higher premium.
Now even if the market turns out to be moderately bullish and Reliance goes up moderately, I still pocket money.
Q: What is the breakup in the share of this cost and reward? An investor who chooses to go in for a bull spread, to decide when he would like the option to expire and opt out of the contract. What is the extent to which the premium and the returns would be divided?
A: When you carry out a bull spread, you buy at the money call option or in the money call option and sell the call option with a higher strike price. When you are buying – if the higher strike price is achieved before expiry, you exit both the options and pocket the returns because you don’t want to wait again for the price to come down further. Your maximum profit is the difference between the two strike prices and the premium paid.
Q: Now what is a bear spread?
A: In a bear spread, the level of risk is very low because you buy a money put option only to sell it at a lower strike price. In case of a put option, you buy at-money and a lower strike price because it will be out-of-money. When you sell that, your risk is low but this offers an opportunity to make money when the market goes down.
Q: When carrying out a bull spread, how can investors exploit the benefits the time factor?
A: If you are going to buy a call option in the beginning of the month and you are bullish on a stock, you will have a lot of time value which will erode if the stock price doesn’t move upwards. To overcome this and mitigate this risk of losing out on the time value, the bull spread comes in very handy.
The strategy involves buying at-the-money call option or in-the-money and selling out-of-the-money. Both when you buy and when you sell, you are covering your time value, mitigating cost and lowering risk. This gives you more time and lower cost to recover your money.
Q: In carrying out a bear spread, how should the investor use time in his favour?
A: The bear spread strategy is similar to the bull spread. Psychologically going short is not easy for most investors. Playing the bear spread is ideal which involves no great loss of money. It is a very popular strategy as the risk involved is lower.