The Hindu Business Line : A profit-only options approach

These are not the best of times in the world of derivatives. One of the members of the extended family of derivative instruments — structured credit products — is responsible for much of the recent mayhem in global financial markets. Like all previous episodes of derivative disasters, this is one more occasion where product abuse and lax controls have caused all the problems. There is nothing inherently sinister in derivatives. Subject to proper controls, they continue to provide investors with some of the most flexible investment choices.

At the retail level, for instance, derivatives strategies (particularly on options) can create a situation where investors only make money and incur no losses. This sounds too good to be true. But the uniqueness of derivatives is that they can be combined in such a manner to generate a “only-profit-no-loss” situation for investors. The example in the Table below makes that clear.

Spread using calls

Consider the stock of Idea Cellular, which is quoting currently in the cash market at Rs 123. We can construct a spread strategy on the Idea Cellular stock using call options. This involves buying a call option on the stock at a particular strike price for a certain expiration date and selling a call option on the same stock at a higher strike price for the same expiration date.

Assume that we buy the October settlement call option on Idea Cellular at a strike of Rs 125 for a premium of Rs 5.75 per option. Simultaneously, the investor has to sell the same October settlement call option on the stock at a strike of say Rs 130. The higher strike price on the call option sold means that the cost of the option will be lower than the Rs 5.75 paid for the option bought.

The Rs 130 strike price option is quoting for October settlement at Rs 4.95 currently. The market lot for derivatives on the Idea Cellular stock is 2,700 shares. Therefore, for the investor, the cash flows at the initiation of the position will be as follows — Rs 5.75 per option paid on the 2,700 call options bought and Rs 4.95 per option received on 2,700 call options sold. Therefore, the net outflow at the inception of the position is 2,700 * (0.80) = Rs 2,160. This outlay excludes any other margin/commission the investor may have to put up with his broker (all prices in the example are market levels).

This call spread strategy creates a pay-off profile for the investor where he caps the loss on the position, whatever the final price on the underlying stock. (Of course, the loss is restricted to the net premium paid for creating the position).

Spread and stand-alone

The difference between this strategy and a stand-alone long call position (that is, where the investor has just bought a call option instead of buying the stock in the cash market) is that the premium outlay at the inception of the position is greatly reduced because of the investor receiving some premium for the option he sells.

In this particular case, for example, the investor would have to put up around Rs 15,500 (2,700*5.75) if he had just bought the Rs 125 strike price option. Against that, as indicated above, the investor is putting up only around Rs 2200 at the inception of the spread position. Therefore, the maximum that the investor will lose from this spread strategy is only Rs 2,200 whereas the maximum that may be lost if the investor had taken a stand-alone long call position will be as much as Rs 15,500.

The spread strategy, therefore, builds further on the inherent characteristic of options which is that they limit losses for investors (buyers of options) but provide a one-way street on the up.

This benefit at the inception, of course, means that the investor has to give up some of the potential upside at the maturity (settlement) of the position. In other words, the spread strategy while greatly limiting the downside for the investor, also limits the upside. But the accompanying table will show that the upside that can be captured will still provide good returns for the investor.

At a final price of Rs 135 on the underlying stock, the investor will exercise his call at strike Rs 125 for a pay-off of Rs 10. But the option sold at a strike of Rs 130 also will be exercised for a negative pay-off of Rs 5. Therefore, the net pay-off is Rs 5 per option. On a position of 2,700 options, this translates into a gross profit of Rs 13,500. Net of the premium paid of Rs 2,160 at the inception of the position, the investor’s profits are Rs 11,340. This is a 500 per cent return on the investment of Rs 2,160 in just a month.

Best of both worlds

The returns, of course, decline with successively lower price levels at maturity. But, as can be noted, the maximum loss from the entire strategy will be limited to the Rs 2,160 premium paid, if for example the stock price at maturity is only Rs 120. In that case, both the option bought as well as that sold will expire worthless. What the spread strategy has done is to provide as much of the benefits of leverage (leverage in options magnifies the profit potential relative to an investment in the underlying cash market) but substantially cut downside for the investor.

This strategy will be appropriate for investors who anticipate or have a bullish view on the underlying asset (called a bull spread) but also attach a certain level of probability to price declines in the underlying. Importantly, this strategy may be affordable for the smallest of retail investors also by virtue of the fact that the initial outlay is greatly reduced by the receipt of premium on the option sold, as explained above.

At a conceptual level, what the example shows is that derivatives (options) enable an investor to take a market position (and possibly profit from that also) even if he does not have any strong directional view on the underlying asset.

This concept, in fact, is scaled up at the level of institutions where dealers just trade volatilities. That is, they do not have any directional view on the underlying asset but perceive that the market will be more or less volatile than it is today. Options are bought when volatilities are expected to rise and options sold when volatilities are expected to fall.

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