Options to hedge your equity portfolio

Options to hedge your equity portfolio

If you are a direct equity investor, you would always face the risk of losing your money due to market volatility. But you can protect your downside through a market instrument itself. Known as options, these are typically used by fund managers and traders, but retail investors, too, transact in them.

The reason why they are not commonly used by retail investors is that they are complex instruments. Even those who understand them need to be careful as there is a high degree of risk attached to options. Before investing you need to not only understand the instrument properly, but also consider the costs and risks they entails. We decipher the product for you.

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“Options are used to hedge a portfolio by investment management companies, fund managers and insurance companies, but most day traders and individuals tends to take small positions to capitalize on intra-day market movements," says Manoj Murlidharan, associate vice-president, IIFL, a brokerage firm.

What are options

These are instruments that are used as a tool to supplement a market strategy you may devise or adopt to eliminate any risk to your portfolio.

Options are similar to stocks in that they are available on the stock exchanges and you need a demat account to transact in them. However, the similarity ends there. Unlike stocks, which are available at a particular price per unit at any point of time, options are time bound and come in lots with multiple price tags, known as strike prices in market parlance. Each lot is a collection of a set of units. To buy a stock, you pay the price of the stock upfront; when buying options you don’t pay the price upfront but a fee (known as premium) attached to each of the units in a particular lot.

For instance, a single stock of Reliance Industries Ltd (RIL) on a given date and time may be 1,000; you pay that and buy one stock. On the same date and time, there may be three lots of RIL options, with 250 units each. The three lots would carry different strike prices, say, 1,000, 1,100 and 1,200, and the premium for each unit in the three lots is, say, 30, 40 and 50, respectively. So, if you are buying the option with a strike price of 1,000, you actually pay 7,500 ( 30 multiplied by 250 units) as the premium. The premium on each unit changes along with the movement in stock prices on an everyday basis. Once paid, you don’t get back the premium, but only the gains, if any.

Till when are they valid: Though the premiums change according to stock movement, the lot price remains the same for the period for which the option is valid. Options have a life of one month to up to three years.

Each option contract has an expiry date within which the trade needs to be settled. This means you cannot keep an option beyond its expiry date. Since the settlement happens only in cash, the expiry date of each contract is the last Thursday of every month.

There are two styles of options available in terms of time period—American and European. In an American option, an investor can transact any time before the expiry date, while in an European contract, the transaction can happen only on the expiry date. At present, Indian stock exchanges offer American options for individual stocks and European options for index contracts such as the Nifty or other indices. Recently, the capital markets regulator, the Securities and Exchange Board of India (Sebi), has allowed domestic exchanges to introduce European options, a move that is expected to boost volumes and liquidity in option contracts.

Call and put options

Let’s understand two basic types of options—call and put. Transacting in these is relatively simple and, therefore, these are the ones mostly used by retail investors.

A call option is bought when the price of a particular stock is expected to go up. Put option is the exact opposite and is made part of a strategy when expectations are that the price of a stock will go down. While in a call option, the premium follows the direction in which the stock price moves; in a put option, the premium moves the other way.

How call option works: Let’s understand this through RIL’s example discussed earlier in the story. In the example, you spent 7,500 for 250 units of RIL in the lot priced at 1,000 at a premium of 30. Now, if the stock price really moves up to say, 1,200 and the premium to, say, 50 (the premium moves according to stock price) at the time of the contract’s expiry, you stand to gain 20 on each stock or 5,000 in all. If it moves up to, say, 1,500 and the premium to say 75, you gain 45 on each stock or 11,250 overall.

But if the stock price falls, the maximum you would lose is the premium you’ve paid—Rs 7,500.

How put option works: In the same example, when the stock price goes down to say, 900, the premium goes up from 30 to say 40 and the margin becomes your profit. For 250 units of RIL, your profit becomes 2,500. If the stock price goes up, again you stand to lose a maximum of 7,500.

How to hedge

Options are used as part of various market strategies of hedging or staving off any risk to your portfolio. Here’s how a typical option can be used.

If you buy 1,000 RIL shares at 1,000 each. After three months, the stock price goes up to 1,300. This means you make a notional gain (since you are not booking profits) of 300 per share, or 3 lakh, overall. Now, if you think the price will go down from this level but don’t want to sell, you can hedge the notional loss by buying put options. You buy four put options (with 250 units each) at a strike price of 1,300 at a premium of 80—your total outgo is 80,000. If the stock price goes down to 1,100 and the premium goes up to 150 (the premium goes up in put option when stock price plummets), the gain you make on each share is 70— 70,000 in all. On the other hand, the notional loss you make on 1,000 RIL shares is 2 lakh. Since you gained 70,000 through the put option, your net notional loss comes down to 1.30 lakh.

Though options are useful, they have to be used with utmost care. You need to keep the risks and costs in mind.