The Hindu Business Line : Who says options are riskier than spot?

A naked buy-and-sell position leaves the trader open to all market risks. An option position either reduces the risk or makes the risk contingent on a certain event happening (for sellers of option).

There is a general impression that trading in options is riskier than dealing in the spot market. The reasons for this are the complexities associated with a new market, and the extensive use of jargon and technical language.

Different strategies

No derivative can be riskier than the underlying market. This is because most derivative products are priced on the basis of the risk element in the underlying market — that is, the volatility automatically hedges the positions of the underlying market. Let's take a look at the different strategies (see table). In the first case, a person has the choice of buying either call option or shares. It is natural that buying call options hedges the risk of falling share prices.

The Table creates 10 scenarios where the person has the choice of either doing a derivatives or a spot trade. One choice is always less riskier than the other. From the Table, it is apparent that the option and futures market is less risky than the underlying stock market. A naked buy-and-sell position leaves the trader open to all market risks, while the option position either

Reduces the risk (for buyers of option), or

Makes the risk contingent on a certain event happening (for sellers of option).

This is because the option market is one of exchanging risk and not of shares. A buyer of option buys a safety tool and transfers the risk to the seller of option. It is like insurance. The option seller gives insurance to the buyer against any market risk that might adversely affect the latter's position.

Buyers of option are not only protected from any adverse market movement but indeed gain substantially in favourable movement. Sellers of option, of course, take the market risk for the option premium. However, this risk is in no way more than that taken by a position in the spot market. In the absence of any market movement, neither the buyer nor seller gains in the spot market. However, a seller of options will gain from the option premiums.

In case of sharp movements in market, buyers in spot market may make handsome profit with spot sellers losing or vice-versa. However, buyers of options (buyers of protection) gain regardless of which way the market moves.

Risk to option traders

Option is less risky if it is traded with adequate knowledge and discipline. For instance, assume `A' has Rs 9,000. He can, buy 10 shares of SBI. Or, buy 300 at-the-money call options of SBI at Rs 30 per option under the impression that he has the benefit of purchasing SBI shares at just Rs 30 and, hence, at less risk. This is, in fact, over-leveraging. The option price of Rs 30 may come down to zero just by a 5-per cent fall in the spot price, reducing the value of the investment by 100 per cent.

However, had `A' owned 10 shares of SBI his loss would be just 5 per cent. If he really does not have funds, he may buy 10 call options of SBI at Rs 30 instead of owning shares.

Similarly, assume the writer of the call option (`W' in the above example) sells call option without security on hand and the price of the SBI stock touches Rs 1,200. `A' may approach him for the shares, which the call writer will have to purchase from the market.

Ultimately, `W' will lose Rs 9,000 (30 options x price rise by Rs 300). This is called an "uncovered sell of option" — the writer is fully exposed to the market risk and does not have the security ready to sell if the buyer exercises his right.

Clearly, the risk to option buyers arises by over-leveraging while that to option sellers arises only against the market price of the underlying shares.

Overall exposure

The overall exposure is not the premium, but it is the notional value underlying the premium amount. Thus, keeping in mind the limit on the overall exposure rightly based on "total underlying value" rather than on the amount paid as premium/margin, derivatives traders normally benefit more than the traders in the spot market, as indicated above. So long as the trader considers premium and margin as risk management tools, he stands to benefit. Once the trader starts thinking of premium and margins as tools for overtrading, he is exposed to `overtrading risk' and not the `option risk'

(The writer works for a leading mutual fund. The opinions expressed are his personal views.)

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