Yesterday, I conducted a 90 minutes session on Trading options in India on WizIQ. I have since recorded the session and have it for you to watch:

Do let me know your thoughts and comments!

Folks, the Free Options Webinar I’m conducting has a changed link, because WizIQ decided I hadn’t conducted my class when in fact, I am only guilty of not having my time travel machine ready since the class is scheduled for later today.

Click here to join the class

It’s free, open to everyone, and there will be a recording. Audio and presentation, keep your headset on, and some coffee, in case I start to put you to sleep.

As part of MarketVision, I’m conducting a free online webinar on trading options, at WizIQ:

Contents

• A *very* brief introduction to the concept
• What price is the right price?
• The Greeks!
• Big Profits, Big Losses: Unbridled speculation
• Strategies To Reduce Portfolio Risk
• Covered Calls, Naked Put Writes, Strangles.
• Adjusting your options positions for profits or losses
• Pitfalls: What you need to watch out for

The class will bring a viewer to a level of familiarity with options, to be able to trade them.

Date: 16 Nov 2011 (Wednesday)

Time: 4:00 p.m.

Duration: 45 minutes; Followed by 15 min Q&A

Prerequisites: Some knowledge of futures and options (Read this introduction) .

What will *not* be covered:

• Advanced strategies (any other than those mentioned above)
• Trading tips of any kind or Market Views
• Technical analysis concepts

Cost: Free. No charge. First come, first serve.

How to register:

• Send an email to lessons@MarketVision.in with your Name and any comments
• Register directly at WizIQ.

OR

• Fill the form below. You will receive an invitation.

The Latest MarketVision Chronicle has a piece about the Pricing of Options:

(Registration required, free)

There are two parts to an option – the intrinsic value and the time value. If a call option’s strike price is below the current market price, the option will have some intrinsic value – that is, the difference between the strike price and the market price. Oh, too much theory. Let’s do an example:

For puts, you get positive intrinsic values only for strikes ABOVE the current market price. These are called in-the-money (ITM) options. Other options are called “out-of-the-money” (OTM) options – the 6100 call or the 6000 put in the example above have no time value, and are OTM.

Intrinsic value is easy: all you need is a mathematical difference. The time value is simply this: If I asked you to buy a share at a fixed price today, but I’ll only give you the share in a month, how much more would you pay me?

The answer lies in multiple pieces:

Time to expiry: The amount of time left on the contract is a determinator – and all other things remaining constant, the time value comes down as you approach expiry:

The volatility of the stock: If a stock goes up 10% in one month and down 15% the next you would think of it has highly volatile. The more volatile you expect the stock to be, the higher “premium” you will demand for a fixed price contract – and therefore a higher option price.

There are two ways to look at volatility. When you take a look at how volatile the stock has been recently, and use that as a parameter to price the option. But that has little value since the past movement doesn’t always follow the future. For instance, would you say that a stock has moved just 1% a month for the last three months, and price an option low, when it has results coming out tomorrow?Historical volatility is useful theoretically but is not very practical.

…

(Read the whole chronicle)

(From my article at Yahoo)

While derivatives have been called weapons of mass destruction and worse, they can provide alternative methods to participate in the markets. To a bystander, these instruments seem complex — and some indeed are so, with SEBI now requiring brokers to ensure that investors are financially capable of handling themselves before they can trade derivatives.

An alternative way to buying stock is to use a "future". Instead of having to buy equity into a company and paying up the full amount of money, we use a derivative and buy the future instead, paying only a margin amount upfront, and putting the rest of the money as cash, which can earn interest in a liquid mutual fund. I tracked the stock of ICICI Bank, bought directly versus buying with a future, since 2006:

I've assumed a single lot of 250 shares, bought for about Rs. 150,000 in 2006, that returns, with dividends. (further assumptions — 30% margins, and the return on cash is 5%)

The futures approach is 10% higher in terms of total return over 5 years! But is it really better?

The correct answer: it depends on who you are. The disadvantages of this system are mainly in the taxes.

a) You get no dividends with futures. While the gains might be baked in somehow, dividends aren't taxed in your hands, so a certain percentage of the dividend gain is lost.

b) You get taxed as business income: Futures trading is considered business income, which is taxable. If you were to lose 30% of your gains to taxes, that negates the entire difference with buying stock. In the example above, the stock gained a total of Rs. 90,000 for which, because of tax rules in India, you pay no tax. (Long Term Capital Gains is nil) But the gain through futures is Rs. 115,000, and a 20% tax will bring it down back to the levels of the stock gain itself.

c) You get no voting rights. Derivatives provide no ownership rights. But hardly any investor votes nowadays, so this is not so much a disadvantage.

d) The process has pain. With a rollover every month, and mark-to-market gains or losses that need a transaction every day, it's a lot more effort for the lay investor.

The "who you are" helps: for many foreign institutional investors, gains or losses may not be subject to Indian tax laws, in which case the above disadvantages are irrelevant. It would help many Indian institutions as well (such as mutual funds or insurance companies, which aren't taxed on gains) but they have strict regulations about how much exposure they can have in derivatives.

Lastly, a trader or a proprietary trading house might benefit from using futures; the taxation disadvantage might be offset by business losses or valid expenses, and will justify the returns.

And there are advantages. For one, you can participate in the downside. Sometimes stocks get overvalued, and it is considered proper trading to short-sell a stock, expecting to profit from a price decline. But in India, you can't short-sell stocks, because there is no liquidity in the "borrow and lend" market.  Futures give you an easier way.

Creeping acquisition rules do not allow individuals to hold stocks without notifying the exchanges and thus, the public — so a large chunk of shares acquired will trigger interest and could take the price high before an organization can finish its buying. Futures, on the other hand, have no disclosure requirements so a buyer could participate in the growth of a stock with no one else ever getting to know.

This lack of disclosure creates many problems as well. In 2008, shares of Volkswagen went up more than three times as Porsche, its owner, declared that it now owned 75% of VW through some derivative instruments. Short sellers — who had a negative view of the stock — had to scramble to buy back shares which were not available (as Porsche had effectively cornered most of the free float), and for a while Volkswagen became the world's most valuable company. The main issue was that Porsche never disclosed the stake, since it wasn't required to report derivative positions. Regulators have realized that derivatives need to be brought into similar disclosure norms that equity shares require.

In India as well, Reliance Industries got into trouble — and still is — for having profited through derivatives in the shares of a subsidiary (RPL) before it sold shares on the market. While creating a hedge, Reliance had used futures to short-sell RPL shares that it eventually sold; but it seems that in the process, it took on greater positions than would be considered a hedge, and therefore is being investigated for insider trading.

It is also quite likely that much of the insider trading market has moved to single-stock futures. Promoters must reveal every single share they buy or sell, but not their futures and options trades. On a piece of news that is known only to a board member, a quick profit can be made through a futures transaction with very little chance of being caught. I would be surprised — given the low level of enforcement or investigation in futures trades — if this is not rampant.

Finally the derivatives bazaar gives you the ability to take more than a "Stock Will Go Up" or "Stock Will Go Down" approach. You might believe that a stock will stay in a range. Or, that the stock will go down, but not too far down. Or that it will go wildly in either direction.  With the use of options, along with a stock, you can create synthetic positions that let you profit from even such imprecise notions. Traders have named them exotically, so you will hear of Strangles, bearish put spreads or straddles — the respective positions you will use to trade the aforementioned beliefs.

It is such synthetic positions that have been used to create "structured products" — where, with options, futures and cash management, a financial product can offer you "complete downside protection with 100% upside" — meaning, you lose no money if the market falls, but you make just as much if it goes up. These products are very useful for a risk averse audience, who might otherwise never even participate in the markets.

Given that we just saw a global crisis because of abuse of derivatives, it is only logical to be afraid of them. But if real estate stocks have fallen 90%, stocks aren't necessarily risk free either. If you consider that we sit in November 2011 at an Index level that is about the same as January 2010, that the US markets are about at the same place they were 11 years ago, or that Japan has fallen 75% from its highs 30 years back, it will seem useful to explore alternative investment strategies that don't require the market to go straight up.

The last two MarketVision Chronicles have some awesome (we’re modest) pieces for you. (You’ll need to register, and it’s Free!)

Sep 12: Protecting the Downside

Protecting the downside: Three Option Strategies

When markets go down, it may be useful to protect your downside with a “hedge” of sorts. There are strategies to cover yourself against what might be temporary moves to the downside.

Buying Puts

Concept: Buy Put Options to hedge against downside risk

Put options are available on the NSE, both on individual stocks and on the index. If I thought that the Nifty was going down below the 5,000 levels then I might choose to buy a 5000 put. For a portfolio of Rs. 10 lakhs, the Nifty needed to cover it is around 200 options (Nifty options trade in a lot size of 50).

But the premium matters – in disturbed times, put options cost a lot of money. A Nifty 5,000 put cost Rs. 156 today with the Nifty at 4947. That means the Nifty put doesn’t protect you till Nifty reaches (5000 minus the premium of 156)  or 4844, which is 100 points below today’s close.

That means you will not be covered for the first 100 points of any subsequent fall, since that is the cost of the “insurance”.  This is equivalent to about 2% of your portfolio; which is the “cost of insurance”.

Look at the payoff curve (Option plus long position together):

(Do read: The MarketVision Chronicle, Protecting the Downside)

Sep 19: Understanding F&O Margins

Understanding F&O Margins

When you trade the futures market, you get charged a margin for each trade. (For more information on what they are, read Futures and Options: an Introduction) If you were to buy a Reliance future, the lot size is 250 shares – at a price of Rs. 820 per share, your future should cost you Rs. 205,000.

But you don’t get charged Rs. 205,000. You get charged a percentage of it; this amount is called a “margin”. The margin you get charged depends on the “underlying” security on which the futures is based and the volatility at the time. Why? Because if you don’t pay the full cash at the time, the exchange has to protect itself from your running away in case the trade doesn’t work out for you – the margin is your skin in the game.

Let’s illustrate with an example. Take the Reliance future. If I try to buy a single lot – 250 shares - at Rs. 800 – I placed a dummy order, the stock’s at 820 – the exchange demands a margin of approximately Rs. 35,000. What’s in it?

There is an upfront initial margin which is applicable at the time of the trade. The actual number is calculated using technology called SPAN (Standard Portfolio Analysis of Risk) which was developed by the Chicago Mercantile Exchange (CME). The idea is that a lot of complex (and shady) mathematics happens behind the scenes to tell you, for an F&O portfolio, what the total margin should be. SPAN generates the number using the price and volatility of the underlying security – In the Reliance case above, the margin determined was around 17% of the stock price. Additional to the SPAN margin is an exposure margin – about 3% of total value of the position. (5% for stock futures)

Example

Let’s say I buy at Rs. 800, and the stock goes to Rs.750 on some bad news. I now have to pay two elements of charges.

One: a mark-to-market amount, which is the difference from my buy price. This is calculated constantly, but charged only at the end of the day. So if Reliance fell to 750, my mark-to-market loss would be Rs. 50 (difference from buy price) x 250 (lot size) = Rs. 12,500. That’s a lot of money (compared to the initial margin of Rs. 35,000, it’s 30%+!)

…

(Read: The MarketVision Chronicle, Understanding F&O Margins)

Many people who trade options towards the last week of expiry have been excited by the volatility this month – coming after nearly a year of relatively sane trading. Options have high implied volatilities and the daily moves in the Nifty are even higher, of the order of 2% (translation: options haven’t really priced in the moves),  which makes the option values look great.

As I write this, the Nifty is at 4870 and the Nifty 4900 call, expiring on Thursday, is at Rs. 48. This means the nifty can move just 2% up from here, and you’ll end up profitable. With a month that’s seen us down over 12% this month, you might expect some sort of a recovery in the last few days.

But note that option prices on the Nifty carry at least a 6 point risk of STT. That is, if you hold till expiry, you’re going to pay Rs. 6 as Securities Transaction Tax on the trade. Towards the last day, options quote at about Rs. 6 less than intrinsic value because of this issue. I’ve made a more detailed video at MarketVision:

Also, commissions are quite high. Most brokerages charge you Rs. 30 to Rs. 50 per lot. A lot of Nifty is sized at 50, so a two-way trade (buy/sell) involves a cost of Rs. 100 per lot on brokerage or subsequent service tax, stamp duty, etc. which could add up to Rs. 150 per lot – that is, for a lot of 50, Rs. 3 per Nifty.

If you’re buying something at Rs. 48, and your costs are Rs. 3 for brokerage+, and Rs. 6 for STT, your breakeven point is Rs. 57 – or nearly 20% higher. You have to keep this in mind when trading options; if you don’t see a ridiculous gain (100%!) you shouldn’t trade the last few days – costs are high.

(A friend runs a brokerage called Zerodha – Disclosure: I’m an advisor -  where I trade options – it costs me Rs. 20 per trade, and if I buy 200 Nifty options, my round trip cost on brokerage is very cheap – just Rs. 50 overall or Rs. 0.25 per Nifty.  STT still applies, but I hardly even hold long options in the last week, unless the costs are accounted for)

Options are a great trading tool if you understand that it’s a very high risk bet as well. In the context of highly priced options, it may be better if, rather than buying, you WROTE strangles or straddles today, for the August expiry; this has the added advantage of the STT loss being priced in by Wednesday and gives you that much of a cushion. As always, there is a huge risk in being short options as well.

On popular demand, we bring in an introduction to option pricing - a primer of sorts - and an explanation of VIX (the volatility index). Followed by an analysis of where we are right now. And of course, all at Marketvision.  Enjoy the IPL final as it ends a very light week in terms of volumes and data on the markets.

An Introduction to Option Pricing and the VIX

The Vix is an interesting index – a volatility index that determines what option prices imply that our volatility is. A quick primer: Options give a buyer the right, but not the obligation to buy or sell a stock or index at a given price (“Strike price”) at or upto a given day (“Expiry Date”). Call options are when you get the right to buy and put options, to sell.

For example, a Nifty 5400 call option expiring June 30 (In India, they usually expire on the last Thursday of the month) was trading at Rs. 66 on Thursday, when the Nifty was at 5415. That means someone was willing to pay Rs. 66 to be able to buy the Nifty at 5500 till June 30. So his break even price is Rs. 5566.

(Note: Options are bought and sold before the “Expiry date”. You can buy Jun 30 options today at 66, and sell them tomorrow at 85, and realize the profit. You don’t have to wait till expiry. Who’s on the other side? Other people, who have the opposite view.)

But why 66? Since the Nifty is at 5415 today, how does he come about to the figure of 66 rupees? Why does it go up to 85 when the Nifty goes up to 5450?

There are many answers, but this has been studied since the 60s. Fischer Black and Myron Scholes eventually created a valuation method for options that is called the Black Scholes method. I won’t go into the details, but you can get to the price using these parameters:
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Are Greek bonds pricing in a massive default? | Felix Salmon

My point here is that although yields on Greek debt are indeed high, they’re not anywhere near the really distressed levels that we’d expect to see if the market was expecting a massive and imminent default. If you buy a bond at 71 cents on the dollar, that’s cheap, to be sure, but there’s also an enormous amount of downside: if Greece does default in anything but the gentlest possible manner, then you’ll end up losing money.

Sector Fund – Should you invest? — The Financial Literates

Before you start reading about sector fund – I would like to tell you clearly that this is the riskiest category in mutual fund. Time to time few of the sectors have given phenomenal returns but end of the day losers are more than winners when we talk about investors. My suggestion is they should never be part of your core portfolio but depending on the individual you may think about this in your satellite portfolio. In this article I have covered what are sector fund, best sector funds, benefits & risk associated with them and finally should you invest in sector fund.

....

Videos

Past Short Takes:

• Reviewing a ULIP: HDFC SL Crest

• Monthly Income Plans
• Conversations: Manish Jain on What's Good About ULIPs
• What is VWAP?
• Liquid and Ultra Short Term Mutual Funds
• Five Stocks in Five Minutes: April 13, 2011
• DLF - After the Rise
• What is Short Delivery?
• ...

(Read the entire Chronicle)

And if you register, the next one's will be in the email this Saturday. And then, every Saturday. Cheers!

In pursuance of SEBI circular no. CIR/DNPD/6/2010 dated October 27, 2010 regarding
European Style Stock Options, circular no. 120 (Download no. 16165) dated October 28, 2010
regarding European Style Stock Options and in partial modification to consolidated circular no.
1136 (Download no. 16104) dated October 25, 2010 you are informed that all Stock Options
contracts expiring on January 27, 2011 and onwards shall have European exercise style only.

Accordingly there shall be no interim exercise available for all Stock Options contracts expiring on January 27, 2011 and onwards and all the in-the-money Stock Options contracts shall get automatically exercised on the expiry day.

All existing month Stock Options contracts expiring on November 25, 2010 and December 30,
2010 shall continue to have American exercise style.

Also read the SEBI circular.

Note: What follows is complex. Read Futures and Options: An introduction first, if you don’t know about F&O .

American options can be exercised any day – and this was creating all sorts of problems. Stocks can be moved to ensure they close at a certain point between 3 and 3:30, options then exercised (the exercise window is open till 4:30?). So the seller of the option (who knows about the exercise only at 5PM) has now no way to cross-hedge – that is, if he held a future or a different option to hedge against exercise, he has no way to take the hedge off.

Complex example: Imagine I have sold a 1100 Reliance call, and am long a Reliance Future to hedge. Reliance goes to 1140, and at 5PM I am told that my call was exercised. At 6 PM there is some adverse news on Reliance, and the next day it opens at 1090. I lost Rs. 50 right there, without even a chance to work things out.

Another problem – options are exercised against the stock, but if you hold a future to hedge, the future can quote at a discount, which ruins the hedging. If Reliance closed at 1140 but the future was at 1120, an interim exercise makes me lose 20 points. (Yes, you could hold the stock, but then how do you hedge against writing a put option?)

In America, you can deliver a stock against the exercise, so the minute you get exercised on a call, your stock is taken away, so you don’t have the above issue. In India, options are cash settled.

European options mean that you can write options and stay at peace without worrying about exercise. A huge positive: covered call strategies will be that much easier, as the stock can be used for margin now, and you don’t have to worry about an interim exercise.

Lastly the whole “dividend complication” will go away. Example: Hero Honda announced Rs. 80 dividend, and immediately the future after the ex-date shot down Rs. 80. Futures were quoting at 1,940 while the spot market showed rates of 2,020 (including the dividend). At this point, the 1900 call was quoting at Rs. 122 – why? The stock would go down to 1940 before expiry, and the Rs. 120 price has an obscene time value – yet, because stock options are American and marked to the Rs. 2,020 spot price, the price had to be at least Rs. 120. This only happened till the Ex-date, and yes, I’ve taken advantage of this many times. But I’m happy to see it go away.

Also Read:

• How does Option “Exercise” work?
• Futures and Options: An introduction

This post is written by Deepak Shenoy, at Capital Mind.

I read your article “Of Options and Choices” posted today.

[…]

It would be helpful if you can through some more light on American Options w.r.t. Indian Markets. I know the basics of these option what I want to understand is that at any given point of time there would be hundreds of Options (for a particular stock)  outstanding. Say there are 2 parties to a trade A (seller/writer) and B (Buyer) and B decide to exercise the option before expiry at 5.00PM on any given day. I want to know 2 things:

1. At what price would the position be settled (since options in India are cash settled)

2. How will exchange decide that A is the person on whom the option has been exercised. Does the exchanges keep the one-one mapping of each contact at the backend. E.g. A initially sold and C bought, C sold (closed position) and D bought and so on say there were 20 such transactions before B decide to exercise the option. How will exchange determine the counterparty for the contract.

First, in American options, stocks are settled at the “cash” market value of the stock. Currently, ICICIBank cash trades at 960, while the future trades at 949. If these are the closing prices today, then a buyer can exercise the 940 call and get Rs. 20.

Because of this difference there is a tremendous amount of market manipulation that happens in the cash markets to bump up option exercise prices. I will post about that separately.

Second, who gets exercised? If there are 100 sellers and 100 buyers, and only 30 buyers choose to exercise, which of the sellers get hit? (It’s called “getting assigned”) Answer: The NSE does random assignment of options to sellers.

This post is written by Deepak Shenoy, at Capital Mind.