Where are the put and call options used?

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Many terms related to equity derivatives trading are not easily understood. Options, calls and puts are also included in such words. What is their meaning and how are they used in the context of the market, know here.

1. What are equity options?

You must be eating yogurt. Its prices depend on milk. If milk is expensive, then the price of curd will also increase. Similarly, the value of equity option depends on indexes like Nifty and Bank Nifty. There are two types of these instruments. Call and put option. You can trade in calls and puts of an index or a stock.

2. What are call and put options? 

The buyer of the call gets the right to buy the underlying stock (which will affect the call if prices fall or decrease) at a fixed and fixed price.

These are purchased by paying premium. It is a part of the total price. Similarly, in a put, the buyer gets the right to sell the shares. The seller who sells the call gets a premium from the buyer. It has to give shares to the buyer at the price of the contract. Similarly the put seller has to sell the shares.

3. How do they actually work?

Let's say that on April 29, the trader buys a 14300 call from the Nifty. Its duration is to end on April 29. Suppose the price of each share of a call is Rs 62.

A contract consists of 75 shares. Let's say that the Nifty closes at Rs 14500 on April 29. In this way, 100 rupees will be called 'in the money' in 14300 calls. In this, the seller of the call will pay the trader in the ratio of Rs 100. That is, the trader will get an advantage of Rs 38 on every share of Rs 62. This is 61 percent of the total return on investment.

Now let us assume that the Nifty closes at 14200 instead of 14300. In this case, 100 rupees will be called 'out of the money' in a call of Rs 14300. In this, the call buyer will lose the entire premium (Rs 62) in the hands of the seller.

The same applies for put. The only difference is that the buyer will benefit if the Nifty falls. At the same time, as the Nifty increases, the seller will keep the premium.

4. How is it different from Future?

In the illustration you saw that the buyer's loss is limited to the premium paid. However, the seller's loss of calls and puts can be unlimited. Practically, buyers of calls and puts can get unlimited benefits. In the case of the future there is no limit to the profit or loss of the buyer or seller.

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With the entire buzz this year about GameStop and gamma squeezes, you might have heard the term ‘call options’ going around. But what exactly are options? Should you start trading 

with them? And when it comes to options, what are your, well, options?

What is a call option?

A call option is a contract that gives investors an option to buy shares at a specific price at a later date. Call options are bought when investors are banking on a share price to rise, so they can profit from the difference in price.

For example, if you were to buy a call option for Netflix (NASDAQ:NFLX) stock at 500 per share (called the strike price) and think it will be going up to, say,502, you’re buying a call option to profit from the speculative rise in price.

It’s all kind of like being at the casino. You don’t know for sure what’s going to happen to the stock, but you think it will perform well, so you place your bets—or in this case, your call option.

If this is all starting to sound a lot like the GameStop scenario, you’re on the money. In this situation, investors bought call options (and stocks) by the bucket load in an attempt to hedge the stock. But as it soared higher, the market makers (the ones that sold the options) had to buy more stock, resulting in a gamma squeeze.

What are my options with options?

The reason that investors are drawn to buying call options is that they can obviously make money from the stock going up in price. But before you go and start placing your bets, there are a few important caveats to know about.

Firstly, in order to buy a call option, investors have to pay a premium. If the investor loses money on their call option, they will also have to factor in the loss of the premium.

The next thing to know is that call options differ in price depending on whether they’re ‘in the money’ or ‘out of the money’. When a call option is ‘in the money’, it means the stock price is already in profit, and the call option will be more expensive. For example, if you bought a stock at a strike price of 35, but it’s currently trading at 37. A call option that is ‘out of the money’ will be trading at below the strike price and will be cheaper (but also riskier) to buy.

The other thing to keep in mind is that call options have expiration dates. Whether it’s weekly, monthly, or quarterly, in order to buy the shares and then sell them immediately to make a profit, investors will need to exercise their option before this expiry date. Call options are more expensive if they have a longer expiry window because investors will have a longer period to wait for the stock to be ‘in the money’, and vice versa with shorter expiry periods.

Just when you thought we were done explaining options, here we are with another option. Alongside a call option, there is also something called a put option. Unlike call options that allow buyers to buy options at a set price, put options lets buyers sell an option at a set price. If the share price drops, then the buyer profits because it gets to sell it at the higher price.

Are call options a good call?

Now that you know everything there is to know about options—and hopefully, you haven’t read the word options so many times it’s lost all meaning—there are a few different strategies out there to start trading.

Ranging from a ‘covered call’, to a ‘long call’, and a ‘short call’, there are many strategies you can use to win at the options game. If you’re ready to give it a go, look out for a brokerage firm to get started. Just know that there are usually about four or five different levels of trading that you will need to be approved before you can start trading.

There are many who have profited from trading call options, but, like all investing, there are also a lot of stories of people getting burned. But no matter which strategy you choose, even if some may seem less risky than others, trading using options, like all investing, comes with inherent risks.

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How To Use Index Options Strategies to Manage Portfolio

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Standardized call contracts, which are some of the tools we will review, were introduced to the markets in 1973, along with the Options Clearing Corporation and, of course, the Black Sholes Option Pricing Model. As we’ve already discussed, buying a call gives the purchaser the right to buy the underlying security for a specific price either at (for a European style contract) or up to (for an American style contract) a specified future expiration date. Sellers of calls become obligated to deliver the underlying securities at these same terms.

Standardized put contracts were introduced into the market four years after the introduction of calls. Buying a put gives the purchaser the right to sell the underlying security for a specific price either at (for a European style contract) or up to (for an American style contract) a specified future expiration date. Sellers of puts become obligated to receive the underlying securities at these same terms.

Puts were quickly adopted as a way to protect or insure portfolios against losses. This differs greatly from the practice of “portfolio insurance,” which was a strategy of selling index futures in declining markets and using those proceeds to help offset portfolio losses. “Portfolio Insurance” has often been labeled as a significant catalyst in the 1987 stock market crash while buying puts to protect against losses has never been implicated in anything except teaching novice investors the potentially expensive lesson to pay attention to volatility.

While there are many entities, such as trading desks and hedge funds, that trade options exclusively and are focused on complex, multi-legged trades, there are still traditional investment managers that take a more basic approach to options. Generally speaking, when it comes to options, equity portfolio managers use them to accomplish two things: i) enhance returns and ii) protect returns. Various option strategies can provide both.

Return Enhancement

A popular strategy employed by managers is to sell “covered” calls. 

Say you have an account that is technology focused and you are looking to augment the overall portfolio yield. You can do this by selling index calls against that position. Any potential delivery obligation would be in cash. 

For this example, assume the Nasdaq-100^® Index is currently trading around 12,700. You want to sell calls but you don’t want to be forced to fulfill your obligation to deliver. In order to protect your position, you want to set the strike price high enough so that the odds of your having to liquidate the position are very low but not so high that you end up earning only a modest premium.

This is where knowing the volatility (23% for this example), of the price level of NDX comes in handy. Say you want to sell one contract that expires in 25 days. An expected, one standard deviation move in the index level of NDX over the next 25 days can be found using the current index level of NDX (12,7000), the annualized volatility NDX (23% meaning that on an annualized basis, you would expect the NDX to fluctuate up to 23% of its current level 68% of the time), and the square root of 25/365, (which is converting annualized volatility of 365 days to a term of 25 days).

Given an annualized volatility of 23%, a one standard deviation move in NDX over the next 25 days would be 764 index points meaning 68% of the time, the NDX would be expected to end up between 12700 plus or minus 764, from 11935 to 13464.

Looking at the options montage for NDX, you see that there is a 13500 strike call that last sold for 68 and a 13450-strike call that last sold for 80, which would net you 6850 or 8070 respectively. If you think that all relevant news has already been priced into the markets and you can’t foresee any other surprises on the horizon that would cause markets to trade outside a one standard deviation range, you go ahead and sell that 13500 strike call and collect the 6850 premium. So what happens if the markets decide to completely ignore your thoughtful analysis and decide to run up beyond your projection, threatening to blow up your trade? At a high level, one of two things could happen:

SHOULD WE INVEST IN IT STOCKS DURING COVID-19?

The COVID-19 pandemic has been a massive challenge for a lot of industries. But for one sector it has proven to be a shot in the arm – the technology space.

In India, the technology landscape is evolving and the larger players are re-inventing themselves. Midcap companies too are growing faster. Digital and internet consumer companies are also seeing a lot of traction.

But how will the sector perform going forward? Nilesh Shah of Envision Capital shared his views.

Higher valuations ahead?

According to Shah, technology stocks have been huge outperformers and several of the technology companies in India have been able to kind of win some large deals across the globe and bring about increased scalability in their business models.

Margins have expanded and therefore that has translated into even strong valuations, he said, adding yhat several companies have managed to win some very large deals.

Will the IT rally sustain?

Going forward, Shah believes the opportunity for technology companies is likely to sustain and even get bigger. It doesn’t seem to be just a short term phenomenon, but it is something which looks very enduring, he noted.

Preferred largecaps in the sector?

Tata Consultancy Services (TCS), Infosys, Wipro, and HCL Technologies – all these four companies have a very sound business strategy, said Shah.

"Each one of them has an edge somewhere in consulting, hi-tech, or in products. But the company that we like the most today, especially keeping in mind both growth prospects as well as the valuations, is HCL Technologies.

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