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Derivative Classroom
Option Strategies Part I- Series VII

      October 22, 2009
 Derivative Classroom -Series V                                                                             `
                                                                    Hedging Strategies
                                                                    In our earlier derivative classroom- “Portfolio Hedging”, we discussed about
                                                                    hedging and its need . We discussed in length the mechanism to do portfolio
                                                                    hedging with Nifty futures.

                                                                    Today we will be discussing on HEDGING via OPTIONS.
  Implied Volatility
                                                                    In our classroom ‘OPTION BASICS’ we discussed on options and its types-
                                                                    Call/Put. WE also studied the usefulness of option in term of exposure to risk. As

  ssss                                                              options are cheaper in terms of premium, it provides good platform to reduce
                                                                    the risk.

                                                                    Hedging Strategies:

                                                                        A)      LONG ON STOCK

                                                                                   (i)       Long Stock/Future, Buy a Put ( Protective Put)

                                                                                   (ii)      Long Stock/Future, Sell a Call (Covered Call)




                                                                        B)      SHORT ON STOCK

                                                                                   (i)       Short Stock/Future, Buy a Call

         Long on stock, Buy Put                                                    (ii)      Short Stock/Future, Sell a Put
         View: Extremely bullish




                                            Long Stock
                                                                    I- Protective Put

                                                                    This strategy can be used when an investor is holding a stock and feels that
                                                                    correction is due in the short term. But long term view on the stock still remains
                                                                    bullish. So instead of selling the stock, he can buy a Put. By buying a Put his
                                  900 930      945
                                                                    downside loss will be minimized.

                                                         Long Put   Illustration 1

    Hedged                                                          Suppose Mr. Shah has 1100 shares of Reliance Capital in his portfolio bought at
                                                                    Rs.930. He is bullish on the stock in the long term but short term trend seems to
                                                                    be negative. So instead of selling the stock he can buy an OTM Put of strike 900

                                                                    with the premium outflow of Rs.15 and hedge his position.
   Karun Mutha
   Sr. Vice President& Head Derivatives
   Tel +91-22-67897833
   Email: Karun.mutha@hsbcinv.com
                                                                         Action             Scrip           Type         Strike Price    Premium


   Tina Khetan                                                             Buy            Rel Capital     Stock @                   -             -
    Analyst - Derivatives                                                                                       930
   Tel +91-22-67897828
   Email: Tina.khetan@hsbcinv.com                                         Buy             Rel Capital           Put           900             15.00




                                                                        Page 1
Derivative Classroom
Option Strategies Part I- Series VII

 Derivative Classroom -Series V




   Implied Volatility                                              II- Covered Call
       Long on stock, sell a call option
       View: Neutral/ moderately bullish                           This strategy can be used when an investor is holding a stock and works best for

  ssss                                                             the stocks for which investor do not expect a lot of upside or downside.
                                                                   Essentially, we expect stock to stay sideways so as to collect the premiums and
                                                                   reduce average cost every month. Thus one can hedge its long position in stock
                                                                   by writing an option. Writer of an option has a limited profit to the extent of
                                                                   margin received; however loss is unlimited.


                                                                   Illustration 1

                                    Long Stock
                                                                   Suppose Mr. Mehta has 300 shares of Reliance Infra bought at Rs. 1,300. He
                                                                   feels that Reliance Infra will rise in future. However in the market volatility stock

 Short Call
                                                                   comes down and losses are huge, Mr. Mehta writes a call at 1,350 with the
                                                 Hedge position
                                                                   premium inflow of Rs. 25, so that his average will come down (at Rs.1,275).


                                                                       .                  Scrip           Type         Strike Price      Premium
                                                                           Action                                        Inference
                     1300
              1275          1350   1375                                    Buy           Reliance       Stock @                   -                -
                                                                                          Infra           1300

                                                                           Sell          Reliance          Put             1350            25.00
                                                                                          Infra




                                                                  Directional Strategies

                                                                   In hedging strategies we discuss how to hedge the position having owned the
                                                                   stock in cash or in future. However option comes handy in designing the
                                                                   strategy with defined risk- reward ratio. Directional spread like Bull Call spread
                                                                   and Bear Call spread is best suited for the conservative investor who wants to
    Buying a lower strike Call and selling                         capitalize on the opportunity available in the market, yet limiting the loss.
    higher strike call
    View: Bullish

                                                                  Bull Call Spread

                                                                   When the investor is bullish on the stock, he goes for creating a spread. The
                                                                   spread has the advantage of being cheaper to establish than the purchase of a
                                                                       Page 2
                                                                   single call, as the premium received from the sold call reduces the overall cost.
                                                                   The spread offers a limited profit potential if the underlying rises and a limited
                                                                   loss if the underlying falls.
Derivative Classroom
Option Strategies Part I- Series VII

 Derivative Classroom -Series V




  Implied Volatility


  ssss




                                       Page 3
Derivative Classroom
     Option Strategies Part I- Series VII

         Derivative Classroom -Series V                                           Illustration III

                                                                Hedged position
 Profit                                                                           Ms. Kiran is bullish on IT sector and feels that the prices of TCS will move ahead

12 1                                                                              therefore she buys one ATM call at 680 with premium outflow of Rs. 15 and
     7                                                            Stock price     sells one OTM Call at 700 with premium inflow of Rs. 7.

          0   Implied Volatility
                               680        695    700 707
                                                                                      .                  Scrip              Type       Strike Price   Premium
                                                                                          Action
-8                                       Long call          Short call


-15
          ssss
         -8
                                                                                          Buy            TCS              Call (ATM)           680         15.00

 Loss
                                                                                          Sell           TCS              Call (OTM)           700           7.00




                                                                                  Bear Put Spread

                                                                                  An investor who enters in bear spread is bearish and feels that stock price will
     Buying a higher strike Put and selling
                                                                                  decline. In a declining market too investor can make profit both by using call
     lower strike put
                                                                                  and put. The spread offers a limited profit potential if the underlying falls and a
     View:bU
           Bearish
                                                                                  limited loss if the underlying rises.


                                                                                  Illustration IV
                                                                                  Mr. Nitin Joshi is bearish on Banking sector and feels that the prices of ICICI
                                                                                  Bank will move down, therefore he buys one ATM put at strike price of 920 at
                                                                                  with premium outflow of Rs.11.00 and sells one OTM put at the strike of 900
 Profit                       Hedged position
                                                                                  with premium inflow of Rs.4.00

         13
                                                                                      . Action           Scrip              Type       Strike Price   Premium
                                                                 Stock
                  Short put

          0                                                                               Buy        ICICIBANK        PUT (ATM)                920          11.00
                              904 900 931             920
         -7
                                         Long put                                         Sell       ICICIBANK        PUT (OTM)                900           4.00



     Loss




                                                                                      Page 4
Disclaimer:
Issuer of the Document:- HSBC InvestDirect Securities (India) Limited*
Registered Office:-
Dhana Singh Processor Premises
J B Nagar, Andheri - Kurla Road
Andheri (East)
Mumbai – 400 059
Telephone: +91 22 6789 7830
Fax: +91 22 6789 7700
Website: www.hsbcinvestdirect.co.in

Disclosure
HSBC InvestDirect Securities (India) Limited (“HISL”), its associate and group companies, its directors, associates and employees may
have various positions in any of the stocks, securities and financial.
Instruments dealt in this document or may make sale or purchase or other deals in the securities from time to time or may deal in other
securities of the companies / organizations described in this document.

Certification
The views and opinions expressed by the author in the document are his own and do not reflect the views of HSBC InvestDirect
Securities (India) Limited or any of its associate and group companies.

Disclaimer Clause
The above is for customer information only and does not constitute investment advice or an offer to purchase or subscribe for any
investment. This document is not directed to or intended for display, downloading, printing, reproducing or for distribution to or use by
any person or entity who is a citizen or resident or located in any locality, state, country or other jurisdiction where such distribution,
publication, reproduction, availability or use would be contrary to law or regulation or would subject HSBC InvestDirect Securities (India)
Limited (HISL) or its associates or group companies to any registration or licensing requirement within such jurisdiction. If this document
is inadvertently sent or has reached any individual in such country, the same may be ignored and brought to the attention of the sender.
This document may not be reproduced, distributed or published for any purpose without prior written approval of HISL.

This document is not intended to provide legal, accounting or tax advice and should not be relied upon in that regard. Persons accessing
this document are advised to obtain appropriate legal, accounting or tax advice where necessary. Financial advice provided has not been
prepared taking into account the particular investment objectives, financial situation and needs of any particular investor. As a result,
investors using the advice should assess whether it is appropriate in the light of their own individual circumstances before acting on it.

* Formerly known as IL&FS Investsmart Securities Limited

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Option Strategies Part I

  • 1. Derivative Classroom Option Strategies Part I- Series VII October 22, 2009 Derivative Classroom -Series V ` Hedging Strategies In our earlier derivative classroom- “Portfolio Hedging”, we discussed about hedging and its need . We discussed in length the mechanism to do portfolio hedging with Nifty futures. Today we will be discussing on HEDGING via OPTIONS. Implied Volatility In our classroom ‘OPTION BASICS’ we discussed on options and its types- Call/Put. WE also studied the usefulness of option in term of exposure to risk. As ssss options are cheaper in terms of premium, it provides good platform to reduce the risk. Hedging Strategies: A) LONG ON STOCK (i) Long Stock/Future, Buy a Put ( Protective Put) (ii) Long Stock/Future, Sell a Call (Covered Call) B) SHORT ON STOCK (i) Short Stock/Future, Buy a Call Long on stock, Buy Put (ii) Short Stock/Future, Sell a Put View: Extremely bullish Long Stock I- Protective Put This strategy can be used when an investor is holding a stock and feels that correction is due in the short term. But long term view on the stock still remains bullish. So instead of selling the stock, he can buy a Put. By buying a Put his 900 930 945 downside loss will be minimized. Long Put Illustration 1 Hedged Suppose Mr. Shah has 1100 shares of Reliance Capital in his portfolio bought at Rs.930. He is bullish on the stock in the long term but short term trend seems to be negative. So instead of selling the stock he can buy an OTM Put of strike 900 with the premium outflow of Rs.15 and hedge his position. Karun Mutha Sr. Vice President& Head Derivatives Tel +91-22-67897833 Email: Karun.mutha@hsbcinv.com Action Scrip Type Strike Price Premium Tina Khetan Buy Rel Capital Stock @ - - Analyst - Derivatives 930 Tel +91-22-67897828 Email: Tina.khetan@hsbcinv.com Buy Rel Capital Put 900 15.00 Page 1
  • 2. Derivative Classroom Option Strategies Part I- Series VII Derivative Classroom -Series V Implied Volatility II- Covered Call Long on stock, sell a call option View: Neutral/ moderately bullish This strategy can be used when an investor is holding a stock and works best for ssss the stocks for which investor do not expect a lot of upside or downside. Essentially, we expect stock to stay sideways so as to collect the premiums and reduce average cost every month. Thus one can hedge its long position in stock by writing an option. Writer of an option has a limited profit to the extent of margin received; however loss is unlimited. Illustration 1 Long Stock Suppose Mr. Mehta has 300 shares of Reliance Infra bought at Rs. 1,300. He feels that Reliance Infra will rise in future. However in the market volatility stock Short Call comes down and losses are huge, Mr. Mehta writes a call at 1,350 with the Hedge position premium inflow of Rs. 25, so that his average will come down (at Rs.1,275). . Scrip Type Strike Price Premium Action Inference 1300 1275 1350 1375 Buy Reliance Stock @ - - Infra 1300 Sell Reliance Put 1350 25.00 Infra Directional Strategies In hedging strategies we discuss how to hedge the position having owned the stock in cash or in future. However option comes handy in designing the strategy with defined risk- reward ratio. Directional spread like Bull Call spread and Bear Call spread is best suited for the conservative investor who wants to Buying a lower strike Call and selling capitalize on the opportunity available in the market, yet limiting the loss. higher strike call View: Bullish Bull Call Spread When the investor is bullish on the stock, he goes for creating a spread. The spread has the advantage of being cheaper to establish than the purchase of a Page 2 single call, as the premium received from the sold call reduces the overall cost. The spread offers a limited profit potential if the underlying rises and a limited loss if the underlying falls.
  • 3. Derivative Classroom Option Strategies Part I- Series VII Derivative Classroom -Series V Implied Volatility ssss Page 3
  • 4. Derivative Classroom Option Strategies Part I- Series VII Derivative Classroom -Series V Illustration III Hedged position Profit Ms. Kiran is bullish on IT sector and feels that the prices of TCS will move ahead 12 1 therefore she buys one ATM call at 680 with premium outflow of Rs. 15 and 7 Stock price sells one OTM Call at 700 with premium inflow of Rs. 7. 0 Implied Volatility 680 695 700 707 . Scrip Type Strike Price Premium Action -8 Long call Short call -15 ssss -8 Buy TCS Call (ATM) 680 15.00 Loss Sell TCS Call (OTM) 700 7.00 Bear Put Spread An investor who enters in bear spread is bearish and feels that stock price will Buying a higher strike Put and selling decline. In a declining market too investor can make profit both by using call lower strike put and put. The spread offers a limited profit potential if the underlying falls and a View:bU Bearish limited loss if the underlying rises. Illustration IV Mr. Nitin Joshi is bearish on Banking sector and feels that the prices of ICICI Bank will move down, therefore he buys one ATM put at strike price of 920 at with premium outflow of Rs.11.00 and sells one OTM put at the strike of 900 Profit Hedged position with premium inflow of Rs.4.00 13 . Action Scrip Type Strike Price Premium Stock Short put 0 Buy ICICIBANK PUT (ATM) 920 11.00 904 900 931 920 -7 Long put Sell ICICIBANK PUT (OTM) 900 4.00 Loss Page 4
  • 5. Disclaimer: Issuer of the Document:- HSBC InvestDirect Securities (India) Limited* Registered Office:- Dhana Singh Processor Premises J B Nagar, Andheri - Kurla Road Andheri (East) Mumbai – 400 059 Telephone: +91 22 6789 7830 Fax: +91 22 6789 7700 Website: www.hsbcinvestdirect.co.in Disclosure HSBC InvestDirect Securities (India) Limited (“HISL”), its associate and group companies, its directors, associates and employees may have various positions in any of the stocks, securities and financial. Instruments dealt in this document or may make sale or purchase or other deals in the securities from time to time or may deal in other securities of the companies / organizations described in this document. Certification The views and opinions expressed by the author in the document are his own and do not reflect the views of HSBC InvestDirect Securities (India) Limited or any of its associate and group companies. Disclaimer Clause The above is for customer information only and does not constitute investment advice or an offer to purchase or subscribe for any investment. This document is not directed to or intended for display, downloading, printing, reproducing or for distribution to or use by any person or entity who is a citizen or resident or located in any locality, state, country or other jurisdiction where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or would subject HSBC InvestDirect Securities (India) Limited (HISL) or its associates or group companies to any registration or licensing requirement within such jurisdiction. If this document is inadvertently sent or has reached any individual in such country, the same may be ignored and brought to the attention of the sender. This document may not be reproduced, distributed or published for any purpose without prior written approval of HISL. This document is not intended to provide legal, accounting or tax advice and should not be relied upon in that regard. Persons accessing this document are advised to obtain appropriate legal, accounting or tax advice where necessary. Financial advice provided has not been prepared taking into account the particular investment objectives, financial situation and needs of any particular investor. As a result, investors using the advice should assess whether it is appropriate in the light of their own individual circumstances before acting on it. * Formerly known as IL&FS Investsmart Securities Limited