Sunday, May 10, 2009

Art of buying options…

Hi I am back with sharing my thoughts with options. Like I mentioned before there were queries and suggestions regarding options – why this and why not this. Many of those questions asked were pretty basic. Basic is just one reason. The reasons and the conclusion I came to why those queries had cropped up were

  • Options are not traded/treated in India as there are abroad – especially in the US and European markets where LEAPS are offered, the volumes are much higher and options are by and large more liquid.
  • We have a mental block – I have been quoting this quote so many times - “A man will spend 1000/- Rs more on something that is useful… A women will spend Rs 100/- less on something that is totally useless.” Unfortunately when we think of buying options we men folk become women. (special apologies to ladies who will read this)
  • We think cheap – I will clarify it in the subsequent paragraphs.

Why would we want to buy options in the first place? Well it can be because of any of the following three reasons: -

  • Speculation – that involves making directional call on a underlying security or Index. This – I believe is the most popular category that is one on everybody’s mind – bloody gamblers we are!! Including me ofcourse.
  • Hedging – Logically this is the idea behind having this instrument in the first place. It is to protect an investment already in place.
  • Income producing – generating a cash flow.

I will tackle the first part only today – the most common desire to enter options ‘the speculation’. Let me help you recapitulate:-

  • We had earlier seen (in previous article) that the options have a real value and a premium.
  • We had also seen that DITM (Deep-In-The-Money Options) have lowest premium, ATM (At The Money Options) and OTM (Out - Of – Money Options) are basically only premium and has no real value to them.
  • There are two reasons for premium – One is volatility and second is Time to expiry.
  • The Option seller are selling the options for two reasons – technically there is only one chance in four that at the end of the expiry that he will have to pay up. (more of it a little later)

That would imply that as the time passes and we near expiry the options premium will reduce and eventually become nil – if the option does not go in money till then you are technically dead especially the options that are at the money or in money.(money invested is now zero – other words you have lost your investment).

If we know all of the above then why do we buy ATM or OTM? I will tell you why – as I said earlier we are misers when it come to investments. Let me tell you how with help of an example. Let us say that I am bearish for the near term. So what will I buy – Puts ofcourse.

  • Let me go a step further and see the pricing. Uhhh!!! Let us see – the market at 3620 on Friday so – DITM 4200 PUT for the month of May costs me 605/- Rs – I will have to pay Rs 605 X 50 = Rs 30,250/- Now that is a lot of money.
  • I will buy ATM (ATM can be taken as +/- 1% of the current price). So let us see 3600 Put for the month of May. That’s Rs 159/- (almost half the amount I would spend on DITM)
  • Better still let us see OTM – after all I expect the markets to let us say drop to 3200 – so how about 3200 put? Brilliant! just Rs 43/-

WOW ! that’s what life is all about 3200 Put for 43 costs me 43 X 50 = Rs 2,150/- -- and can you believe it that this idiot – Cheema does not want me to enter this trade? After all what do I loose? 2 thousand bucks for a chance to make what – unlimited amount – after all the reason to buy options are to make unlimited money with risking just 2 thousand.

Convinced that you prefer to buy a OTM for 2,150/-? Well now hear me out to tell you why you are a looser. Okay the principle on which you are betting is limited downside and unlimited upside. Why is the seller selling this when he knows that the profits are maximum of 2,150 and losses unlimited? Well you know why all the insurance companies are having a ball of a time – after all he takes just a thousand bucks and insures you for 1 lakh! Its because of law of probabilities – he knows by statics that if he insures 10,000/- people he will be giving out money to perhaps 1 or 2 people only. If he finds that you are now of 40 Plus age – he will increase the premium and so on and so forth. Ultimately they are making a killing selling us one thousand a year policies and we are doing what – just loosing one thousand every year – Got it?

Similarly a option seller know that the chances of you taking something from him are bleak as hell. Let us see why

  • In the first scenario market does not go in our favour. It goes up (like it did for millions of aspirations last month) you will loose your 2,150/-
  • second scenario it remains more or less here only – like it generally does when it is in a non trending mode. Once again you loose 2,150/-
  • Third scenario It drops – Thank GOD! No? Let’s see: -
    • It drops to 3,200 and the series expire. I loose Rs 2,150/-
    • It drops to 3,167/- ( I just recover the money I paid (Rs 43 Premium)
    • Market goes to 3,100/- Thank GOD I have made money let me get out of the markets fast.

At this moment I will introduce you to a term called Delta it is one of the Greek terminology that is used in Options to convey a mathematical end. It is generally represented in form of a fraction starting from 0.000 to 1.000. I want to dwell on this in detail. It is a representation in percentage as to how much your Option will move for a unit move in the price of the underlying. for example my 4200 put has a Delta of 0.846 – that means in simple language that for every one point move of underlying asset the option pricing will move 84.6%. if nifty drops by 100 points the Put will gain by 84.6 Points. The 3600 Put has a Delta of 0.448 or in other words will move 44.8% of the move of nifty. The 3200 Put has a delta of 0.159 – means that the option price will move 15.9% of the underlying.

Two important things – Delta changes as the market moves. Delta of OTM and ATM will contimue reducing as the expiry comes nearer. DITM have higher deltas and ATM and OTM have low deltas. Eventually if the options do not come in money – they will expire worthless. This is the reason where in you find the market going in your direction and still the options not moving at all and your disgustion, desperation, hope and fear increases as the days pass by.

Then what the hell should I do? Well to my mind three things…

  • Have a entry and exit strategy if you have to buy options. That means that you should do technicals, fundamentals or something to get the trend right.
  • After you are certain of the trend then you buy a DITM Option. It will give you most bang for your buck. Like in the example above – If the markets move 100 point in my favour I gain 85% odd of the move.
  • As the market moves more and more in my favour Delta will keep increasing to as much as 100% where I get one point for one point move of underlying.

Now let us see 1. Market moves in the direction I thought it will – I gain. 2. Market does not move I loose just 25 points (almost half of OTM). 3. Markets move in opposite direction – Ideally I should have an exit policy or should hedge my position.

Just give it a cool thought – though technically you can make unlimited money on this Put of yours have I really made a killing? Now think over it what were and are your chances of making money buy OTM or ATM? chances are indeed bleak – but still it is so strongly imbedded in your head – limited risk and unlimited upside that you hope against hope and keep giving small amounts of money to strike it rich one of the days. Believe me it is a pure gamble – as it is buying options – of the three reasons I listed in beginning is speculation and I am sure you will think hard before someone give you a call – 2800 June call is just for 50 bucks – buy me 1 lot because you feel you will just loose 500? Hope I have conveyed my point… And if you still insist that you have to buy cheap ATM or OTM options then as soon as they give you a return pocket the profit. Do not let the decay kick in and eat your profits – other than we are strongly trending in your favour – but unfortunately the chances are indeed low.

One last thing – I would have loved to discuss another Greek for options called Theta – Please do a google and I am sure you will find the definition easy to understand. And as to how you can get to know all these values – go to site called and download OptionsOracle – it is a must have software and it supports Indian stocks – just change to NSE India.

Please feel free to comment – I will eagerly look forward to the response and plan the next session if required on options depending upon what you desire.



mash said...

cheema sir,
very lucidly and simply explained...u have a knack to simplify considerably difficult things...thats what made ur classes so interesting.

geniusjaggu said...

a excellent post on options..keep it up...

Uma said...

hey cheema, listen to this

S S Cheema said...

Thanks Uma: it is indeed a wonderful world. Thanks once again that bliss of listening to is was too beautiful to describe.

Mash and Jaggu: thanks a ton as always for lending me your ear.

shaq said...

sir...the rss feed is not working of late...i subscribe using google reader..and the blog is not updating...any workarounds??

S S Cheema said...

Shaq please try subscribe via email link - Please let me know I will fight it out with FeedBurneer if that does not happen.

r m said...

Thank you Paaji! Your blog has given even me an option to become intelligent - albeit in distant future.

S S Cheema said...

LOL - rm come on - you all are my guiding lights..

Anonymous said...

Dear Mr.Cheema,
It is excellant. I was away for two days so that I could reply immediately. Pls continue with your Option Classes so that new entrants like me will get educated. If possible and time permits you, may I request you to reduce the time itervel, instead of weekly once - can it be once in three days or so. It is a request.