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In this edition of The Derivatives Show on CNBC-TV18, 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.
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.
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