February 7, 2008

Futures, Options and hedging

If your first thought is – Options and value investing …what a combination? You are not alone. You will rarely find discussions on options and derivatives in books and articles on value investing. But then just because most value investors don’t talk about options, does not mean one should not even try to understand them.

That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.

Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t :) !).

The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000

The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.

I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –

Options pricing is generally dependent on the following variables
- strike price
- time for expiration
- Interest rates
- Volatility

Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.

The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.

The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)

In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.

Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.


Prashant said...

Hi Rohit,

I am a believer of value investing and am trying to practice it as well. Hit upon your blog by googling and found your posts very interesting.

I have speculated (yes) on options a couple of times. All part of learning process on NOT speculating on stocks or anything.

While the most common book is Hull, it is academic and option trading in India is very difficult in actual practice. For one very few stocks have liquidity in options..that too absolutely nothing in 2,3 month...only near month..so sometimes, even if all goes right, sheer lack of liquidity makes option trading/hedging unsuccessful. I, of course, have long stopped it.

Thats one reason why in India, futures, though more risky, are more heavily traded and not options.

Having said that, please let us know on the site your experiences on options and any books or material you get related to them.

Vivek Krishna said...

A good starter
in options trading without getting into log normal distributions and calculus.

I suggest you also look at spreads
Although it may be difficult to do that in the indian market. A simple strategy is to buy a put option and a call option on the same stock.Such a spread has positive payoffs if stock has large volatility (in either direction) but there is a small negative payoff (you lose the premium) if there isnt much change in stock price.

Vivek Krishna said...

Ofcourse if you have the apetite for some serious math, Pick up John C Hull and solve the excercise problems..Very interesting problems on arbitrage opportunies,hedging and options

Ninad said...

Hi Rohit

I believe in the principles of value investing and hence find a certain dissonance between options and value investing.

Lets look at the various approaches that you discussed in your post.

1) Options as a leveraged bet with limiting downside - As a value investor the horizon that one would define for the business would invariably be longer than a adequately liquid option period and I would say significantly longer. So it would be always be cheaper to leverage externally from the debt market for a leverage position than the option market as the option price would factor in both the interest cost + risk of volatility. On limiting downside, as a value investor the downside in a business is not the stock price but the business itself. So i dont think there is a option product available for that. Ex - Option on the country's GDP.

2)Hedging the portfolio - If u have a overvalued stock then possible scenarios

a) Sell the stock today

b) Stock cant be sold bcos of tax implications then an put option makes sense.

c) Impact cost is very high because the size of portfolio is large. Well if u r sitting on a few thousand crores :-) then makes sense to hedge.

But in both the above scenarios it is not a investment call but a call to reduce frictional costs of transaction.

I would however add that I think there is greater opportunity in writing options. Stastical evidence worldwide indicates that most options expire hence the writer takes the money home.

Rohit Chauhan said...

thanks for the book recommendations

till date i have done more paper trading on options than actual. my main trade has been buying put options on infosys to hedge the stock options i had from my employer. beyond that it has been an academic exercise

vivek - spreads based trading sounds to be good strategy. what has been your experience around it ? does it work for specific sceanrios and is it profitable after considering the cost of funds and premium and other costs ?

ninad - buying long term options (if they are available) may be strategy if one is bullish. however i have never tried and do not know how well it would work. personally i am not for taking on debt to invest ...too risky

in addition hedging is good only if there are plans to sell in short term, and one cannot sell immediately due to tax concerns. otherwise i agree with you that if one thinks the stock is overvalued, selling it straight away may be better.

I am not so confident of writing calls ..here you make small premium and may end capping your gains. in addition there is no protection on the downside

Vivek Krishna said...

I have no experience in trading in straddles (the name of the spread)
but it is a good strategy to mull on in these volatile times. I will have to check and get back on the premiums and see if there are derivatives traded which make such spreads possible.

Rohit Chauhan said...

hi vivek
i have read a bit on straddles but never tried it


How to hedge your portfolio using Option since, as I observed,
option price is not mathematical. ie If say 4500 put is 20 when market is 5500 If market crashes to 4900, 4500 put price is not 620. So please explain how to calculate and how to hedge portfolio using Options.


Rohit Chauhan said...

Hi chintan
as you are aware options pricing is not linear. so it will not change in direct proportion . however in the example above if the crash is sudden and the underlying volatility increases, then you can use black scholes or similar option pricing model to figure likely values before hand.

however it would be a rough number. so if i was looking at hedging, using your example above i would do a very rough back of envelope calculation to the likely option price (using an online calculator) at 4900 (for a specific duration of the option), check the cost of the option and buy it if the cost justifies the risk to my portfolio.

the above approach is not too mathemtical ..more like buying life or health insurance where you wanted to fairly protected against a disaster at a reasonable cost.