Option Strategies Part I

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Option Strategies Part I

  1. 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. 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. 3. Derivative Classroom Option Strategies Part I- Series VII Derivative Classroom -Series V Implied Volatility ssss Page 3
  4. 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. 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

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