Futures and options are derivative products. The value of the derivative product is determined by an underlying asset. The underlying asset can be stock, index or commodity. We will restrict the discussion to the equity market as the aim of the blog is to give a clear understanding of options and how good is option buying. Those who have some idea of Futures and options would find this blog really helpful. If you are a beginner, and interested in learning about futures and options, I would urge you to go through these two posts and return to this post later.
We would learn about options from an option buyers standpoint in this post. We would cover option selling in a later post.
When would you want to buy a stock or an index option
A. We can buy an option when we want to trade a directional move
After some analysis, you feel nifty can show a sharp up move and you want to make some gain out of the would-be movement. What are your options? We would restrict ourselves to buying option. You know you have to but a Call option. Let’s see this chart for our test case.
Let us go for buying a call. Here we have three choices, buying deep in the money call option, buying at the market call option and buying out of the money call option. All these scenarios are analyzed and we see that all these turn profitable. We can clearly see that choosing the best strike price has the potential to affect your profitability. Although when one buys deep in the money option, he pays less for the time decay and pays mostly for the intrinsic value of the option. Small reversals do not affect the Profit and loss in such a position. You can go through this blog to understand time decay and intrinsic value.
|Entry Price||Price per lot||Lot Size||Lots you can buy with 5 Lakh||Exit / Day Close Price||Profit at day close|
|Nifty 15200 CE 3rd June 2021||342||25650||75||19||395||75525|
|Nifty 15500 CE 3rd June 2021||74.85||5613.75||75||89||108.05||127158.75|
|Nifty 15800 CE 3rd June 2021||6.85||513.75||75||973||8.20||98516|
B. We can buy an option when we want to hedge a cash Position
Let us understand this with an example. Suppose you are very bullish on ITC in long term. You have bought 3200 shares of ITC at an average price of 200₹. You sense that in short term ITC may correct by 20 per cent, and it might go to 160₹ per share. In spite of that, you don’t want to exit the cash position since there is always a chance that it might not correct much and maybe rally up.
In such a case, you can still protect your holdings against the suspected correction of 40₹. This can be done by buying at the Money put or Deep in the Money Put. Note that the Put option can be bought in multiples of lot size. Right now the lot size of ITC is 3200 and one lot of ITC put can help in hedging 3200 ITC shares. We can buy ITC Put of 200 strike price and we are protected against any downside in ITC beyond 200₹.
If the ITC closes at 170₹ at end of the contract period, you can make a gain of 96000 (minus the premium paid) in Put option. Though you will see the value of the holdings of ITC has decreased by 96000, but you have not exited the holding value and booked no loss in it. You can still close the holdings position at 170₹. In such a case you will end up making no loss as the gain in the put option is same as the loss booked in cash holdings. This way we can hedge our positions in cash segment.
C. We can buy an option when we want to hedge a Futures position
This is similar to hedging a cash position, except that we have gone long in futures and bought the Put option to hedge long position. Suppose you are very bullish on ITC and bought one lot of ITC futures. The average buy price is 200₹. You sense that the price can dip a little in the next few days. You can either exit with a predefined stop-loss or hedge the position by buying at the money or in the money put option of a suitable strike price. Any loss in futures position will be covered by put option. In case of upside, the gain would be ideally infinite. So you can make a limited loss, unlimited gain strategy using this.
D. We can buy an option when we want to hedge an option sell/short Position
We can sell options as well. You can read more about prospects of options selling here in this blog. Options selling requires good capital and money management skills. If one is not active enough, the losses can be infinite. To protect yourself against infinite loss, you can buy an option too. This will ensure that the loss is finite.
ITC has been trading rangebound for quite some time. We suspect that it cannot go any lower than 200₹. We can sell PUT option of strike price 200₹. We can track trading price live at NSE website here. Suppose 200₹ strike price PUT is trading at 1.2₹. If we sell this option, we get a credit of 3840₹. This credit amount is product of lot size and trading price.
Maximum loss in selling this option is almost 6,40,000₹ if ITC price goes to zero. if we do not want to take a risk of 640000₹ to gain 3840₹, we can buy a PUT option of lower strike price in this case. One can buy 190₹ strike price Put option and limit the losses. We can make various options strategies using buy and sell combinations. Although option selling has a higher probability of success, it comes with a risk of huge losses. We can limit these losses by buying an option.