F&O expert Jitendra Panda on ratio spreads, ladders & more

The direction of the market can surprise the most experienced of investors or traders and if the direction is opposite to the derivatives position you hold one loses a whole lot of money. But if one did not invest and the market moved in favour then a great opportunity is lost. The answer to this puzzle lies in strategies like ratio spreads, ladders etc.

Jitendra Panda, Business Head-Broking, Capital First explain that ratio spreads are nothing but an extension of a vertical spread and here the investor basically has to take a view whether it is bullish or bearish. He further elucidates the difference between the bull spread and a ratio spread. Below is the verbatim transcript of his interview to CNBC-TV18 Q: If we start with ratio spreads what kind of psychological profile or sentiment of the investor do they answer to? A: Ratio spreads are nothing but an extension of a vertical spread. Here the investor basically has to take a view whether it is bullish or bearish. If he is bullish then he can take a bull spread, but then here is using ratio. What is the difference between a bull spread and a ratio spread? In a bull spread you are buying at-the-money (ATM) or in-the-money (ITM) Call option and selling a higher Call option. For 1:1 it is called a bull spread plain vanilla. However, if you are buying one Call option and selling two Call option out-of-the-money (OTM) then it is called a 1:2 ratio spread. This ratio can be 1:2, 1:3 based on the risk appetite. So the ratio spreads are done to gain near the premiums. Since you are selling two OTM Call options you get twice the money in and so your outflow is very low for buying the Call options. The advantage is your payout is very low, but that advantage comes with a higher risk. Q: Can you give us example of how much money could you possibly lose if your ratio spread does not work as you have perceived it? A: Let us take an example of Tata Steel. For our example the price is at Rs 300 in the stock market. So ATM option is Rs 300. I buy a Call option of ATM and if it cost me for example, Rs 10. In a ratio spread I will try to sell OTM Call option. For example, I believe it is moderately bullish I will go and sell two Call options of Rs 320. Each option is at Rs 4 there, so when I sell two Call options I get Rs 8, Rs 4 each for the option, so my inflow comes Rs 8, my outflow was Rs 10, so the net cost to me is only Rs 2. So, I have bought a Rs 300 Call option of TISCO in a bull ratio spread with Rs 2. So anything above Rs 302 which is my breakeven point, the strike price plus the outflow, the risk if TISCO explodes, suddenly there is some event and it moves above Rs 320. My risk can go to unlimited the higher it goes, because I have to pay because I have sold two Call options. So the risk is unlimited if it explodes above Rs 320, but if it remains within Rs 320 I make Rs 18 profit. Q: Your cost Rs 302 because of the premium that you have brought in which was about Rs 8. Beyond Rs 320 that is where you start to make losses. How do you decide that within this Rs 18 range when do you book your profits? A: If you go through the books they will say at Rs 320 you selloff. But practically when you see Rs 302 we have seen that people exit at Rs 310-315 range, depending on the risk appetite. As you move ahead the option premium of Rs 320 will move faster, so your losses will start increasing. So you need not wait for that. So Rs 310-315 range is where you need to exit and make your gains. For Rs 2 you will have maybe Rs 5-6 profit after paying out all the Rs 320. So you will make three times of your money in a month and that is fair enough. They say you control your greed in this market. This is all about greed and fear and we have read and we have learned so much, now let us put in practice. Q: How do you manage factors like time value, the volatility on a counter like this? A: Spreads always have this advantage. The time value comes up and that is what you are doing. When you are in a ratio spread, when you are buying one Call option you are paying some time value, but when you are selling two options of the outside you are in fact gaining the time value, because those options have time value which you are taking in. So you are gaining those time values, because you are selling Rs 320 Call options of Tata Steel. So ratio spread gives advantage that if you feel that Rs 320 is a major resistance level and may not crossover the markets, ratio spreads are most popular at those times. When you know that those are critical levels on valuations fronts or on technical fronts or within the timeframe available for the option, you feel that Rs 320 is a very stretched target options available. You sell them and you have risk in your hand and some risk you have to pay. Q: How popular are Put ratio spreads? When you use such a strategy? A: Since ratio spreads give you very low cost and an advantage, because your breakeven points are very closer to the options which you have bought, because you sold in case of a bearish spread Put options. In case of a bear spread, it is very difficult to be bearish in the market and play the market. However, bear Put spread, when you buy ATM Put option and sell two or more higher OTM Put options you gain. You gain the benefit that market moves little down also and when they fall they have that advantage of taking it. But I would like to warn you, based on markets, when the market goes up they go slowly and steadily, but then they fall they fall like a ping-pong ball. Doing a ratio spread on Put side, the bearish ratio spread, you have to be very cautious. _PAGEBREAK_ Q: How do you put in a stop loss then so that if you feel that the market has a better chance of losing, you do want to go in for a Put ratio spread. Is there a way that you can minimize your risk over here? A: In case of spreads the outflow is very low, so generally people do not put any stop loss, because your outflow, as I said in the bull spread case example Rs 2, that anybody should be able to take in. Similarly in the bear Put spread if you see at times people do spreads and when you sell two Call options, the outflow is literally zero. There are opportunities where depending on the strike price OTM or selecting, if you select very close OTM option, you maybe sometimes literally paying nothing, your strategy setup will be at zero net cost to you. So, you do not have to put stop loss, you just have to wait that the market does not explode, either downside if you have done a bear ratio spread or upside if you have done a bull ratio spread. Q: What exactly is the thought process for a ladder to work as an investment strategy? A: Ladders are a very interesting strategy. In the derivatives market, as I said, you can make strategies based on what risk profile you are or what market direction you are making. Let’s say long call ladder to take first which is also popular is where you feel the market is going to be range bound. Within a range bound but you are trying to make money, where the money could be good enough, better than strangle but you have unlimited risk also on the upside. So how do you work this long call? Let’s take an example. In the long call ladder you have to play with three options. What are these options? First you buy in the money call option. Simultaneously, sell at the money call options and sell out of the money call option. It may sound little complicated but it’s very simple. When you are buying in the money call options i.e. you are paying a premium and when you are selling, it is like a spread which we spoke but you are doing two different strike prices - one at the money, one out of the money. It is an extension of ratio spread but it has its returns and rewards accordingly managed. Let’s take an example of Infosys, current price of Infosys is Rs 2,500. So we go and buy in the money call option which is say Rs 2,400 and the premium we get is Rs 120 because Rs 100 is the minimum which was already there, intrinsic value and say time value of Rs 20. So we pay, we buy in the money call option in a long call ladder. So when you are buying between Rs 120, that’s the outflow. At the money call option, C is at Rs 60 so you sell that, you get that which is at Rs 2,500. Simultaneously, you sell Rs 2,600 call option also because you believed that it will not go above Rs 2,600 - that’s a range bound market you are expecting for Infosys. Infosys plays within this range. When you sell the Rs 2,600 you get another Rs 20. So your net inflow was Rs 60 plus Rs 20 - Rs 80 and your outflow was Rs 120. So you have Rs 40 outflow for doing this strategy. The returns for this - in case Infosys remains within his range of Rs 2,500 and Rs 2,600, if it goes to say Rs 2,600, you will have your in the money option going to Rs 200 plus and that Rs 2,600 will expire worthless because market is within that range and it remains there, it doesn’t go above Rs 2,600. So that expires worthless. That’s the idea of the market that you believe that it will not cross Rs 2,600. Now this strategy will give you what is the maximum Rs 100 minus your cost what was it Rs 40, Rs 60 is the gain which you will have. So that’s the maximum profit you can make. So Rs 40 is the risk in my example and Rs 60 is the profit. But in case the market goes below Rs 2,500 and remains below Rs 2,500, you will have Rs 40 risk. So your risk is limited Rs 40 but in case it goes above Rs 2,600, the way it was in ratio spread, you have losses, you have unlimited losses here also. Q: How do you manage it if you find that Infosys is likely to crossover beyond Rs 2,600? How do you limit your losses? A: The way I told in ratio spread, same way you have to manage. This is an extension of ratio spread. As it nears closer to the Rs 2,600 you have to exit out of the strategy, you have to exit all the positions, whatever the options you have bought and sold has to be squared off and you have to exit out of the market. If it goes beyond Rs 2,600, you have losses in your hand and it will eat away your profit. So you have your breakeven level which is beyond Rs 2,600 of course because you have Rs 60 profit in your hand which will get into that. So the breakeven level is where you need to watch what you have gained, you will have to sacrifice beyond Rs 2,600 means Rs 60 so Rs 2,660 we are breakeven beyond which you cannot keep your positions. Q: Let’s move to the other aspect of it which is short call ladder or a bear call ladder as it is known. What is the risk profile that you would keep in mind here if you were to go ahead with the example of Infosys? A: In short call ladder, here I am selling in the money call options. So, I sell first. My view is that the market will move beyond Rs 2,600. Even if it remains lower, I will still have some money below Rs 2,500. Either it will be below Rs 2,500 or it will be beyond Rs 2,600. So, how to setup this short call ladder? In this sell in the money call option - that’s why it is called short call. You are selling in the money call option so you get Rs 120. In my example you will get Rs 120. You are buying at the money call option which was at Rs 60 so you pay out. So from Rs 120 you paid out Rs 60 and you also buy the Rs 2,600 call option which is out of the money where you again payout Rs 20. So you pay out Rs 80, Rs 40 is in your hand. If Infosys remains at Rs 2,500 or comes below, your Rs 40 are always there with you. So you have a mildly bearish or an overly bullish view. In your view it is not that you will remain between Rs 2,500 and Rs 2,600. Whatever the event is, whatever reasoning you have as an investor, if you have certain events like Infosys or SBI or Tisco where events are like that that either goes down or if it goes up it will break even something and it will be explosive upside, you do a short call ladder. On downside I said Rs 40 gain, what happens if it goes above Rs 2,600. You have sold one but you have bought two call options. The benefit is that since you have bought two call options, if it goes beyond Rs 2,600 you will make Rs 2 to every rupee goes up but you pay only Re 1. So you gain. So you again have an unlimited profit potential above Rs 2,600. _PAGEBREAK_ Q: Would you say, after having spoken about the long call ladder and the short call ladder that your short call ladder is actually a safer option for an investor to take? A: If you are looking at the risk reward ratio, this has a limited risk and unlimited profit potential in short call ladder whereas in the long call ladder where you buy the call option first is an unlimited risk strategy. Based on the profile of the client, if you feel that the market is going to remain down or come down in our example Infosys Rs 2,500 and below or if it is going to go up, it will explode, there could be an explosive one and Rs 100 and above jump then you go for an unlimited profit potential. But if you feel the market is going to be range bound and not do much, you can go for the long call ladder which has unlimited risk potential but your view on the market or on Infosys is that it will be range bound. Q: We are going to talk about synthetic options. First explain to us the concept itself. A: The word synthetic means artificial. You are working in a strategy where you create an artificial product. If I buy Future then I have the upside but downside risk is totally there with me. Now, if I simultaneously buy at the money Put Option, I have bought the Future and at the money Put Option if I buy I am protecting the downside because when I buy a Put Option the downside risk is taken care of because the Put Option will give me money if the market goes down which is risky for me in the Futures. If market is going to come down, whatever loss I incur in Futures some money is recovered back with the option. If you look at it, what you are doing is, downside is protected with a limited cost, what premium you have paid for the Put Option and upside is yours. It is nothing but a Call Option. In a Call Option you have a limited downside but upside is yours. So, by buying a Future and buying a Put Option you created an artificial kind of payoff for Call Option. Q: Explain to us how much of a risk reduction in premium can you benefit by, how much can you limit your risk to? A: Overall the market is bullish so everybody is looking to buy Call Options. The demand is higher, even the seller the writer of the Call Option knows that the market sentiments are bullish. So, even he prices the Call Option much higher, the trade happens at a higher price. So, the implied volatilities are very high for the Call Option because the market sentiment is bullish and you would also like to jump in and buy a Call Option. Here is an opportunity to create a synthetic call. There will be fewer buyers for the Put Option so the demand being very low the price will be low. So, you are buying a Put Option and you are buying the Future. That benefit, that extra implied volatility, the time value, the cost which you are paying is the benefit which you get here because implied volatility will be lower for the Put Option and your breakeven will be lower. In case of a Call Option where the options price was very high your breakeven would have been much higher. Q: How would you calculate your breakeven in this case? A: In this case whatever the Put premium you have paid add to the Future price, whatever your Future price you bought add to that and that is your breakeven and practically it will be lower than Call Option price. Q: Can you reverse the case scenario as well, if there is a bearish sentiment in the market can you use the synthetic option then too in your favour because I would imagine in a bearish scenario Put Options would get expensive, do they get so expensive that it would make more sense to take a combination of a Call and a Future than to go with an option of Put and Call? A: Yes you can create a synthetic Put. A synthetic Put, since you are bearish in the market you want to sell. So, you are selling a Future. You sell a Future, you are bearish you will make money but if the market goes up on the Future you will incur a loss. So, what do you do? You buy a Call Option and as you said the Call Option will be cheaper because overall market sentiment is bearish, there is negative news there in the market or economic news or whatever news is there on the stock or on the broader market. So, you are selling the Future of that stock or on the market and buying a Call Option which will be cheaper. The breakeven will be what? The price of the Future plus the Call Option premium which you are paid to ensure your risk on the upside is what is your breakeven point. The difference between the breakeven point, this breakeven and buying a Put Option, the difference is what you save. _PAGEBREAK_ Q: Give us also an idea of when there is a merger or any kind of a swap between shares of two companies how do you use that opportunity? Is there a possibility for arbitrage to your advantage in the F&O segment? A: In this market you either play options that is plain vanilla - taking a risk there will be a bullishness in one of the stock or there would be a bearish activity in other stock. So, people play both the stocks. Buy Call here where they believe it is undervalued and buy the Put where that is overvalued in the two companies. If the ratio is already announced there is also another opportunity, there is one side of the opportunity where they believe undervaluation and overvaluation - buying Call and buying Puts. If the ratio is as I said there are other opportunities when the ratio is announced there is a pricing difference. So, people when they buy they know finally it is going to merge in 2:1 or 3: 1 ratio depending on finally what the company is going to deliver on the merger ratio and all that. So, you can buy the Futures, wherever there is an opportunity you can buy one Future and sell the other three. So, finally you know it is going to merge and the ratios are going to be same but the difference between the two pricing will be yours. Q: So far we have spoken about taking a view on the markets and their volatility and their movement. What if we reduce this universe to a sectoral play. Typically one sees that there is always a tussle between valuations of private versus PSU or public service undertakings it is very apparent especially in the banking sector, what if you are taking a play on the banking sector? How would you use a trade strategy which involved two underlying stocks from this particular sector to ratify your view and make your profit here? A: It is a clear analysis of the valuations front. For example, in a market condition where PSU banks are being sold or are in an oversold range, let us take for example State Bank of India (SBI). SBI you will find suddenly there is - due to some rating or due to some agencies or due to whatever market environment it has come down and it is in the oversold range whereas the private banks lets take an ICICI Bank, it is holding on or it is up, the prices are up so what do you do? You sell the ICICI Bank expecting not to move much ahead from here because already valued or the upside is capped or not there and buy the SBI, buy the PSU because it is oversold range and it has taken a beating and in a short time it has seen 10 percent correction or maybe more than that. The basic idea in a pair trading is that most of the stocks, most of the companies within a sector work within a certain parameter of valuation, there is a benchmark. If ICICI Bank is valued at certain level SBI will be valued at certain level and there remain over a longer period or they have a mean. So, that study of mean and any standard deviations above 2.5 in this mean you have an opportunity to buy the undervalued stock and sell the overvalued one. So, what happens over a period of time as we are closer to expiry over a time they correct. SBI will come up because it is oversold, ICIC may remain there or maybe ICICI may come down. Q: What is the likelihood of a risk? For example if supposing there is an announcement it could be a credit policy announcement, it could be some other announcement which benefits the private sector more than the public sector in which case you may see a spurt in ICICI Bank whereas SBI either does not move up substantially or just stays where it is. How do you decide when to knockoff a pairs trade? A: This is not an arbitrage strategy. This is a risk strategy. You are working on a mean, the mean of standard deviation is 2.5 and it can go to 3.5. So, you have to keep a stop loss of 3.5 maybe so that is what you have to maintain. The stop loss is on the deviation, the deviation goes further you have a loss in your hand. As you rightly mentioned it can be there but then are you able to sustain that loss? If not cut your losses off but if you are able to sustain that then over a period of time SBI catches up with the mean value because the valuations, they work on tandem. Q: Pairs trade is a high cost strategy? A: I would say you need to be prepared for the risk, you need to have your margins and mark to market in hand. You cannot leverage with full money and not have anything and then you will be cut off