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Sunday, May 1, 2016

Stock Derivatives

The quarterly result season has begun and those with risk appetite tap the derivatives segment of NSE and BSE to lay wagers on company performance. Those with greater risk-taking ability buy or sell stock futures, while the more conser vative buy either call or put options on a stock.

The ones with deep pockets sell or write the options, and assume huge risk in doing so

1. Why play on stock derivatives?

Many traders (not investors) might not have the amount of cash required to take delivery of stocks. Also some might just want to make a quick buck. Ahead of important events like re sults, those with a yen for speculation often buy or sell stock futures or buy stock options betting on a rise or fall immediately post result announcement.

2. Is it risky?

Sure is. But the magnitude of risk differs. Those buy ing or selling stock futures assume greater risk than those buying a call or put option. That's because, say if you buy an ABC stock fu tures contract pre-result, by putting up a fraction of the actual cost of the share, and it falls post result, you could be exposed to huge mark-to-market (MTM) loss. MTM is the difference between the price you choose to settle your deriva tives position and the price you bought or sold it. Say , ABC share costs `100 but 1 ABC futures cost `20. So you put up initial margin of `20 to trade. If ABC futures contract rises post results to `110, you earn `10 or 50% profit. However, if ABC falls to `90, your broker deb its `10 to your account .

3. What's the alternative?

Buy a call or put option on ABC.

Calls and puts can be purchased at different strike intervals or levels.Calls could be at `100, `110, `120, `130...levels and so on while puts can be at `100, `90, `80, `70 and so on. Say instead of ABC stock futures I buy an ABC option at `110, I pay a premium of `5 per share based on the Black Scholes model for calculating an option's price or premium. If I am bearish on ABC, I buy a put at, say , `90 for `5. The thing about your risk in options is that the premium or option price is the maximum you can lose (not so for the call or put seller who can lose his shirt, but here we talk of the buyer). But your gains are unlimited. So, the deal is that in stock futures profits and losses are unlimited; in options gains are unlimited, thanks to higher leverage, but losses are limited to premiums paid.

4. Is there something to play in options when uncertain about stock performance post results?

There are a lot of strategies but a simple, albeit risky one, which most traders play is called a straddle. Take Infosys, whose Q4 beat street expectations on Friday . The stock closed down 0.5% at `1,176 a share Wednesday , in a truncated week. Traders' outstanding positions jumped a cumulative 50% to 55,699 contracts on Wednesday . On that day many traders purchased a 1,200 strike call and put on Infosys -a long straddle. Basis the closing price, the combined per share value of the straddle (Infosys minimum lot is 500 shares) was `96.95 or 8.1%. For these traders to make money , theoretically, Infosys must rise above `1,297 or below `1,103 a share before or by expiry of the current series of derivatives on April 28. In practice, apart from underlying stock movement (delta), option prices are determined by price swings or volatility of the underlier (IVs), rate at which the underlying price changes (gamma) and time to expiry (theta).

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