Friday, August 15, 2008

Futures’ cool, but options’ smarter

DNA, 15th August 2008
The derivative tool can be used by investors to good effect

Kishorilal switches on the telly a few minutes before the programme on investment strategies is to begin. In the last episode, he had watched Nicky, a professor in finance at a renowned business school explain how futures could be used as an investment tool. Today, she would be dealing with options.They are still playing advertisements, but Kishorilal desists from switching channels for fear he would miss out on parts of the programme. He even catches himself humming the familiar refrain of a paint company: “Jab ghar ki raunak badhani ho, deewaron ko jab sajaana ho…” If only he could own his dream bungalow... May be Nicky’s tips would help him realise that.He doesn’t have to wait long. The smiling professor soon appears and runs the viewers through the basics of option contracts, explaining how options allow the buyer more freedom than futures contracts do.Options are contracts that give one the right to buy (call option) or sell (put option) a stock at a predetermined price (exercise price) sometime in the future, she says. This right comes at a price, known as the premium.In a call option, if the market price of the asset is lower than the exercise price on the expiry date, the buyer of the call option will simply let the contract lapse. He is not obliged to buy the asset from the seller. Whereas, if the price is higher, the buyer will decide to exercise the option and the seller must deliver the asset. Hence, in this case, the buyer of a call option has limited his losses, but can also take advantage of unlimited gains if the price of the asset falls.A put option, on the other hand, gives the buyer of the contract the option to sell an asset at a predetermined price in the future. Just as in the case of call options, the buyer of the put option will simply let the contract lapse if the market price of the asset is higher than the exercise price on the expiry date.So far so good, thinks Kishorilal. But, how does one actually make money using these contracts?Nicky seems to be reading his mind. She starts explaining how various combinations of option contracts (known as strategies) could be used in different circumstances.“For example, if you know that the share price is going to move substantially, but are not sure in which direction, up or down, you can enter into a ‘straddle’,” she says.Now what’s a straddle? Well, it involves a call and a put option with the same exercise price and same expiry date. So, if an investor believes the price of Reliance shares will move substantially in the coming days, he can buy call options and at the same time buy put options which expire on the same date. The exercise price for both the options must be the same.From the investor’s point of view, the maximum loss in this case is the premium paid for obtaining the options. But, the maximum profit is unlimited.Kishorilal finds himself nodding. Certainly, the maximum loss will be the premium paid to obtain the call and put options in the event that both are not exercised. But how can the profit potential be unlimited?Say the exercise price of Reliance call and put options is Rs 2,160, Nicky explains. Now, upon expiration, if the stock price of Reliance goes up to Rs 3,000, the investor can exercise the call option, which gives him the right to buy the shares at Rs 2,160. Then, he can sell those shares in the market for Rs 3,000, making a profit of Rs 840 per share. Higher the price of Reliance shares, higher will be the gain from exercising the call option. Also, in a scenario where the price of the shares rises, the put options expire unused.On the other hand, if the price of Reliance falls to say Rs 1,600, the investor can exercise his put option, which gives him the right to sell the shares for Rs 2,160. Thus, he buys the shares from the market at Rs 1,600 and sells them for Rs 2,160, making a profit of Rs 560 per share. Lower the price of Reliance shares, higher will be the gain from exercising the put option. Also, in a scenario where the price of the shares falls, the call options expire unused. In order to calculate the net profit, the premium paid for buying the options must be deducted from the profits. Let’s assume that the premium paid to buy the call option was Rs 65 and the put option was Rs 100. Even after deducting the total premium of Rs 165, the investment in a straddle turns out to be very profitable.Nicky closes the session with a quote from Walter D Hopps: “Derivatives are nothing more than a tool. And just as a saw can build your house, it can cut off your arm if it isn’t used properly.”“The statutory disclosure,” thinks Kishorilal, but agrees that it can cut both ways. He is glad to have sat through the session, for now he knows he can invest in derivatives and get higher returns while keeping his maximum losses under control. He decides to study a few stocks closely for sometime before taking the plunge. His dream house couldn’t be very far away.
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