Vijay had felt acrophobic when the Sensex crashed by 540 points on February 28, 2007. He had bought March futures of Tata Steel, which ended lower by Rs 33 from his buy price, eroding Rs 22,275 from his portfolio.
“I had bought futures to make bigger gains. The lot size was 675 on the contract, which meant for every single rupee move, I stood to lose or gain Rs 675. Though I had time till March 29, the contract expiry day, the fall was too steep that one more move in the same direction could have raised requirement for additional margin money. So, I closed my position at a total loss of Rs 22,275. But I picked up a few lessons from there,” says Vijay (name changed), who considers himself as a better trader now.
Since then, Vijay has not traded in stock futures. He now trades in stock options and feels safer.
Like Vijay, most Indian traders use stock futures, either due to their profit potential or a lack of knowledge of options. While there is no doubt on the profit potential of futures, the risk involved in stock futures makes options more attractive.
“We always advocate trades in options. They sort of insure your risk. Rather than taking position in stock futures, one should think of buying options as the risk is limited to the amount of premium paid,” says Rahul Nangalia of Nangalia Stock Broking.
The fundamental difference between buying a stock future and an option is that the latter is not obligatory. While a future is an agreement to buy or sell a security at a certain time in the future for a specified price, an option gives one the right but not the obligation to do the same. This right to buy or sell comes at a price, which is called the premium.
There are two types of options – call option and put option. While a call option gives the buyer the right to buy a security on a future date at a predetermined price, a put option gives him or her the right to sell a security on a certain day at a certain price. The future price that the parties to the contract agree upon is called the strike price.
Now, let us see how a transaction in the shares of ABC plays out in each segment.
Say ABC shares are quoting at Rs 100 and you expect the stock to hit Rs 120.
Buy 100 shares of ABC for Rs 10,000 (Rs 100x100 shares).
Case I – The stock reaches the target of Rs 120.
You will make a profit of Rs 2,000 (profit of Rs 20 per share x 100 shares).
Case II – The stock falls by Rs 30 to Rs 70 – You will incur a loss of Rs 3,000 (loss of Rs 30 per share x 100 shares).
Buy a contract of 500 shares (lot size) of ABC for Rs 50,000 (Rs 100x500 shares).
Case I – The price reaches Rs 120.
You will make a profit of Rs 10,000 (profit of Rs 20 per share x 500 shares).
Case II – The price drops to Rs 70.
You will incur a loss of Rs 15,000 (loss of Rs 30 per share x 500 shares).
Buy a call option for 500 shares at a strike price of Rs 103, paying a premium of Rs 2,000 (considering a premium of Rs 4 per share x 500 shares).
Case I – The share price hits Rs 120.
You make a gross profit of Rs 17 per share (Rs 120-Rs 103), from which the premium paid has to be deducted. That makes your net profit per share Rs 13 (Rs 17-Rs 4 paid as premium). Hence, you make a total profit of Rs 6,500 (Rs 13 x 500 shares).
Case II – The share price drops to Rs 70.
Here is where the option shows its advantage. You have bought only the right to exercise an option (in this case buy). Hence, what you lose in case of an unfavourable movement to any extent is only your premium. In the said example, your loss is limited to Rs 2,000 (the premium paid for possessing the right to buy 500 shares at Rs 103).
As is evident from the above example, options have a clear advantage of limiting risk on positions taken to either side of the market. Buying a call option reflects a bullish stance and the position taken enters the profit zone as soon as the share price goes above that level which is the sum of the strike price and premium. Similarly, a put option represents a bearish stance and the profit zone starts from below the total of strike price and premium.
However, selling options can be as fatal as futures or leveraged cash market positions. The seller or writer of an option ensures that his profit is limited while leaving risks open to infinity. The writer of an option profits from the premium he collects from the buyer for providing the assurance to buy or sell securities at the predetermined price. This way the seller of an option has only obligation and no rights. Hence, in case of unfavourable price movements, the writer of an option could incur massive losses.