Stock option and its implications

Anup Menon

OVER the next few months the operations of the Indian financial market is likely to undergo a sea change.

For the first time derivative securities, in the form of options, are likely to be introduced. Initially, options are likely to be introduced on stock indices, and thereafter on individual stocks.

Multi-faceted impact

Options are financial instruments that provide a great deal of flexibility for the investor in making investment decisions. Options trading has thrown up some great success stories in the world of high finance. But it has also destroyed established traders and individuals.

Users have to, thus, exercise a certain amount of caution. Options are traded on a variety of securities, including equities. Given the basic operations, investors have to understand certain key terms. These are the critical factors that affect the price of an option.

World of equity options

Equity options are traded in both the over-the-counter markets and registered exchanges (in India, SEBI has permitted the NSE and BSE to start trading in options). Just as in the case of a share transaction, there is a seller willing to sell a quantity of shares at a given price to the buyer, for an option too, there is a seller willing to sell a given quantity of options at a price.

Calls and puts

The simplest of options can be classified into a put and a call option. The former gives the owner the right but not the obligation to sell a share at a given price. The latter gives the holder a right but not the obligation to buy a share at a given price.

For instance, consider the case of Infosys Technologies. Option quotes are not given on the price of the underlying security; the trading is on the premiums -- the strike, or exercise, price that corresponds to the price at which the option can be exercised on maturity.

Assume that Infosys options with a strike price of Rs Y are trading at a premium of Rs X for maturity on November 1. It means the investor can buy options on the Infosys stock by paying the premium, that is, Rs X. On the maturity date (November 1), the investor has the option of exercising the option or letting it expire. If the spot price of the underlying security is lower than the exercise price, he is not likely to exercise the option. In either case, the maximum loss suffered by the investor is to the extent of the premium paid.

Assume that the spot traded price of Infosys on October 20 is Rs 8,000. Call options at a strike price of Rs 8,300 and maturing on January 20 (three-month maturity) are trading at a premium of Rs 1,300. If an investor takes a position in the spot market, he would have to buy one share paying Rs 8,000. However, if he were to buy the option at Rs 1,300, he can buy approximately six options with the same investment of Rs 8,000.

On maturity in January, if the stock price moves to Rs 9,000, the investor would make a profit of Rs 1,000 (without taking into account the time value of money). On the other hand, he would make a profit of Rs 4,200 on his option position. How is this possible? He has a long position with six options. His original investment is Rs 8,000. On the maturity date, the investor exercises his option and buys six Infosys shares at the strike price of Rs 8,300. When he sells the entire six shares for Rs 9,000, he makes a profit of Rs 4,200 (700*6).

On the other hand, what happens if Infosys' price declines to Rs 7,000? An exposure in the spot position means the investor faces a loss of Rs 1,000. If the investor decides not to exercise his option, the maximum loss will be the premium paid. If he decides to exercise the option, he incurs a loss of Rs 1,300 per share. This translates into a net loss of Rs 7,800.

The leverage effect

One of the important features demonstrated by the above example is the power of leverage. By using options, you can use the same initial investment to purchase or sell more number of underlying shares. Or, in other words, the premium/price paid for the option works out to a fraction of the investment required to make an outright purchase of the stock. This leverage means that by using option, the potential profit can be enhanced. However, as shown in the above example, leverage also has significant negative connotations. In case the stock's price does not move as anticipated, the losses tend to get magnified through leverage.

Limited risk for buyers

Another important feature of options is the limited risk for buyers. The risk can be quantified in terms of the option premium paid. This means the buyers' risk is limited to the amount paid as premium. On the other hand, writing of options (equivalent to selling an option) tends to be fraught with risk. This is especially true in the case of an uncovered writer.

Return enhancement strategies

The above is one of the simplest strategies using options. There are others too.

a) At some point in time you may feel that stock Y is underpriced and you would like to take an exposure in the counter. Assume that you are strapped for cash. If you postpone your investment decision, you may not get the stock at the price you wanted. Assuming that you are not in a position to borrow and invest, is there a way out of this predicament? Yes. You can own the shares by buying call options. The immediate cash outflow will be the premium alone.

If you have taken a long-dated maturity, you will have time to raise money to take the stock's delivery. The only additional cost likely to be incurred is the premium paid on the option. But this will be of marginal concern, given the potential profits that can be made in the long term.

b) Stock markets are prone to short bursts of volatility. There have been occasions when fundamentally good stocks have been hammered down in a weak market. Investors can reduce their risks using put options. Assume that you have a long position in the stock at Rs 1,000. Given that the current market price is Rs 1,500, you can protect your exposure by buying into a put option (which gives the right to sell). In this case, assume that the put option is purchased at a premium of Rs 50 and the exercise price is fixed at Rs 1,400.

This means you are now assured of selling your stock at Rs 1,400 during the duration of the option. Assume the stock's price falls to Rs 1,200 and the value of the put option rises to Rs 300. At this point, you can exercise the option and also sell the long position. The net gains from this strategy would be Rs 300.

c) Another oft-used strategy for enhancing returns is call writing. This is writing call options on against an existing long position in a stock. Investors can profit from two directions -- the premium income received which increases the realised rate of return, and protection of the existing long position (to the extent of the premium received).