Introduction to Futures and Options on Nifty - Part2

Now we move on to the Options aspect on NSE.

To provide instruments for hedging and facilitating speculators with lower margins to trade on the exchange, NSE allows Options to be traded on all futures contracts that are traded on the exchange. Options on NSE are always European Style options on both Index and Stock Options. The contract size of the option is usually the same as that of the futures contract size.

Call Option: An instrument that one can buy assuming a stock / index will go up in value

Put Option: An instrument that one can buy assuming a stock / index will go down in value

Long = Buy

Short = Sell

Hence Long Call is same as Short Put and Short Call is same as Long Put

The seller of the option thinks the opposite i.e. the Seller of a Call Option assumes that markets will go down and is hence willing to sell the Call Option. The seller of a Put Option assumes that markets will go up and hence willing to sell the Put Option.

Factors that determine price of an Option

1 – Distance of Strike Price

2 – Time to Expiration

3 – Volatility of The Market

4 – Demand and Supply Situation

For instance, suppose that a trader is under the impression that on September expiry, Nifty index value will be 5400 whilst on the 10^th of September the value of Nifty is 4980. The trader has a choice of Strike Price i.e. he can buy a 5300 Call or 5200 Call or for that matter even a 4800 Call or 4900 Call.

Distance to Strike Varies and lesser the distance between spot price and strike price, greater is the options premium to be paid. For instance, an option chain price may show the following setup

Instrument	Strike Price	Option Type	Distance From Spot	Price	Intrinsic Value	Premium
4800 Call	4800	In The Money	-180	350	180	170
4900 Call	4900	In The Money	-80	300	80	220
5000 Call	5000	At The Money	20	250	0	250
5100 Call	5100	Out of Money	120	200	0	200
5200 Call	5200	Out of Money	220	150	0	150
5300 Call	5300	Out of Money	320	100	0	100
5400 Call	5400	Out of Money	420	50	0	50

The spot value is 4980 on Nifty. So the 4800 and 4900 Calls are already in the money as the trader is buying an option that at this point of time has a fairly reasonable chance of gaining more. However, there are still 2 weeks for September expiry and hence, he has to compensate the seller with some options premium. The intrinsic value is determined by the distance from spot whilst the premium is based upon time value, volatility. In range bound sessions as we move closer to expiry, the premium keeps dropping and the only price that remains in the options price is the Distance From Spot or the Intrinsic Value.

A call is taken in the hope that markets will go up. On expiry, if the value of Nifty is greater than the strike price,  the trader receives a difference of the value of Nifty on Expiry and the Strike price. If Nifty closes at 5400, then the payouts will be as follows

Instrument	Strike Price	Expiry	Payout
4800 Call	4800	In The Money	600
4900 Call	4900	In The Money	500
5000 Call	5000	In The Money	400
5100 Call	5100	In The Money	300
5200 Call	5200	In The Money	200
5300 Call	5300	In The Money	100
5400 Call	5400	At The Money	0

Now there are a lot of complex Greek alphabets that come in the options aspect like delta, vega, theta etc etc etc. Most of it is academic bull-shit i.e. all of them were created for the multitudes of financial engineers who decide to venture out in an artificial world to make millions out of speculation rather than work towards enhancing GDP of the nation with real goods and services. Now if the job itself is to play with these instruments, it is obvious that a complex web of jugglery needs to be created to keep them occupied and try to generate profits for the bonuses and plush offices. [it is a disease of the mind to create wealth out of thin air and the mind needs to satiate its interests through something complex because it has been 'programmed' for financial engineering]

Before I digress further, there are 3 critical aspects that the mango trader needs to evaluate. What is the intrinsic value of the option and extrinsic value of the option. Instrinsic value as illustrated in the tables above are determined by distance to strike. Extrinsic value is basically a premium that one pays for the following
1] Uncertainty of Time and hence the options premium start dropping as we move closer to expiry
2] Uncertainty of Volatility that deems appropriate that an option writer get something more for writing that option
3] Delta is nothing but the change in value of the option price basis change in the underlying instrument

Coming to a rising Nifty and Call Options
The 4800 Call will tend to have a Delta of 1 to the extent Nifty is above 4800 i.e. each point rise in Nifty will increase the intrinsic value of the option by 1 rupee [and that means a gain of 50 rupees on the lot] and to the extent Nifty is above 4800, the value of the intrinsic option price will decrease by 1 rupee for each point fall in Nifty. On the other hand, the 5200 Call and the 5300 call will not get any major increase in options price with a 1 point rise in Nifty. The 5300 Call would probably need a 7 point rise in Nifty to generate a 1 point increase in the intrinsic value of option price until Nifty spot 5100. After that, if Nifty continues to increase, a 4 point rise in Nifty may be sufficient to generate a 1 point increase in the intrinsic value of the option. However for these Out of Money Calls, the gain in options price will also be offset by the loss in time value. The theta is nothing but how time value gets destroyed with passage of time and lower volatility.

So in a nutshell, to keep things simple - the best way to look at an option is what is the intrinsic value and extrinsic value? How far are we away from expiration? Where are the markets headed towards expiration?

Some Myths and Facts
Myth1: One should trade options only after the 10th or 15th of a calendar month when options premiums dry up making them cheaper

Fact: No - it does not matter when you buy the option because the odds of the option fetching a trader money depends on how well the trader has analyzed the potential move of the underlying, the Nifty index for this illustrative post. It also depends on how well the trader has analysed the Delta and Time Value of the option s/he is picking up. In fact, trading options despite the high options premium is much better in the first 2 weeks of a series compared to the last 2 weeks of a series. IMHO, if one is looking at trading options regularly, one should trade as follows
15th Sep to 15th Oct - Trade in Oct series options
15th Oct to 15th Nov - Trade in Nov series options

Why is it dangerous to build a strangle with OTM options towards the end of a series?
A safe trader at Nifty spot 5000 decide to build a straddle by taking Long 5200 Call and Long 4800 Put of September series on the 15th of September. If the market just keeps oscillating in the 4950-5050 range for 1 full week, both the Calls and Puts that anyways have no intrinsic value will drop significant time value premiums as we are heading closer to expiry and the end result will be that at least 30% to 40% of the options premium paid will go for a toss for nothing.

Just 1 illustrative example
Around 15th/16th September when Nifty spot was trading around 5050 levels, some traders jumped for the Sep 5300 Call at around 16 rupees a piece. Nifty did take that high jump to 5110 levels and this Call option at 10am of trading session was quoting 35 rupees a piece. Then the market suddenly started oscillating in the 5092 - 5132 range for more than 3 hours. Towards the end of the session the markets bounced back and Nifty went above 5130 levels as well - still the Sep 5300 call was only worth 27 rupees i.e. the gain via delta was more than offset by the loss in extrinsic value courtesy decreasing time value and lower volatility.

The lure of lower investment requirment tempts a lot of people to jump into the options bandwagon without a thorough study of the dynamics. The same trade if one had played via October series options, the person would have emerged a winner. Alternately, a smart trader with 2 lots of Nifty futures hedged would have ended making more money

Margin Requirment would be apprx 55k and the trade would be say Long via Sep series Futures and Short via Oct series futures. When the markets started going above 5080 with volume and momentum, one could easily drop the losing short position and continue with the Long position and square it off at 5125 levels and still end up making more profit than the person who bought the Sep 5300 Calls [and Lord help the traders who bought the 5300 Sep Calls in Bulk!] This is nothing but what I call 'Burn Rate' of options. As difficult as it may seem to put forth a capital of 55k to start trading in Nifty futures, it would be prudent for a lot of aspiring traders to take a hard look at their 'tukka' options trades for the last 6 months. How much margin was fed in for trading, what is the net P&L after taking out losses, brokerage and other levies? In most of the cases, the amount of money people end up adding to their trading margin out of salary or regular income far exceeds the net profits made via options [i.e. there are significant losses on the options trade than profits] In a vast majority of the cases, the amount of money fed into the trading account far exceeds 55k rupees i.e. a patient wait for 2 or 3 months, devoted for analysis would have ensured that they make more profits than losses!

Advantages of Futures and Options v/s Share Trading

In the futures and options segment, a trader is not dependent on what conditions prevail in the market i.e. bull conditions or bear conditions. It is a trending market where one takes the price of the underlying on a particular day and takes a directional bet. At the end, if s/he has got the direction right, s/he has greater chances of taking home the differential value of buy and sell. Secondly, he does not have to own the stock or the index to enter such a trade. For instance, one can sell LnT shares only if one has bought the shares in the first place. For a one day period, one may short-sell LnT hoping that it will come down but at the end of the day, he has to buy LnT shares from the open market regardless of whether LnT has moved down or no and square off the position. In case of futures, he can just hold on to a position until the expiry of a contract and square off the position when the conditions are suitable.

Options are an advantage because they provide a low cost hedge to a position – if the directional bet is that a particular stock will go up, one can initiate a Long contract and just hedge the downside risk by choosing a Put in such a way that the loss on the Long contract can be offset by the gain in Puts in case the stock starts moving downwards.

Fundamental Reasons Why People / Banks Lose Money in Futures and Options:

First and foremost, the main reason why people lose money is because they do not hedge positions and do not get out of a position that is losing money on time. Rather they keep averaging out their positions. As far as institutional funds are concerned, they tend to take big ticket risks and they really don’t care what happens because they have the wrong incentives in place. It is not their own hard earned money in the first place; if they gain something out of it, anyways it is not payable to the investors. If they lose the money, they can always rejig the portfolio in such a way that the NAV of the funds drop. Even large institutional fund houses do not have adequate risk controls and monitoring systems in place due to multiple fund managers staking money on different kinds of derivatives. In 2011, 2 major cases have surfaced from reputed fund houses and nobody knows how much mess has been created in the background because of unreported cases. Big fund houses at some point of time lose complete control and take unidirectional bets on a very large scale and the same happens with a lot of retail traders as well.

In the period November 2010 to January 2011, the top management of Aditya Birla Money were so confident that a bear market was in place that they took very aggressive short positions via Short Futures and Long Puts. Whilst the futures could be salvaged by the roll-over and stake adjustment mechanisms, crores of rupees were lost due to aggressive positions in Puts that expired worthless continuously for 3 months in a row leading to a loss of more than 600 crores of shareholder value. The top brass was fired but the investors are still poorer nevertheless and this piece of news will never surface in any of our business magazines. It was just put out as a notice on BSE and NSE and lakhs of investors just got a notice saying that investments in certain midcaps went bust and hence the NAV of the fund has gone down.

Coming back to Nifty itself, majority of people do not know or take the time to understand the markets, have the tendency to take positions at every tick of the index and simply cannot get to terms with the fact that every position cannot yield profit. The hunger to make quick money with options has ruined many individuals. They simply do not see the burn rate of options and think of options as a ticket to riches [can be profitable if played properly but such high probability trades come just about 3 to 4 times in a month]. People do not adhere to money management in the 'hope' that things will turn around according to their positions.

That is just about it from my end for Futures and Options. This will be taken forward by harshalji and hopefully WWji and Raghuji can put it all together in brief with their seasoned expertise of the markets with strategies for risk management and options spreads [wwji and harshalji are the experts on options whilst Raghuji is very seasoned with futures trades]

We sincerely hope and pray that fellow boarders take advantages of these posts, take a hard look at how they are currently trading and take more educated bets on the markets in due course of time. Last but not the least, even I am in the learning process and there are instances when the directional bet goes wrong. Thanks to the guidance provided by seniors of mmb [and here I must also add MGUSAji to the list who first taught me to look at an options price basis intrinsic/extrinsic value and also guided me through some classic TA chart patterns via a book called Encyclopedia of Chart Patterns by Bullkowski - I will forever remain indebted to him to help me tide over certain uncertainties of the trading world by spending a lot of his valuable time to steer my thought process]