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C. Raja Rajeshwari

If my expectations are bearish on an underlying stock, what should be my positions in the futures and options market - Bhanu

When you have a bearish outlook on an underlying stock, some of the simple strategies that you can use to make profits in the futures and options market are to sell a futures contract (short futures), buy a put (long put) or write a call (short call)

Short futures: When you short futures, the profit you make is the difference between the strike price and the spot price.

If the underlying stock rises, then you are on the wrong side of the rising and you would be left with losses.

This position would mean that you would have to maintain initial margin and variable margins (differences in the futures price on a day-to-day basis).

To put or call: The difference between a long put or a short call is the profit or loss that the position enjoys. A long put is `limited risk, unlimited profit' whereas short call means `unlimited risk, limited profit strategy'.

Long put - protected downside: When you buy a put, you pay the premium up front.

# In the case of upside or range-bound movements in the underlying stock, the put expires worthless and the loss is the premium paid.

# In the case of downside in the underlying stock, then the profits would be the difference between the strike and the spot.

# This is a low risk, high reward strategy, if your stock declines.

Short call - unlimited downside: When you short a call (write a call), you get the premium, but you have to maintain margins.

# In the case of an upside in the underlying stock, the difference between the spot and the strike price would be the loss.

Unlike in the case of buying, the put where the maximum loss is limited to the profit paid, the loss (difference between the spot and the strike price) sustained by writing a call is unlimited, as the spot price can have sharp up swings.

# In the case of neutral and bearish markets wherein the puts would expire worthless, the profits would be the premium.

When to use: When each of these strategies should be used would depend on your risk profile and payment styles (whether you want to pay upfront or receive cash up front).

I have a doubt in your article `cover your call', dated November 9, 2003. In the example, you said that Rs 464 is the break-even point. Even when the cash price comes down to Rs 464, the Rs 500 call option still quotes at some premium. When I have to square-off the call option originally written, I have to still pay some premium, which will impact the break-even point on the higher side. How do I estimate and build the premium in the break-even point to decide the stop loss. - Pattabiraman

The example cited in the article was as follows: You sell one 500-strike call of SBI (market lot consists of 1000 units) for Rs 16 per unit and buy 1000 SBI shares at Rs 480 per share.

The call is out-of-the-money. As long as the stock price remains below 500, the call remains out-of-the money and the call writer pockets Rs 16,000 (1000*16).

# At any point of time, your position is better by not squaring - off your position, as a need to square-off arise only on the rise in stock price above the strike price-Rs 500.

# The covered call strategy suffers from downside risk only.

When the underlying stock price declines, the long position in the stock suffers but not the short call position.

When to close out: The long position in the stock should be closed out on Rs 464 (break-even point), or you make losses.

In case the underlying rises above Rs 500, which is the call strike, making your call in-the-money; you could either square-off the short position without being assigned or sell the underlying stock on assignment and pay the assignment money.

Why should you go for assignment?

Suppose, SBI stock appreciates to Rs 520, then your call is in-the-money by Rs 20.

If you were to buy a call to square-off the short position, the call would cost you more than Rs 20, as factors such as time to expiry and volatility of the underlying stock, add up on the intrinsic value costing you more to square-off your positions.

As compared with this, if you wait for assignment, then the difference you settle would be the intrinsic value only (Rs 20).

There are chances that you might be not be assigned. On assignment, you can sell the shares in the cash market and make a profit of Rs 40 per share (480-520), which works to Rs 40,000.

You offset this profit against the loss of Rs 20,000 (20*1000) in the call assignment.

The net profit is Rs 36,000 (40,000-20000 + premium received on writing Rs 16000)

With this strategy, on any price movement above Rs 500, your profits get limited to Rs 36,000.

If you were to square-off the short call position, then you end up paying more and you reduce your net profits from this strategy.

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

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