September 24, 2009

life in financial markets: good future for options

Equity derivatives has its utility for long-term/short-term investors, day/week traders/speculators & arbitrageurs.

Derivatives involves futures and options. Which among the two are better -- futures or options? If you are 100% confident of a price movement in a particular, either up or down, direction then futures are better. If you are somewhat confident but fear a potential opposite movement then buying options is better. Buying and selling options are different from buying and selling futures. The latter is similar to buying and selling shares from the cash market.

Options, when bought, give the buyer a right but not an obligation, to buy (as in a Call option) or sell (as in a Put option) the underlying. The buyer pays a premium, determined and traded in the exchange, which he never gets back, no matter what. When sold, options oblige the seller to sell (as in a Call option) or buy (as in a Put option) if the buyer exercises the option. The seller receives the premium that is her's for keeps.

So, buying options entail keeping all profits and limiting the maximum loss to the amount of premium paid in buying the option. Selling options entail taking unlimited risk of loss and getting to keep a maximum profit of the amount of premium received in selling the option.

So, why will anyone sell options? Generally, sellers of options do not sell options only to take a view on the movement of the underlying. Their option sale is a part of a strategy (strangle, calender spread, and many more) that involves another/multiple trade/s in cash market, futures or other tenure/strike price options contract.

There is perhaps only one condition under which you could have just an option sale and nothing else. Say, you are looking at Nifty 29Oct09 Call Options prices right now (11 am) and you see if you sell it you will get around Rs 175. The underlying Nifty is quoting at 4907 in the spot market right now. On selling this call, you will lose money if Nifty stays above 4900 on any date before 29 October when you want to square off or on 29 October, expiry date, when the trade is automatically squared off. You will gain if Nifty stays below 4900. Now, you could have sold Nifty 29Oct09 futures at 4907 instead of selling a Call option. But if Nifty is at, say, 4850, on expiry or on any day when you want to square off. You profit only Rs 50 whereas you have already profited Rs 175 by selling the Call option. The flip side is that if Nifty falls to, say, 4600, then a sold futures trade would profit Rs 300 whereas your maximum profit in the Call option sale is Rs 175.

Also, if Nifty goes up to, say, 5000 then the futures trade would have given you a net loss of Rs 100, whereas in your Call option sale trade you have lost Rs 100 in the option trade but you have already received Rs 175 as premium when you sold the Call option. So, while your profits are limited to the premium you received in your Call options sale trade your losses, though unlimited, are also less by the premium amount. In Futures sale trade you gain unlimited but the quantum of your unlimited potential loss is more as compared to the loss in Call options sale.

Anyway, I spotted a trend in Indian equity derivatives market where trading turnover in in options trades are rising to match that in futures trades. I wrote about it last month in the magazine I work for currently.

Here it is:

Refuge option

For the first time ever, options trading in equity derivatives is playing a prominent role compared to futures.The risk appetite of investors in domestic and global equity markets might have gone up with regard to making investments in the cash market from a short-term, or long-term, perspective. But the unprecedented intra-day volatility in the domestic equity market is causing those investors and traders who play the equity derivatives market on an intra-day, or inter-day weekly, basis to tweak their investing style so far.

They are increasingly dabbling in options trades on the National Stock Exchange (NSE), particularly options on the S&P CNX Nifty. From 1 July to 18 August, the options' traded value (notional) has crossed that of the futures on NSE's derivatives trading segment a higher number of times, 9 out of 35 trading sessions, than ever before.

Since their advent, the Indian equity derivatives market's trading trends has deviated from those in overseas developed derivatives markets where options trading dominates. For many years, the futures on Nifty and stocks traded much more than options on Nifty and stocks. "This began changing, and one saw trading volume in options rise rapidly, after the markets crashed during 2008 and investors' risk appetite came down sharply," says Sandeep Nayak, senior vice-president and head of private client group at Kotak Securities, a NSE-cum-BSE broker.

Aggregated for financial year, 2008-09, options trades contributed to a healthy 35.9% of all equity derivatives trades on the NSE. The current financial year's aggregate figures so far, till 17 August, has seen options' contribution to total has become even healthier at 42.2%.

Day traders, ultra short-term investors and foreign institutional investors (FIIs) are driving the change from futures to options. "Earlier, a typical day trader client of ours would trade in 20 Nifty futures contracts in the derivatives segment, but now the same guy is trading in 15 Nifty options contracts and just 5 Nifty futures contracts," says Mrugank Sanghvi, a dealer in Jagvin Investments, a NSE broker.

(click on image below to see it enlarged & clear)

The FIIs who, unlike domestic institutional investors, are allowed to speculate freely in equity derivatives, are doing alike. In recent months, of the total trades in equity derivatives, FIIs' trades make up for between 10 and 20 per cent on an average.

As per FIIs' derivatives trading data, released by the Securities and Exchange Board of India, for the first time, FIIs' aggregate trades (sum of purchases and sales) in options in August, upto the 17th, were more than their trades in futures, amounting to 56% of their total derivatives trading value. In June and July, their options trades' proportion was 41% and 49% respectively.

More than 90% of options trades are taking place in index options, primarily in Nifty options, and the balance in stock options. In futures trades, the spoils are shared roughly equally by index futures and stock futures. "The high liquidity in Nifty options is a major attracting factor for traders," says Sanghvi. "This was earlier limited only to Nifty futures and futures in select stocks."

The shift in trader preferences from futures to options, according to Kotak's Nayak, is on account of convenient trading strategies in options and synthetic stop loss trades through a combination of options and futures. The high volatility in Nifty was resulting in top loss trades (stops) in naked Nifty futures positions get triggered too often. The stops do not get triggered when done through a synthetic stop using options.

"When it comes to FIIs, we are seeing some of them sell call or put options of various strike prices and buy or sell futures to make it a delta neutral position," says Nayak. Traders, including FIIs, with views are getting hit by new information much more often in the recent weeks' dynamically shifting undercurrents in the stock market. Options contracts, therefore, acts a refuge for such times.

Whether the new trend will sustain or not is not certain, given the propensity for most brokerage firms to give to their retail investor clients recommendations on derivatives strategies involving only stock and Nifty futures. "But the phenomenon of high options trading volume is here to stay," says Nayak. Investors will be glad if Nayak is right.

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