The Hindu Business Line : Using Futures/Options

Daily volatility statistics that are available on the Web site of the National Stock Exchange (www.nse-india.com) give the volatility of the underlying stock and that of the futures contract. Theoretically, the volatility of the futures contract and the volatility of the underlying should not be different. In practice, however, they are different due to the difference in the speed with which information is priced in the market.

If the volatility of the futures prices were higher than that of the index, then it has implications for investors - speculators and hedgers. If you are simply trading in futures, you must expect higher returns from trading in futures than you would expect trading in the index as the futures are more volatile. For hedgers, if the futures price volatility is higher, then the hedge may not be effective. If the volatilities are consistently different, it might also indicate mispricing of futures, which investors can take advantage of.

Several studies indicate that the volatility of futures prices are less than that of the underlying in the case of the Index in overseas markets. In India, however, NSE's statistics indicate that futures prices are either more volatile than that of the underlying or as volatile as the underlying. The differences, however, do not appear to be significant.

Implied volatility

The price of an option depends on the volatility of the underlying stock. In any option-pricing model, volatility is an input. That is, the volatility of the underlying stock decides the price to be paid for an option. All other factors remaining the same, option of a stock that is more volatile will be priced higher than the option of stock that is less volatile. Usually, estimates of future volatility of a stock or an index are used to arrive at the price of an option. The estimate of future volatility that is built into an option price is referred to as implied volatility. It explains the prevailing option price. Web sites such as www.bseindia. com or www. indiainfoline.com have option calculators. These are useful to calculate the implied volatility.

Implied volatility is important. The Web site of the Chicago Board of Options Exchange pithily explains implied volatility thus: "Just as p/e ratios allow comparisons of stock prices... ..implied volatility enables comparison of options on different underlying instruments and comparison of the same option at different times. Theoretical value of an option is a statistical concept, and traders should focus on relative value, not absolute value. The terms overvalued and undervalued describe a relationship between implied volatility and expected volatility."

Given that implied volatilities determine whether an option is under priced or over priced, they are extensively used to construct trading strategies. One simple strategy is to compare implied volatility to historical volatility on the assumption historical volatility is the expected future volatility. If implied volatility is higher then it is considered a good time to sell options while if it is low you can buy options. For instance, if the historical volatility of a stock is 30 per cent and the implied volatility is 20 per cent then the option is considered to be under valued and vice versa. Some complicated strategies also use implied volatilities of out of the money options and in the money options.

All farther month calls are quoted high with low or no volumes, 7-10 days before the expiry date of near month. I understand the premium rises and falls according to the trends in the stock price. How to choose single-digit premium options (I am aware the far-off OTMs cost less) keeping in mind how day traders and speculators operate..... before the expiry and after the expiry of the previous month. — Vijay

Constructing trading strategies in options are complex exercises. There are no simple thumb rules that would help you trade and make profits. If you want to trade in options with out working out the risks that you are exposed to then the minimum that you need to do is to:

· *Identify stocks which have the potential to go up or decline in value sharply

· *Find out if the options of such stocks are traded with good volumes

· *Finally trade options which have relatively low time value. A lower time value exposes you to lower risks. The difference between strike price and the price of the underlying is intrinsic price. The difference between intrinsic price and option premium is the time value. In the case of out of the money options, the entire option premium is attributable to time value.

Alternatively, you can choose to invest in futures contracts. Single stock futures and index futures offer much more to a trader and speculator than options.

What is put-call ratio? — Dhanesh Kashyap

Put-call ratio is the proportion of puts traded to calls traded. Puts would be bought if investors were bearish while calls would be bought if investors are bullish. Thus, this proportion is an index of investor sentiment. A higher proportion of puts traded to calls traded may indicate bearish sentiment. Many a time, however, put-call ratio can be contrary. — Suresh Krishnamurthy

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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