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.

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 don’t 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 one’s 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 HLL’ 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.

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.

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.