The Hindu Business Line : Economics of equity options

MY friend, a successful trader, strongly believes that it makes economic sense to buy options instead of futures or shares. His argument is hard to beat. Why?

Suppose you have a positive view on Reliance. You can buy futures or options on the stock. Or you can buy the shares in the spot market.

If you buy futures or the stock, you have to place a stop loss. This is to ensure that if the price declines below a certain level, you close the trade and take the losses.

Assume that you buy futures at Rs 830 with a stop loss at Rs 815. What if the futures price declines to Rs 810 and then moves up? You would have lost Rs 9,000 (Rs 15 x 600 units for Reliance futures).

Importantly, you will be unable to profit if Reliance subsequently moves up from Rs 810 to Rs 850, unless you buy another futures contract.

But what if you buy a call option with the money that you are willing to risk as stop loss on the futures contract?

Suppose the December 840 call trades at Rs 20 per option. For an additional risk capital of Rs 5 per option, you can continue your exposure in Reliance till the contract expiry.

If Reliance moves up from Rs 810 to Rs 900 by mid-December, your 840 calls will generate handsome profits. Should Reliance decline instead, you may choose to sell your calls or hold it till expiry.

The maximum loss is the premium paid upfront, which may be marginally higher than the stop loss on futures. My friend applied this strategy extensively to make a fortune in the stock market in the last two years.

(The author is Head-Research at Navia Markets)

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