November 11, 2009

Moving to the dark side – bought options

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance

In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

  • Strike price of the index put
  • Duration of the put

The Strategy

At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result

After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion

Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios

  • The market appears considerably overvalued and options are underpriced due to low volatility
  • I wish to hedge a specific stock position which I plan to sell in the next few months.

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J

27 comments:

Vic said...

Wow!!

I didn't know you were already into these.

But it is great to know that you're exploring these alternate strategies.

It definitely adds value when it comes to Portfolio Management..hint..hint..:-)

Thanks,

Vikas

Sachin8778 said...

Hi Rohit,

Interesting read. I have to admit that I have not understood it completely but it was interesting to see you, as a value investor, are also exploring derivatives.

I will keep visiting in serach of some more 'gyan' from your posts and comments from readers.

Cheers,
Sachin

Rohit Chauhan said...

hi vikas
yes been exploring options and arbitrage for some time now :) ..brings some excitement in life ..just joking ..seriously looking at how options and arbitrage can take volatility out of a portfolio.
on the portfolio management ..will come out with something by next year ..lets see how it works out

regards
rohit

Rohit Chauhan said...

hi sachin
let me know what is not clear and i will try to clarify. i have to admit, that i have not gone too much into depth as the entire topic of options and pricing is a course in itself

regards
rohit

jagan said...

one off topic question. Which online broker do you use to maintain you portfolio or to buy options.

kumar said...

Rohit,

I used option only once when I thought the stock I owned was reaching its intrinsic value but did not want to sell since I had to pay short-term capital gains.

Another case I would consider would be selling puts for stocks I consider to be of good value. Only problem - either those stocks are illiquid or not optionable.

Kumar

Anonymous said...

Hi Rohit,
Have been a regular reader of your blog.excellent post as usual.
I had some questions:
1) where are you learning abt derivatives from?any books you would recommend?
2) are you planning to learn / incorporate Technical analysis for portfolio mgmt in the future?
have been learning a lot from this blog.
Thanks,
Arjun

Mayank said...

Hi Rohit,

I enjoy reading your posts! Thanks for posting interesting thoughts.

Had a couple of questions:
1. If you equate buying options with buying insurance, as a long term investor in the stock mkt should'nt you look at buying the farthest contract, in this case 28th June 2012
2. If i understand correctly premiums have had a very volatile past week, with a high of 195 and a low of 68.5 How do you abstain yourself then, from indulging in speculation.

If you would have sold your option close to the highs you would have pocketed a near 100% return, while today you are staring at a loss of 30%+

Regards,
Mayank

Anonymous said...

Hello Rohit,
Just a question regarding ur use of options to hedge..
dont u think there is a disconnect here? u r hedging ur portfolio, made up mostly of midcaps, by buying index puts, where the index is made of large caps..an imperfect hedge eh?
neeraj

Rohit Chauhan said...

Hi jagan
mainly icici and geojit

hi kumar
most of the stock i hold or want to buy have no options..so i am in the same boat

rgds
rohit

Rohit Chauhan said...

Hi arjun
i am learning from books and online. i will post the books i am referring soon.
no plans of incorporating technical analysis in the future. its not my cup of tea

rgds
rohit

Rohit Chauhan said...

Hi mayank
valid questions
i will anwser in detail in another post.

short answer - i am looking at options as insurance or hedge at a low cost. the long dated options are too expensive and illiquid.
on the decision to sell..you are right ..very diffcult to avoid speculation. i will try to answer in more depth in the next post.

rgds
rohit

Anonymous said...

All said and done, one is still timing the market with options. There are no options available for more than 3 months duration so one is hoping/insuring against something happening in next 3 months.

Anonymous said...

Rohit,
What are you hedging against? Your portfolio consists of undervalued midcaps held for the long term. Neither the duration nor the held asset was being insured. If we had midcap leaps of some sort, dabbling in those would be a hedge. The rest is speculation - having made money doesnt neccessarily make the logic right.

Anonymous said...

hai rohith !
im new investor. can u pls. guide
me in investing in present levels.
i m rerular reader of ur analysis.
MANOJ VARU

Rohit Chauhan said...

hi neeraj
my disclosed portfolio is midcaps, but i do have mutual funds and infosys (from my job) which also form a substantial piece my portfolio.
hence the hedge on the index
rgds
rohit

Rohit Chauhan said...

Hi anon
i think you are missing the point of my post.
i am dabbling in options to learn and hedge my portfolio which also consists of mutual funds and infosys.
it may be speculation too ..i dont deny that ..however the amounts involved are miniscule for that specific reason ..i am still in a learning phase and hence will be doing all kinds of experiments. whether that logic makes sense to others is for them to decide

regards
rohit

Anonymous said...

Rohit,

What you think about Bharti Airtel as a long term holding, looking at the growth Indian Market has to offer Airtel is one of the better cos to be with. I am looking at 10-12 yrs horizon. Regards,

madhav said...

Hi Rohit,

Calling your post informative is stating the obvious. Great post!

Question- As a value investor does one need to understand the impact of future contracts and open interest that the "gurus" keep talking about all the time, or could I be oblivious to the rattling and simply invest in the stock?

Thanks in advance.

Rohit Chauhan said...

hi anon
i plan to look at bharti, but i am not too confident about it for the long term. the telecom industry has a high level of change and 10 yrs is a very long time for this industry ..for ex: think of how this industry was 10 yrs back in 1999

rgds
rohit

Rohit Chauhan said...

hi madhav
i personally never care about volumes and open interest for my picks.
by default undervalued stocks have low level of interest and hence these indicators would be of no interest to me and would only distract me

rgds
rohit

Anonymous said...

Rohit,
Why not evaluate the naked selling puts and selling calls. At least in a stable market, you keep on earning something.
deepak

Rohit Chauhan said...

Hi deepak
several reasons i dont want to go down that path - one stable markets can get unstable quickly and your position can turn negative quickly
second - a lot of close monitoring is needed for such positions ..which i cannot and dont want to do

and third and most important reason for me - i am too chicken for it and dont want to loose my sleep over such positions

rgds
rohit

Anonymous said...

Rohit,

What if you are long on a stock and then place a covered sell call that is very difficult to achieve. In that way at least you keep on holding the stock and keep on getting some money for it. It is considered to be a very conservative approach and also a lot of brokerages have this for retirement accounts in US.

plus u keep getting dividends.

At least it is better than having a stock and it not growing but u r just holding it.

Prove this wrong.

There is nothing wrong in it when u r playing with a fundamentally very strong stock and u know it will not go to 0

am also a new learner to this and wud like to know ur comments.

regards

Deepak

Rohit Chauhan said...

deepak
covered calls and naked calls are two very different things. i have myself sold out of the money covered calls several times.

you have understand the market is efficient and other participants are smart too. as a result premium for out of the money covered calls is not too high ..for ex: if strike price is 20% higher..then it could be 3-4% of the current price.

if you try to sell a covered call for lesser strike price ..say 10%, then i dont think you are getting a great deal ..you may giving a good upside for a few % return. ofcourse the above works well for an overvalued stock which you are fine to hold long term

as far as buying for retirement account is concered ..less said the better. a lot of brokers have sold 'safe' stuff which has come to bite the person later.

rgds
rohit

Mayank said...

Hi Rohit,
for example if i believe PNB shall be overvalued for the short term at lets say Rs 1000 and i sell a Put Option for 31st Dec, is my understanding right that i shall get Rs 87.8 (Fri's closing price). Hence what it means is that only if PNB closes above 1000+87.8 will i loose money..
Sorry for posing a very basic question.. For the benefit of others like me kindly educate..

Regards,
Mayank

Rohit Chauhan said...

mayank
anything can happen in the short term..what if the stock rises beyond this level ? selling naked puts is risky ..i would never do it.
you can right 10 times and wrong one time and lose all that you gained

rgds
rohit