Previous Post : Selling Call Options- Lies, Lies and Damn Lies -7

A call option is a right to buy assets at a future date. Therefore they are for potential investors. It is quite natural that there exist options for holders of assets too. All those who have bought assets for investment fear that the prices of their asset might fall in future. This fear is true and there are options to reduce this risk also. Consider an investor who has bought 1000MSFT at $25. He wants to get some protection if price of MSFT falls in future. In the derivative markets there are traders who will take this risk for a price. As the price demanded by the seller is related to his risk, amount received by the seller is in the form of a premium. The seller of this option gives the buyer a right to sell his asset at his stipulated strike price if the price of the asset falls below that contract price. In effect buyer of this option gets a right to put his shares on the seller of this option if the price falls below the strike price at which option is written. Therefore such options are called put options. Put options are derivatives because they derive their value from some other asset. In our example the asset is MSFT.

When a put option is sold the seller takes some big risks. If the price of the asset falls below the strike price on the expiration date, he will be forced to take it at the contracted price. This will result in big losses as he purchases an asset that has fallen considerably from the contracted price. Therefore seller of put options will assess his risks well and estimate the likely losses before he attempts to write a put option.

The choice of the strike price is also with the buyer of the put option. If MSFT is trading at $25 in the spot markets, many strike prices above and below 25 will be provided by the exchanges. For example our investor can buy put options at 24strike price. As the asset is trading at 25, writer of a put option at 24 has less risk writing this contract. If the investor chooses a strike price 26 the writer of the put option takes more risks because the asset is trading one dollar above the strike price. This results in more premiums.

Therefore premium of a put is related to variables like spot price, strike price, interest rates and time to expiration. Option at strike price at 25 is called ATM (At The Money). All options above 25 are called OTM (Out of The Money). Put options below 25 are called ITM (In The Money).

Put options are meant to reduce risks to holders of assets. When put options are bought by investors of assets, they transfer the risk to sellers for a fee. Most of the writers of put options are speculators. They estimate the probable level to which the asset price may fall and sell puts below that. If the asset price remains as per their expectations they get their premiums free. This is easy money. Even far out of the money put options would have some premiums. Astute option sellers write such puts every month and get interest on the money they pay to exchange as margins. This is very lucrative as long as it works. However all the profits and their capital will vanish when the share price plunges sharply. This happens at least once or twice in ones life. As the consequences are deadly writing even far out of naked puts is very risky.

Similarly speculators buy puts assuming that asset prices will fall. Here they are taking a direction to the markets. It should be noted that there are speculative buyers and sellers of puts and they can not be right at the same time. If a speculator buys puts and market goes up he loses the premium he paid. If this is repeated many times he will lose all his capital. Thus buying puts as a speculative activity is also very foolish. However brokers and advisers generally publish their achievements in taking directional calls with no accountability. Poor investors and traders naturally fall for these claims.

However, selling put options can be utilised by investors to buy their stocks at very low prices with no risk. This strategy is popularly known as covered put strategy. Suppose an investor wants buy 1000 MSFT. MSFT is trading at $25 in the spot market at that time. The investor wants to buy MSFT at a price of $23. He has money in the bank. He has two options. He can wait for MSFT to come down to 23 and buy it then and there. He may have to wait many months to get it at that price. Instead of that he could sell put options on MSFT at strike$23 getting a premium of $1. If MSFT does not close below $23 the investor gets $1 premium free. Writing of puts at $23 can be undertaken every month till MSFT closes below$23. Suppose it took ten months for MSFT to close below$ 23. By this time he would have received $10 as premium free. Then the cost of his MSFT would have fallen to $23-$10=$13. This is a highly attractive price. Had he not written puts at $23 strike price his MSFT would have cost him $23 after ten months. There is no risk in this trade because the investor is ready to buy the asset and has the funds for that. He could also have selected his price at $21 and wrote puts at strike 21. However the premium on strike$ 21 would have been very less. This strategy can be used to generate interest on margins by investors on idle money in the bank.

**HEDGING STRATEGIES BY PUTS**

Speculators buying puts and selling puts are usually losers because they assume a direction to the market. This assumption has only 50% chance of being correct. However there are methods to reduce the losses by using puts in such cases also. Suppose a speculator sells 1000 puts on MSFT at srike25 at a premium of $2 when its spot rate was $25. His losses can be substantial if MSFT falls considerably. Therefore he will be asked to pay a big sum as margin by the exchange. However his potential losses can be reduced and margins too brought to very small amounts by hedging his sold puts by buying puts at a lower strike price. For example the trader can buy 23 strike price puts at a premium of $1.when a speculator does this, the puts bought will take care of what ever fall MSFT makes after 23. He already has a receipt of $2 from the sale of put options. Therefore his maximum loss is now reduced to $1000 paid for the put at strike price23. Therefore his margin will also be reduced to $1000. Here the speculator assumes an upward direction to the share price. Hence this strategy is called a bull spread by puts. His maximum profit is now reduced from $2000 to$1000. It will be seen that risk reward ratio is below 1 in all such hedging strategies. Probability of getting some profit also is less than 50% in such strategies. Therefore this is not a good strategy.

In the case of speculator buying puts he will lose his premium if share remains above the strike price. He expects the share price to fall. By selling puts at a higher strike price he can reduce his losses if share price remain above his strike price. Suppose a speculator bought 1000MSFT puts at strike price 25 paying $2. His maximum loss is $2000 and occurs when MSFT remains at 25 or above 25 on expiration. This loss could be reduced by selling 1000 MSFT puts at 27 strike price receiving a premium of $1. If MSFT closes above 25 on expiration date the speculator losses $2000-$1000=$1000 from his position. By selling the puts he reduced his losses to $1000. Here also risk reward ratio is less than one and probability of profit is below0.50. Therefore this strategy is also not advised. As speculator expects the share price to fall this is called bear spread using puts.

Most speculators are quite reckless and never think of the consequences of their trading methods. Most of the them believe strongly in Technical Analysis. Some may have charting software also. Their blind faith in Technical Analysis might lead them to ruin on many occasions. These speculators buy futures in indices and single stock assuming a direction based on Technical analysis. Since trading in futures is very risky puts can be used to reduce risks in their positions. Suppose a speculator is long on 10 contracts of SPY futures at 110. If SPY goes down he loses money. There is no limit to his losses. However his losses can be reduced by buying puts on SPY. There are puts at 110 available on SPY. Suppose SPY puts at 110 strike is available at $3. If he buys 10 SPY put contracts at strike price 110 he pays $3000. If SPY goes down below 107, all loses below that will be taken up by the puts. Thus buying puts at 110 strike converted his unlimited losses to a loss of $3000. As he is long in SPY, he gets unlimited profits if SPY goes up considerably. Thus spending $3000 provides him a certain amount of insurance.

Similarly many speculators sell futures contracts based on Technical Analysis. These people also face unlimited losses if asset prices move up considerably. Suppose a speculator has shorted 10 contracts(1000) on SPY at 110. He gets unlimited profits if SPY falls considerably. He faces unlimited loses if SPY moves against him. Here the speculator can sell 10 contracts of SPY puts at strike 110 receiving$3as premium. If SPY moves up above 110 he is protected up to 113 by these puts.

There is a strategy called ratio put spread which is a modification of bull spread using puts. Here the speculator expects a limited downward direction to the market. He buys an out of the money put and sells twice or thrice the number of far out of the money puts. Suppose MSFT is trading at $25. He buys a 10 put contracts at 23 strike paying $0.75. He also sells 20 put contracts on MSFT at 21 receiving $0.5 per put as premium. Here his receipts are $1000 and payments are $750. If SPY goes up above 23 he gets $250 as profit. If SPY goes down he gets his maximum profit at 21. He receives a profit of $1250 from his 23 put and $1000 from his 21 puts. His loses start at 18.75. This strategy may look very safe as losses start only far below the current price. However the losses can be considerable if MSFT falls below 18.75. These unusual happenings are quite usual in stock markets and even a careful speculator will lose his capital when such events happen. Therefore this strategy is not advised.

To be continued

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

jitin says

August 31, 2010 at 8:04 pmmr. CYRIAC J. KANDATHIL ,

plz tell me what to look at to trade stock options positionally . tx .

Cyriac says

September 1, 2010 at 6:45 amTrading options is exactly similar to trading stocks.Stocks are real assets and options are derived instruments from the assets. Buying an asset involves some speculation because buyer expects the price to go up. At the same time the seller expects the price to go down. Therefore buying and selling stocks and options for for trading purposes are speculative activities where you will never make profits consistently even if you are clever. You may win some ,you may lose some. Ultimately your broker gets your money as brokerage.

But there are good strategies using options by which you eliminate the uncertainties and risks. I will come to them in my subsequent articles

Cyriac