2 Mar, 2013

Option Buying – A Pervasive Predisposition

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Option Buying – A Pervasive Predisposition

            Since times immemorial, history is replete with instances where stock investing has been a ticket to a quick buck. It becomes all together more pronounced when it’s the case of options trading. Now the question arises, what an option is?

Call option is a contract which provides right to the option buyer, but not the obligation, to buy the underlying stock at pre-determined price (strike price) on pre-defined date (maturity). To get this right, option buyer pays premium to the option seller. Option buyer at maximum can lose the premium paid if underlying closes against his favor (below strike price) and can earn the unlimited profits (for call option: underlying close price – strike price) by exercising his right if underlying closes in his favor (above the pre-determined price). As market is zero sum case, so profit/loss is just opposite for option seller. In put options, buyer gets the right to sell and rest of the terminology is just like call options.

Most of the traders think that option buying is a safe haven. Psychology of people tells that they buy the option as the loss is limited in this case, even if it ends up worthless; ironically same people hesitate to put the ‘stop loss’ to fulfill the same goal to limit their losses. Why does one think that buying an option is a safe bet? It is mainly because theory tells that option buyer has limited risk & unlimited return and vice versa. But the pertinent question here is “Does this unlimited return ever materializes?’. The only catch is of the word ‘unlimited’, which creates fear in the mind of people and they hesitate to sell an option. In real sense, unlimited means uncertainty. Stock market is the synonym for uncertainty. If uncertainty always exists, while making a trade then why one should one pay extra premium for just the sake of word ‘unlimited’. Why don’t people understand one simple thing if option ends worthless, they lose 100% of their investment. So if option buyer can lose all of his investments then how it could be a safe bet. To cite an example, suppose NIFTY is trading at 6000 and someone, who is bullish, buys a call option of strike price of 6100, whose maturity is after 20 trading days, at Rs. 70/-. Option will end up worthless if NIFTY closes below 6100 & will rise by just Rs. 10/- if NIFTY closes at 6180 (which is a huge upward movement of 3% in NIFTY). Also if trader is so much bullish then shouldn’t he buy NIFTY & put the stop-loss of 70 points which he otherwise is paying as a premium.

Traders buy options to earn profits even though history tells that most of the time, options seller make money. Why does option seller make profits most of the time? There are only three outcomes of market, it may move upward, downward or sideways.  Buyer of option makes money only in one situation, i.e. if market moves heavily in the direction he wants it to, whereas option seller gets the benefit in the rest of two situations. So the probability to earn by option buyer is one third and of option seller is two third.

So, to sum it up, traders should tread on unorthodox path of either selling options or trade in futures with a stop-loss over buying options to generate profits.

 

Manish Kumar

Manager Research

Innovative Financial Management

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