Investors typically use derivatives for three reasons — to hedge a position, to increase leverage, or to speculate on the asset price movement. Hedging a position is usually done to protect against or insure the risk of an asset. For example, the owner of a stock buys a Put option if he or she wants to protect the portfolio against a decline in price. The shareholder makes money if the stock rises, but also gains/loses less money if the stock falls because the Put option pays off.
A number of option strategies are is use, but they are all based on two fundamental tools: Call and Put. Using these tools, one can create a range of strategies to maximise the payout from a stock movement.
The most common strategies used are :
The Covered Call:
To create a Covered Call, a trader sells Call options for an underlying stock he owns. In this case, the investor expects the stock to remain relatively flat, allowing the Call to expire worthless. This allows the trader to pocket the premium without having to sell the stock at the strike price.
Let’s understand this with an example. Suppose one holds ITC in his portfolio and the current market price is Rs 180. The movement in the ITC stock is not wide. So one can sell a Call at strike price Rs 195 and receive the premium. In this case, the maximum payoff on the Covered Call is the premium received. This allows the option seller to keep the premium without having to sell the underlying stock or losing any money on it. But if the stock price rises above the strike price, the investor would lose all the stock’s upside that s/he could have otherwise realised.
The Married Put
The other strategy followed before an event is Married Put, which requires buying a Put to safeguard a portfolio from the fall in a stock price. The investor suspects the stock may fall in the short term, but wants to continue owning it because it may rise significantly. Here, the Married Put protects the downside for the investor.
Let’s understand this with an example. Suppose, you own ITC shares whose CMP is Rs 180, but do not want to sell and want to safeguard against any downside in the stock. Then you can buy a Put at strike price Rs 180. This can help you profit from any decline in the stock price without having to sell it.
There are many more option strategies available such as Butterfly, Condor, Ladder, Strip and Strap, and it all depends on the risk profile and requirement of an individual and what he wants to execute in the market. Investors looking to protect or assume risk in a portfolio can employ long, short, or neutral derivative strategies that seek to hedge, speculate, or increase leverage.
(DK Aggarwal is the CMD of SMC Investment and Advisors)