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C. Raja Rajeshwari

BY `buying a put' or `writing a call' you can cash in on a bearish view in a stock.

The difference between the two strategies is the payoff's and the right's/obligation's. In the case of buying a put, you stand in an `unlimited profits, limited losses' position. Also being the holder of the put, you have the right to sell which means, you can exercise the option any day and pocket the profit.

# The profits would be the difference between the strike price and the market price.

# The loss is limited to the premium paid

# The lower the spot the greater is your profits

# The net payoff is (strike-spot) - premium paid

In the case of writing a call, you are in a `limited profits, unlimited losses' position. Being the seller of the call, you have the obligation to buy shares in case of the other party's exercise on any day and shell out the difference amount.

# The profit is limited to the premium, you pocket on selling the call.

# The loss is unlimited, as you have to shell out the difference between the market and strike price.

# The higher the spot, the greater is your loss.

# The net payoff is (spot - strike) - premium received.

# You need to maintain margin with the stock exchange, since you have the obligation to purchase shares.

Let's illustrate with an example. You have a view that the Ranbaxy stock remains neutral (not much of a change in the spot price). So now, you have to choose a strike price high enough that the stock will probably not reach prior to expiration. The permitted lot size of Ranbaxy is 800 contracts. You sell 800 contracts of the Ranbaxy June 660 call for a premium of Rs 8,800 (800*11). This will be credited to your account.

Scenario analysis: If the stock was to decline in value (i.e. Rs 630), the option expires worthless as it is out-of-the-money and you could keep the Rs 8,800 call premium.

If the stock price were to remain range-bound (640-645) then option would expire, which leaves you with the premium.

If the stock were to rise above the option strike, then you have to pay the difference between the spot and the strike. In the chart, you see the increase in the losses as the spot climbs.

Time value: An option's premium consists of both intrinsic value plus time value. As time passes, the time value portion of the option erodes (i.e., decays).

A call writer has positive effect from time decay. Hence, it is critical that you sell an option, which has not more than 30-45 days until expiration to benefit from the increased rate of time decay. Time decay is change in an option price to the decrease in time to expiration. Since all stock options decay over time and the rate of decay increases in the month of expiration, it is recommended that you never sell an option that has more than 30-45 days until expiration.

Note: This strategy works best if practiced in neutral to bearish market conditions.

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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