Almost every one of us has bought some sort of an insurance policy at some or the other point in our life. It may be in the form of life insurance, health insurance, accident insurance, house insurance or any other form of insurance. The basic aim of almost all insurance is to provide financial protection against losses arising out of an undesired event happening in our lives.
For instance if we buy a house insurance to the tune of Rs 50 lakh by paying a small predetermined premium to the insurance company, it is legally bound to pay us the sum of Rs 50 lakh in case our house is destroyed in earthquake, flood or any other natural calamity. In other words, by paying a very small sum as premium, we can protect ourselves against a huge loss arising out of any unpleasant happening.
All this is just great. But, what about the hard-earned money that we invest in the stock markets? For many of us this forms a sizable part of our investment kitty. However, no insurance company is foolish enough to insure something that is as uncertain and unpredictable as the stock market.
The insurance company would always be a loser in this sort of an arrangement. So are we left to the mercy of the market makers to decide the fate of our investments in the markets? Well, not really. There is some consolation though. This insurance exists in the forms of Stock Options.
Options are widely used by market players as a form of insurance. Only when it pertains to the markets, the commonly used term for this insurance is Hedging.
Hedging
A position established with the specific intent of protecting an existing position in case of an unwanted event happening is called hedging.
In our previous issue, we dealt with the basics of options trading. For the benefit of all, the basic things to under-stand in options trading are:
Option
It is a contract that gives a buyer the right but not the obligation to buy or sell an underlying asset (index/stock) at a specific price on or before a particular date. There are two types of Options. One is the Call Option and the other is the Put Option.
Call Option
Gives the buyer/holder the right to buy the underlying asset at a fixed pre-determined price within a certain fixed period of time.
Put Option
Put Option gives the buyer/holder the right to sell the underlying asset at a fixed predetermined price within a certain fixed period of time.
Option Premium
The price paid by the buyer of an Option to the seller of an Option is called Option Premium.
How Options can help prevent the huge loss to your investment portfolio and even generate income:
After seeing the rip-roaring surge in the stock markets immediately following the recent elections, most of us had a feeling of being left in the lurch. The next big event on the cards was the budget.
Everyone wanted a piece of the action and so investors started buying stocks in huge quantities hoping that the budget would be a landmark budget and the Finance Minister would offer a lot of subsidies and perks to many beaten-down sectors.
Alas, the budget was a dud. The markets didn�t like what it had heard and therefore came crashing down. Overnight many people were staring at huge losses on their stock investments.
Even though the fundamentals and valuations of these stocks were sound, investors feared more equity erosion would be on the cards and they cut their open position and booked their losses. Those who held onto their investments into the markets spent many a sleepless night and had anxiety attacks waiting for the markets to bounce back so that they could recover their lost capital.
All this could have been easily avoided or at least minimized if the investors had bought something known as a Put Option as a hedge against their investments. (Note: A Put option gives the individual the right to sell the underlying shares at a predetermined price called as the �Strike Price�.)
Here�s how it works.
Let�s say you had bought 150 shares of Reliance Industries just prior to the budget. The total cost of the entire lot in accordance with the then-existing share price of around Rs 2,000 per share turned out to be Rs 3 lakh in totality.
Now you are afraid that an unexpected move in the stock market can cause a capital erosion of your portfolio value. So, in order to prevent this kind of a loss to your capital, you buy a �Put� option of Reliance Industries with a strike price of 2,000 worth Rs 3 lakhs. This Put can be bought by paying a relatively small amount called the Option premium.
This premium depends on a lot of factors such as the price of the stock, time to maturity, volatility, etc. This premium is exactly like the premium that you would pay to an insurance company if you have to buy a life or health or any other insurance for insuring yourself against a huge loss.
Scenario I
The price of Reliance Industries stock goes up after election: Say the stock price of Reliance Industries goes up from Rs 2,000 to Rs 2,400 you are making a profit of Rs 400 per share. You let the 2,000 Reliance Put lapse and expire worthless. That is, you lose the total amount of premium paid for it. But then again it is a very small loss when compared to the profit that you have made on each share.
Scenario II
The price of Reliance Industries stock goes down after the election. Say the stock price of Reliance Industries crashes to Rs 1,500 from Rs 2,000. You are making a loss of Rs 500 per share on your portfolio but then don�t forget that you have a 2,000 Put of the same stock, which gives you the right to sell the Reliance stock at Rs 2,000 even though the current market price is Rs 1,500.
So you go ahead, exercise your option of selling Reliance Industries at Rs 2,000. Now your only loss is the premium paid for the 2,000 Put plus the brokerage and taxes. Thus, a major loss of capital that could have arisen is averted.
Such a strategy is called the Protective Put strategy. The Protective Put strategy lowers risks and presents an opportunity for unlimited gain. You are also entitled to all the benefits with respect to the stock, namely dividends, bonus, voting rights, during the life of the put, till the time you sell your stock.
The only flip side of this strategy is that in India Options currently are traded only for 1, 2 or 3 months at the most at any given point of time.
So if you are a long-term investor, your duration of the Protective Put would last a minimum of 1 month and a maximum of 3 months depending on the term of the contract bought by you. After this, you would have to buy a new Options contract so that you can keep your insurance cover going.
Investing in the stock markets is like bungee jumping; it can have vicious and violent movements either ways, but with a firm harness in place, you can enjoy the adrenaline rush sans anxiety.
Source: Nirmal Bang
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