• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

B. Venkatesh

FUTURES contracts have become costly because of the ad hoc margins imposed by the National Stock Exchange (NSE). You will now have to deposit an initial margin of Rs 5 lakh to buy/sell one contract of Tata Motors; it was about Rs 2 lakh earlier. This has prompted some to consider trading in options instead. But the important factor when initiating an options position is the speed of the stock movement in the spot market. Why?

Suppose you decide to buy call options on Tata Motors, expecting the spot price to move from Rs 400 to Rs 430. You buy the December 420 calls for Rs 15.50 per option. The profit you make on the long calls position depends on when the stock moves to your target price of Rs 430.

If, for instance, the price moves to Rs 430 five days after you buy the option, the December 420 calls will be approximately worth Rs 21 per option. On the other hand, if the stock moves 15 days later, the same calls will be only worth only Rs 16 per option. The reason?

The price you paid to buy the option contains a time value factor. Typically, longer the time left for the option to expire, higher the time value. This is because you have more time for the option to generate profits.

So, as each day passes, the option's time value will decline. This is referred to as time decay, and is captured by the option theta in the valuation model.

The option theta was the reason why the December 420 calls generated higher returns when the stock quickly touched Rs 430. This is also another reason why you should not typically buy an option on Friday. Your position will time-decay on Saturday and Sunday.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Karnataka Bank's `Swarna Nidhi'

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line