How much risk can you tolerate? The answer to that decides your choice of stock, the portfolio you form and then the derivatives you can use to better your returns.
In this edition of The Derivatives Show on CNBC-TV18 focuses on the big 'O' — Options. Hemant Thukral, national head, derivatives, Aditya Birla Money explains that Options are the ideal choice for investors not prepared to take unlimited risk while looking forward to considerable returns.
Below is an edited transcript of the show on CNBC-TV18
Q: What exactly is an Option?
A: An Option offers an investor the right to buy or sell with no obligation. Options have limited risk attached while offering greater chances of making higher rewards. Basically Since there are no obligations, transactions are settled in cash which helps investors put in extra margins or take extra leverage in an attempt to make extra returns.
Q: Can you explain the difference between an option and a future that investors need to keep in mind?
A: The basic difference is the rights offered. Options offer investors the right to sell or buy with no obligations attached while futures mandate obligations. Though the derivative market is still settled via cash, while selling futures investors do not have to give up deliveries. The entire impact of the underlying price is present in futures whereas in options the impact is limited.
The next difference is the size. Unlimited risk in a future always creates more problems. In comparison, an option while offering lesser leverage positions, lowers risk of losses while maintaining the level of profitability. So I would prefer buying an option rather than going ahead with trading a risk at future when risk appetite is low.
Q: What are the varieties of Options?
A: American Options allow investors to operate after market hours. If you are a buyer of an option and there is illiquidity in the market, you can exercise that option and it will be settled cash. However, an European Option limits operations to trading hours and expiry of series.
Q: When can an options contract be settled? Does the buyer have to wait till expiry or can he square off his positions as soon as he sees the opportunity for profit?
A: European options allow an investor to also trade in options and book profits any time during the contract.
Q: When you are deciding on an Option, the first thing that everybody says with any investment is you need to have an agenda, a defined goal. What is that goal you need to keep in mind if you want to use Options?
A: The basic agenda is to judge the direction. What exactly are you looking for? We have different types of Options but first we have to decide whether you want to go long or short on this market. So, the direction is the key and then it comes that how much premium I have to pay for that Option, how much risk I have to take and how much reward I am looking for.
This is because if you are going for a Future that means you are taking a higher risk and are looking for a higher reward. In that way, you have to judge which option to buy, what premium to buy and if I buy that option how fast the result will come for me because Future is a more riskier product but gives faster result.
So one has to keep the agenda in mind, the direction of the underlying that we are thinking and how fast we want the result out of it and then it will decide how much premium we are ready to pay. Therefore, these three agendas should be very clear in mind before we buy an option.
Q: In an Option what you see is what you get, the premium is the extent of your loss that you will incur on an Option, is that correct?
A: Correct. So, maximum loss is completely to the premium that you are paying for that Option.
Q: Now explain to us Put and Call Options. If we start with Call Options, how do these work, what do you understand when you are going in to pick up a Call Option?
A: Let us clear up the agenda. The moment that agenda gets cleared, the first point is the direction. We immediately get answer that what Option to do with because Call Option gives a buyer a right to buy the underlying without any obligation. So if you are bullish on that underlying, then you have to buy that call.
Exactly opposite is Put. If you are a buyer of a Put that means it gives you the right to sell without any obligation. So if you are bearish on the underlying then you have to buy Put. Therefore, Call denominates bullishness and Put denominates bearishness. So if we know the direction of the underlying then we decide what to buy. Call is for people who want to be bullish and Put for bearish people.
Q: Both Call and Put Options have a strike price. What is strike price and how will it work?
A: The second point of agenda is how fast you need the results. That will be determined by what strike price of the Option you have chosen. Strike price means at what rate you are asking for that right to sell or right to buy. Strike prices are determined by exchange and there are different strike prices for stock and index.
An index at a given point of time 10 strike prices will be opened as per the change rule, what is the current market price (CMP). There are 10 strike prices above that CMP and 10 strike prices below the CMP will be opened by the exchange.
A stock is five strike prices above the CMP and five strike prices below the CMP will be opened. The strike prices will be decided by the volatility or beta of that stock. If it is a high beta stock the difference of strike prices will be 50-100-150.
For example, Infosys is a much high beta stock than Ashok Leyland. So Infosys Strike prices are with a gap of Rs 50 each. Ashok Leyland strike prices are with a gap of Rs 2.50 each because it is very clear that it is a low beta stock, so that is the way strike prices are decided by the exchange. Your CMP changes the new strike prices and will keep on adding as per the rule but the old strike prices remain till that expiry because some people may have traded on that Option and so this is the way strike prices are decided.
Coming back to the choice of strike prices will totally depend upon the agenda of how fast I need the result. If you want it to be as fast as Future then you have to buy something which is extremely close to the market price the strike price.
Q: When is the Options price declared, the different strike prices declared for each stock? When do I go to my broker or decide on what is my view, what strike price do I want to choose, what are the Options available to me, when can I take that call?
A: This decision should be first taken in the morning. Even if CMP has moved more than 20 percent of an underlying, even then exchange doesn’t introduce the strike prices on the same day. The new strike prices will only come in action when market opens for the second day and that is the rule of the strike prices.
Exchanges decide which strike price is to be chosen. Again it comes back to the third point of our agenda of how much risk reward I want to take because if I want an immediate action to reaction on an option price, then I will be either looking for a very close strike price. Therefore, if Infosys today is Rs 2380, I will be buying a 2400 Call because I want it to move faster. One should realise that it will have maximum premium to be paid out. So that is the risk amount I am ready to pay for that premium.
Now if I pay that risk amount then results will be faster but if I am not ready to take that risk then I have to look for a outer call, may be a 2450-2500 Call which will take less premium as a risk but the results will come slowly. Infosys may then have to move 3-4 percent underline move to actually start giving me profits. So higher the risk, faster are the results. The strike price to buy totally depends on the investors risk appetite that how much risk is he ready to put in on Infosys or any other underlying security.
Q: How does in-the-money Option work?
A: What we were just explaining was that how many options will be available to us for trading on that particular day. Let us take an example that if Reliance is quoting today at Rs 790, keeping Rs 790 in mind as CMP, 5 above strike price and 5 below strike price will be available. What is in-the-money Option, that is the first question which can come in the minds of the viewers.
On the Call front all Options which are below CMP that means right from Rs 780 till Rs 740-720 which are available are all in-the-money. Why are they in the money for Call people is because they have some intrinsic value attached to it, that means the Option has some value attached to it. Apart from above Rs 790 that is Rs 800-860 all will be out-of-the-money for Call Option people. The reason is because they do not have any intrinsic value at all.
So all below CMP are in-the-money and all above CMP are out-of-the-money. Ones which are closest to the CMP or exactly matching the CMP will be at-the-money Options. They do not have an intrinsic value, but a very high time value, the reason is because the stock is exactly at that moment, at that strike price.
Now how to choose, that is the second question for viewers. If you want a faster result or you want that underlying movement should be caught immediately then you should favour either buying in-the-money or at-the-money Options, because they will give you a faster result.
But a higher premium has to be paid for such Options. When you want a slower result or you are aiming for a full month contract, supposedly today this series maybe bad for Reliance, but I think for entire July Reliance can move out to Rs 860, then should I buy in-the-money Option, the answer is no, you should buy out-of-the-money Option, maybe at Rs 840 Call where you have to pay less premium, because it is an out-of-the-money Call, but your Call for the whole month stays valid.
So tomorrow if Reliance at the end of July even goes Rs 860 you will make at least Rs 20, which is the inherent value of that Option. So you do not have to pay a higher amount, you do not have to take a higher risk if you have a good contract call or a medium-term call in derivatives is 10-15 days trading. So if you have a 10-15 day trading call then you should prefer out-of-the-money Options.
If you have an immediate call, that means you expect Reliance to move tomorrow by Rs 30-40 upside, then you should not try for out-of-the-money Options you should always try for at-the-money or in-the-money because they will give you proper results. So it totally depends on how much premium I want to pay and how much is the trading call time that I am taking, because time is a key factor when you go with Option pricing.
Q: The other thing that one always tries to do is if you do go ahead and purchase an out-of-the-money Option. You are bullish on how Reliance could pan out over the span of the month, but you see Reliance taking a direction which you had not expected. How do you strategise in a situation like that? Would you advise investors to hold onto their view and see it to the extent of expiration because their losses are already known to them or do you find frequently that investors change their strategy, there might be a kneejerk reaction where they will try to contain what is a perceived loss?
A: All Options have automatic stop loss. When we trade in Futures for a directional bet, we all have to keep a stop loss. We all know that our calls can go wrong. So tomorrow if I think that I am bullish on Reliance and I buy out-of-the-money Call that means I have taken less risk. I know my stop loss where it is because automatically if I pay just Rs 12 as premium, so Rs 12 is my stop loss.
So I do not mind holding till the time of expiry, provided my view stays.
Sometimes it may happen in the first two sessions and you may feel that Reliance view has changed completely, so in that it is advisable to book loss because at least some premium will be left in Option, so your loss will not be Rs 12, maybe a Rs 3-4 loss would be there.
So that is totally on a view change. If you are an Option holder you should not be worried about movement of Rs 1-2, because your stop loss is automatically placed. So if your view does not change please hold till expiry, because your stop loss is already fixed in the system. So nothing can go wrong than Rs 12.
Q: Explain a bit to us about premium. What all contribute to deciding the premium of an Option, intrinsic value being one of them?
A: Intrinsic value is what we call as an internal value. This you can correlate with anything in your day-to-day use basis. Supposedly we go and buy any pen or any stationary and the shopkeeper quotes Rs 15. Even if you bargain there will be a price where he will not go below, he may not go below Rs 7. That means that Rs 7 is the minimum purchase value of the shopkeeper or an intrinsic value attached to that pen.
Similarly every option has an intrinsic value provided it is below the CMP. So let us take a real time example. Today if Rs 800 call of Reliance is Rs 5 and the stock is Rs 790, it does not have any intrinsic value to it. It is purely time value.
There are two things, one is intrinsic value, one is time value. Intrinsic value is very clear, the difference between the cash price and the Option price, if it is greater than zero then there is an intrinsic value attached to it.
If it is less than zero then the Option pricing is totally dependent upon time value. Time value is a complex instrument because it is being derived by a lot of things like dividend, interest rate, volatility. Volatility is a major factor in time value.