The Hindu Business Line : Using options to time investments

After a bull run that lasted a good four years, the temptation is often strong to grab stocks when the market plummets. But your recent experience would have taught you that in a sideways market, gains may only be temporary, which makes it difficult to decide on an entry point so that you can maximise your long-term returns.

Determining entry point

If the huge swings in the market worry you, you can use stock options to time your investments. Say, you want to buy shares of Reliance Communication for your long-term portfolio, but fear that the stock’s price may fall after you buy it. Instead of buying the stock in the cash market, you can use options to postpone the purchase to a price and entry point that you would be more comfortable with. This can be done by buying call options (at a strike price that you want to buy the shares at) on Reliance Communication.

Now, if the stock price does fall, as you had feared it would, while you may stand to lose the option premium paid, you can still take advantage of the lower entry point.

Alternatively, if the share price moves up, the call would give you the right to buy the stock at the strike price, which will then be lower than the market price of the stock.

Removing market influence

If a rising tide lifts all the boats, a falling one may well take them all down. So, if you have made large investments in a particular stock whose prospects you are convinced about; but are worried about overall bearishness in the market taking a toll on it, here’s a strategy.

You can buy Nifty puts and weed out the broad market influence on that stock. The number of puts you might need would depend on the stock’s Beta value and the percentage of hedge you require. So, even if your stock loses value because of a fall in the Nifty, the puts you hold would gain in value and offset (to an extent) the notional loss suffered by your investment. But, if the market does not fall as you feared it would, you would have incurred a cost in the form of the premium paid for buying the Nifty puts. Consider this a one-time payment for securing your investment!

The fine print

In both these strategies, we have suggested only buying options, though the same results can be achieved by selling options too. This is because selling options entail not just the stomach for risk, but also the pocket for it, and hence is best left to seasoned traders.

Further, while buying options make sure that the premium you pay does not exceed the amount you are comfortable losing. Since the liquidity in most option contracts is good only for the next one month’s time-frame, it is advisable to use these strategies for that period only.

SRIVIDHYA SIVAKUMAR

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