January 27, 2010: The Indian stock market, for the first time recorded the highest ever turnover of Rs. 1.8 lakh crore. The F&O market turnover was 1.65 lakh crore.
Ever wondered from where does all this money come from? How can million of rupees be traded on a single day in the stock markets?
Look deeply and you will find that the cash market has hardly any contribution to these values. It is the Futures and Options market where the big game is being played.
In this article, I would not delve into the history and objectives of the Futures & Options segment. I would rather stress on the ways “Options” can be used to secure traders of their short term positions in the market and earn big by fulfilling a nominal amount of margin requirement. They are also heavily used for arbitrage purposes. Long term investors usually stay away from such exotic products.
An Option, as the name suggests to a lay man, is a right but not the obligation to do something. It is very similar in case of the securities market. First of all it must be noted that Options are “Derivatives”, i.e., they derive their values from something else which is generally known as its “Underlying”. For example a “Reliance 1000 Call Options” is a Call Option which derives its value from the price at which Reliance is being traded in the cash market.
Everyone earns money in a bullish market, but smart traders are those who can earn even while the markets face heavy selling, which is possible only by making a contract in the Futures & Options segment. Options are of two types: Call Options and Put Options. Call Options are those which are purchased by traders who expect the market to be bullish and Put Options are those which are purchased by traders having a bearish view about the market. The price of an Option depends upon two factors: It’s “Intrinsic Value” which for a Call Option is the amount the stock price is trading above the strike price of the Option and for a Put Option is the amount the stock price is trading below the strike price of the option. The other is the time value of the option also regarded as the amount traders are ready to bet on the market. All options have an expiry date which is the last Thursday of every month. Hence as it can be understood, the time value of an option will be the most during the beginning of the month and will tend to zero at the time of expiry. The premium at which the option can be purchased or sold is the sum of its intrinsic and time value and it is determined in the market itself by the buyers and sellers.
Options may be bought in the market and then sold or it can also be the other way, i.e. one may short sell the option first and then buy it later. In the former case one undertakes limited risk and the profit potential is unlimited but in the latter case one may lose millions in order to gain a few rupees. Strangely, the probability of making profits is more in the latter case. There are also various strategies that traders use to maximize their profit potential. Some of them are Long Call, Protective Call, Bull Call Spread, Short Call Butterfly, Collar and Bear Put Spread.
Now let us take an example to move forward and understand the concept clearly.
Underlying: Nifty
Market Lot: 50 scripts and multiples thereof.
Current Value of Nifty: 5000
Current Date: 1.01.2012
Date of Expiry: 25.01.2012
Trader’s view on the market: Bearish
Let us assume that the trader purchases a Put Option of Strike 4800 at a premium of Rs. 50 per script. Hence, he will gain if the index is below 4750 on the date of expiry. If the index is above 4800 he will have to forego the entire premium and the contact will expire worthless. Here the maximum loss that the trader can suffer is Rs. 50 per script but the more the markets fall, more he will gain which cannot be determined. Let us assume that the index slips to 4700 which means the trader gains Rs. 100 per script; an astonishing 100% return on the premium paid in a month. During the fall of 2008, Investment Banking Company, Goldman Sachs, made profits instead of huge losses that its peers had to face. This was because they had huge amount of accumulated Put Options which helped it overcome the losses it made on the portfolios.
Buying a Call Option or Put Option is the most basic of all strategies. Risk comes into the game when one begins to short sell or “Blank Sell” as traders term it. If in the above example, instead of buying a Put Option the trader could also have sold Call Options. Let us assume he shorts a Call Option of Strike 5000 at a premium of Rs. 125 per script. Here as long as the index stays below 5125 he does not lose anything but as its value increases the trader loses a rupee for every point increase in the index. At 5125 he is at no profit no loss. Also, the maximum he can earn is Rs. 125 per script.
It is a result of these exotic products that the stock indices all over the world are becoming so aggressive and volatile. The Futures & Options market which is used by most fund managers to hedge their portfolios is also used by individual traders to bet on the market. Several tools such as technical charts analysis and resistance & support identification do help traders but at the end of all it is the smartness of the person which can help him stay away from huge losses.
Futures & Options segment was introduced to protect traders and investors. Today trades in the Futures & Options segment form the expectation of the market and all that happens every day is just the way expectations are being matched with the actions of other people. The stock market is the only market where there is competition between buyers and sellers, not among buyers and sellers.
By Harshwardhan Khandelwal
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