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Suresh Krishnamurthy

I have some basic questions regarding options. — M. Vijay

I understand buying call option is less risky than puts and spreads. Now many contracts are open and there are many strike prices. How to pick up the right strike price with optimum or less premium quotation?

Buying call options need not necessarily be less risky than spreads or buying puts. The risk involved in a spread can be lower than that of calls. Similarly, the risk in the case of both calls and puts bought is limited to the option premium paid. Writing, or selling, options is riskier than buying options. The potential for loss is unlimited in writing options. The important factor in option trading is primarily the pricing of the options. Options are priced using a model called Black-Scholes Option Pricing Model.

The model takes into account factors such as the spot price of the underlying, strike price of the option, risk-free interest rate and time to expiry of the option. These factors are the inputs and the output is the theoretical option price.

Which option to buy or sell would typically depend on:

*how far removed the traded option price is from its theoretical price - *purpose of your purchase - *traded volumes in that particular counter - *risks that such trades carry

If the intention is to hedge your position in the spot market, then you would be comfortable buying options that are fairly priced or under priced. Hedging is typically done to counter the risks that you are exposed to in the spot market.

If you are hedging, then volumes in the option that you intend to trade are critical. Reasonable amount of volumes are necessary if you want to trade options at prices that you desire. In addition, reasonable amount of volumes is also an assurance that if you want to reverse your trade then that would be possible.

If your intention is to construct strategies to take advantage of your views on the market or a particular stock, then the risks that such trade carry is equally relevant.

Risks that options are subject to is measured using a number of variables such as Delta, Gamma, Theta, Vega and Rho. These tell you how the option price will change in response to change in factors such as:

*price of the underlying - * relationship between option price change and stock price change - *change in time to maturity - *volatility of the underlying - *change in interest rates

These risks, along with pricing of options and traded volume, will determine whether your view on the market or a stock can be exploited.

On the other hand, if your intention is to take advantage of inefficient markets, you would want to trade only in mispriced options. In these trades, reasonable amount of volumes in the options concerned critical. Without such volumes, such trades cannot happen. It is also true that if trading volumes rise, options will not be mispriced. So, constructing such risk-free arbitrage trades is difficult in practice.

Will the open interest positions have any bearing in picking up right options at the optimum strike price?

A) There is no such thing as an option with the right strike price. The pay-off for each strike price for an option is different and so is the price. If the price to pay-off ratio is attractive, you can pick up an option.

The open interest position is not relevant in picking up an option. It is, however, a relevant factor in forming views on possible future price movements. Changes in open interest positions, put-call ratio, put-call open interest ratio and implied volatility will help you in forming a view. You can take advantage of such a view by trading in options.

Queries relating to futures/options may be mailed to fno@thehindu.co.in or to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002.

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