Buying protection isn’t that expensive

Buying protection isn’t that expensive

A week since the Sensex and the Nifty crossed the 20,000 and 6,000 mark, respectively, the markets continue to trade at the same levels.

But as much as the markets are getting accustomed to these new-found highs, investors are also increasingly buying protection against a drop. The put-call ratio based on the outstanding positions in Nifty options is around 1.9-2 times. In other words, there are two put option contracts outstanding for every outstanding call option position.

Also See Purchasing Cover (Graphic)

According to Yogesh Radke, head of quantitative research at Edelweiss Securities Ltd, the Nifty put-call ratio had last reached these levels just prior to the uncertainty surrounding the general election results in May 2009.

The increase in demand for buying protection against a fall in the markets is also reflected in the rise in the India VIX index. This index measures the implied volatility in Nifty option prices. The India VIX index has risen from a low of 15.2% in the first week of September to around 22% currently.

Put simply, the cost of buying protection has risen, along with the rise in the markets. Even so, buying protection against a fall in the markets isn’t particularly expensive. An at-the-money Nifty put option with a strike price of 6,000 and expiring a month from now in October was available at 101.50 towards the close of trading on Tuesday.

Each Nifty contract has a multiplier of 50, so the total cost of buying this Nifty put option would be 5,075. The buyer would break even when the Nifty falls to 5,898.5 (that is, 6,000 less 101.5).

That’s a drop of just 2.2% from the Nifty’s prevailing levels. Buying similar protection for a contract expiring in end-December would cost 10,400, with the break-even at 5,792, or just 4% lower than prevailing Nifty levels.

Beyond December, there are hardly any quotes available, though there are a few available for contracts expiring in June 2011. Analysts say that while some long-dated options trade, they are done through the negotiated route and then struck on the exchange.

But if one is expecting a correction in the markets by the end of the year, buying protection against that outcome isn’t all that expensive. That indicates most people believe any fall in the market will be seen as a buying opportunity.

Graphic by Yogesh Kumar/Mint

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