Rupee options on their way! - Outside View by Asad Dossani

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Rupee options on their way!
Oct 25, 2010

Lately, there has been some good news for investors interested in currency derivatives. The Securities and Exchange Board of India (SEBI) has given approval to the United Stock Exchange (USE) to start trading rupee options. The USE has already begun some mock trading exercises to test the options, and it is only a matter of time before these are available to the general public. Initially they are planning to introduce options with 7 different strike prices. 3 will be out of the money, 3 will be in the money, and 1 will be near (or at) the money. This should ensure there are a sufficient number of alternatives for investors to choose from. They will be on the USDINR spot rate to start with, and eventually will likely be extended to other currency pairs.

How will these options work? First, they will be European style options. This means they can only be exercised upon expiry (as opposed to American style options which can be exercised at any time up to and including expiry). In practice, this is fairly irrelevant, as it almost always never makes sense to exercise an option prior to expiry. If you wanted to book a profit on an option before expiry, it would make more sense to sell the option rather than exercise it. Second, the options market will consist of both call and put options. Call options give you the right to buy, and put options give you the right to sell. Finally, the contract size will be 1000 USD (for the USDINR options contract). This is the same contract size as the USDINR futures contract. Additional information is available on the USE website: www.useindia.com

Once options become available to trade, there will be a significant number of additional trading strategies that investors can use. If you believed that the rupee would appreciate against the dollar, then you could buy a USDINR put option, which gives you the right to sell USDINR at a particular price. (Remember that USDINR is the value of dollars in rupee terms. This means that if USDINR falls, the dollar is falling and rupee is going up and vice versa).

What's the difference between buying a futures contract versus an option contract on USDINR? A futures contract is fairly simple. Assume you are long USDINR. Then you make money when USDINR goes up, and lose money when USDINR goes down. The magnitude of gains and losses are identical, meaning that a gain from a 1-rupee rise in the contract is equal to the loss from a 1-rupee fall in the contract.

Options work a bit differently. Let's assume once again that you want to be long USDINR. You first pay an upfront premium. Then in addition, you will make money when USDINR goes up, but if USDINR goes down, you don't lose anything. So if the trade goes in your favor, your total profit is the gain you make minus the premium you initially paid. If the trade goes against you, your loss will be only the premium initially paid.

If you are interested in understanding more about how options work, I would suggest reading Equitymaster's free guide The Definitive Guide to Derivatives. This contains a much more detailed explanation of how options work and how to trade them, along with providing plenty of examples. In the meantime, we will keep you updated as to when currency options become available to trade for the public.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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