X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Index options: The workings (Part II) - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Jun 11, 2001

    Index options: The workings (Part II)

    In the previous article we had considered cases where Rajiv and Ajay had bought Call and Put options. But now we will look into what happens when they write options. Writing an option i.e. creating a fresh sell position. The writer or the person who has a short position gets into an obligation to sell or buy the underlying depending on a call or a put option that the person has written respectively.

    Suppose Rajiv is bullish about the markets. He therefore writes a put option with the view that markets will never fall below the strike price and therefore, the option will never be exercised. Since he writes the option he gets the premium. Suppose, the index is currently at 1,390, and the strike prices available to Rajiv are 1,350, 1,370, 1,390,1,410 and 1,430. He sells a put option for 1,370 at premium of Rs 11. He will get the premium of Rs 2,200 (11*200). His gain is limited to this amount.

    But on the expiry day if the index is below the strike price the buyer of the option will excise the options and Rajiv will suffer losses. The extent to which he will bear losses depends on the difference between the strike price and the closing level of spot on the expiry day.

    Put Strike Price 1,370
    Nifty expiration level 1,330
    Option value 40
    Less Premium 11
    Loss per nifty 29
    Loss on the contract Rs 5,800 (Rs.29* 200)

    When Rajiv writes the put option he will have to pay an initial margin and he will be marked to market everyday so that there is no chance of him defaulting on his obligation.

    Therefore, while buying an option the risk is limited to the premium only. However, when you write options the losses, theoretically, can be unlimited. Therefore, individual investors must be extremely careful while taking a short position or when writing options. Unless you understand the options markets very well donít step into this. In the initial stages it is better to avoid writing altogether.

    The options can be used to reduce the uncertainty or the extent of losses to oneís portfolio i.e hedging. It is with this philosophy that options were created. Suppose a person holds 10,000 shares of HLL @ Rs 200. The portfolio size is Rs 2 m. Theoretically the risk associated with the portfolio is Rs 2 m. But if there is some way by which the person can be sure of the downside the extent of losses is reduced. This can be done by buying a put option, a right to sell the index at a fixed price even though the index might be far below it. Though the person make loss on the HLL shares, a part of these losses are offset by his position in the put option.

    Suppose the beta (correlation in movement of HLLí stock to the index) is 0.68. Therefore, you will need a contract of the size of 1.3 m (Rs 2 m * 0.68) to hedge your portfolio. The Nifty June month put of strike price 1,412 is trading at Rs11. To hedge, you buy 5 puts (contract size Rs 1.4 m). The premium paid is Rs11, 000 (5*200*11). If at expiration Nifty declines to 1,329, and Hindustan Lever falls to Rs.191, then therefore, even though there were losses in the portfolio these were offset by hedging using derivatives.

    Put Strike Price 1,412
    Nifty expiration level 1,329
    Option value 83
    Less Purchase price 11
    Profit per nifty 72
    Profit on the contract Rs.72,000 (Rs.72* 1000)
    Loss on Hindustan Lever Rs.90,000

    For stocks that are a part of the Nifty or the Sensex we can determine the movement in the indexes due to movement in the stock prices.

    Company Movement Change in
    Sensex (Points)
    Change in
    Nifty (Points)
    HLL 1% 5.6 1.6
    Reliance 1% 5.3 1.5
    Reliance Petro 1% 3.0 0.9
    Infosys 1% 3.6 1.0
    ITC 1% 2.4 0.7
    MTNL 1% 1.1 0.3
    SBI 1% 1.6 0.5

    To find out an estimate of the contribution each of these stocks made to the gain in the Sensex, check out our Sensitivity Analyser.

    This completes an introduction to how the options will work. In the end we would again like to stress that options are risky instruments. Also, the lifetime of a contract is just 3 months compared to years on end in case of stocks. Therefore, if a hasty view is taken the time to take a corrective action is very short. Therefore, be safe than sorry.

     

     

    Equitymaster requests your view! Post a comment on "Index options: The workings (Part II)". Click here!

      
     

    More Views on News

    Sorry! There are no related views on news for this company/sector.

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    MARKET STATS