The concept of Derivatives as a trade able instrument is still
in its nascent stages in India. Moreover, before people actually
understand the meaning of derivatives, they have been termed as
Derivatives are weapons of mass destruction- Warren Buffet.
Derivatives are still regarded as complex instruments which are
understood only by few people in the industry. However, the truth
is that derivatives are simple contracts and easy to understand.
The complexity comes in deriving a fair price for these derivative
instruments. For retail participants, pricing should never be an
issue and therefore they do not need to get into the complexities
of fair price. They should always have a view on the underlying
asset price and trade derivatives at the current market price. With
the advent of algorithmic trading, which will trade for risk free
arbitrages, the retail participants can safely assume that the
current price is the fair price at this point in time.
Various studies have been done on Derivatives, specifically
Options to understand the pricing of these instruments. However
much more needs to be done in this field. Most of the research has
been on the theoretical aspect of modeling and mispricing, and very
little research work is done on practically employing strategies
and its implementation for profit from a retail investors point of
view.
Derivatives such as options basically were designed as hedging
tools, which eventually have evolved to become the best speculation
tools as the losses are limited in this instrument, whereas the
profits can be potentially unlimited.
An option is a tradable instrument which is a contract in which
the buyer of the option has the control and the right to exercise
the contract if it is in his favor, or deny obliging the contract
if the prices are not in his favor.To get this right, the option
buyer pays a cost which is also called the premium. A trader need
not hold his position till the expiry; he can sell the contract at
the prevailing premium.
Options traders can take multiple views on the market by trading
a combination of options. These combinations are called strategies.
These strategies have a structured payoff at the end of the expiry
and hence it is easy to understand the risks involved before
initiating a trade. With some underlying assumptions or views on
the market, one can make profits in the long run.
Any combination of buy or sell of call or put can result i n a
structured payoff at the end of the expiry. Based on this, a trader
can take multiple views on the price of the asset. For instance, if
a trader is bullish, he can buy call option or sell put option. The
choice of which to choose depends on further specifying the view.
If the trader is bullish in the sense he thinks the price of the
asset will increase above the breakeven point which is arrived at
by strike + premium, he will buy a call option of that strike
price. If the trader has a view that the price of the asset will
stay anywhere above a particular strike price, then he can sell the
put option of that particular strike price. Thus, in case a trader
sells a put of a lower strike price than the current market price,
and the price of the asset goes d own but still manages to remain
above the strike price on the expiry day, the put option seller
will make profit. The decision to buy call or sell put is also
dependent on the risk the trader wishes to take, in case his view
goes wrong. In selling a put, there can be potentially unlimited
loss, whereas, in buying a call option, the loss is limited to the
premium paid.
In a similar way, a trader can be bearish by buying a put or
selling a call, depending on his specific view.
An options trader can take few more views. He can take a view
such that, he doesnt know in which direction the price of the asset
will go, but he knows that the price will move fast in any one
direction, due to an upcoming event after which the price of the
asset will see a big move. Fo r such a view, the trader can buy a
call and buy a put. If the market sees a big move upside, the call
can make potentially unlimited profit, whereas the put will make
limited loss to the extent of the premium paid. If the asset price
crashes down, the put will make huge profit and the call will make
limited loss to the extent of the premium paid. Thus, even when a
trader cannot take a directional view he can create a strategy by
combining the payoffs of buy call and buy put. This strategy is
called a Straddle (if the strike price of call and put is the same)
and Strangle (if strike prices of both options are different).
Bull Call Spread:
For a bullish view, a trader can make a bull call spread, in
which he buys a call at a strike price near to the current value of
the asset, also called the At the Money call, and sells a call of a
higher strike price, also known as Out of Money call. By buying an
ATM call, th e trader will start making profit as the price of the
asset goes up. However, he will start losing after the price of the
asset goes above the strike price of the sold option. Thus one
cannot achieve unlimited profits but is sure to get some profit if
the price of the asset goes up. The trader has given premium to buy
the ATM call and received premium in selling of the OTM call. Hence
his total outflow of cash becomes less. Now, if the price of the
asset goes down, both the call options will become zero. Hence the
trader will lose the initial cash outflow only. Thus this is a
strategy in which there is limited loss and limited profit. This
strategy usually gives a very good reward to risk ratio. This is
the best strategy known for retail investors.
Bear Put Spread:
Similarly for bearish view, a trader can make a bear put spread
in which he buys an ATM put and sells a put of the lower strike
price which is OTM put. The trader will make limited profit if the
price of the asset goes down and makes a limited loss if the price
of the asset goes up.
KEY TERMINOLOGIES
FUTURES: A financial contract obligating the buyer to purchase
an asset (or the seller to sell an asset), such as a physical
commodity or a financial instrument, at a predetermined future date
and price. Futures contracts detail the quality and quantity of the
underlying asset; they are standardized to facilitate trading on a
futures exchange. Some futures contracts may call for physical
delivery of the asset, while others are settled in cash. The
futures markets are characterized by the ability to use very high
leverage relative to stock markets.
OPTIONS: A financial derivative that represents a contract sold
by one party (option writer) to another party (option holder). The
contract offers the buyer the right, but not the obligation, to buy
(call) or sell (put) a security or other financial asset at an
agreed-upon price (the strike price) during a certain period of
time or on a specific date (exercise date).
CALL OPTION: Call options provide the holder the right (but not
the obligation) to purchase an underlying asset at a specified
price (the strike price),for a certain period of time. If the stock
fails to meet the strike price before the expiration date, the
option expires and becomes worthless. Investors buy calls when they
think the share price of the underlying security will rise or sell
a call if they think it will fall. Selling an option is also
referred to as ''writing'' an option.
PUT OPTION: Put optionsgive the holder the right to sell an
underlying asset at a specified price(the strike price). The seller
(or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the
option expires. Investors buy puts if they think the share price of
the underlying stock will fall, or sell one if they think it will
rise.STRIKE PRICE: The price at which a specific derivative
contract can be exercised.PREMIUM: The income received by an
investor who sells or "writes" an option contract to another
party.IN THE MONEY:1. For a call option, when the option's strike
price is below the market price of the underlying asset.2. For a
put option, when the strike price is above the market price of the
underlying asset.OUT OF THE MONEY: A call option with a strike
price that is higher than the market price of the underlying asset,
or a put option with a strike price that is lower than the market
price of the underlying asset. An out of the money option has no
intrinsic value, but only possesses extrinsic or time value. As a
result, the value of an out of the money option erodes quickly with
time as it gets closer to expiry. If it still out of the money at
expiry, the option will expire worthless.IMPLIED VOLATALITY:
Theimplied volatilityof anoptioncontract is that value of
thevolatilityof the underlying instrument. In general, implied
volatility increases when the market is bearish and decreases when
the market is bullish. This is due to the common belief that
bearish markets are more risky than bullish markets.AT THE MONEY: A
situation where an option's strike price is identical to the price
of the underlying security. Both call and put options will be
simultaneously "at the money." An at-the-money option has no
intrinsic value, but may still have time value. Options trading
activity tends to be high when options are at the money.
OBJECTIVES:Stock markets have always been looked upon as
speculators paradise and never as a source of wealth creation. To
add to the agony, Derivatives have only increased the pain of the
retail investors and kept them away from markets. This study is an
attempt to prove that wealth creation can be done with the help of
derivatives. To design an options strategy which when applied in a
simple mechanical method, results in long term wealth creation for
retail investors. To study investors psychology towards this
options strategy and towards derivatives as a whole.METHODOLOGY:
Designing a direction neutral strategy with the help of options and
back testing it mechanically through secondary data available from
NSE website. The strategy will be executed at the open of every
expiry month and close on the expiry date of that month. It will be
mechanically executed in the form of a simple algorithm for 7 years
starting from 2008 and ending in 2014 and the cumulative profit
will be recorded. A survey was conducted with a mixed research
design, to understand the psychology of respondents towards
investing in derivatives. Investment behavior of the respondents
will be recorded and their response to the option strategy will be
assessed. The research will also explore the reasons why the retail
investor distances himself from derivatives and its strategies.
This research will be based on a questionnaire which will have open
and closed ended questions.
DATA ANALYSISBack testing of strategies:
Strategies or combination of option trades, which are done once
and squared off on expiry are called static strategies. Strategies
begin with a view on the market. Options trading allow a trader to
take multiple views and hence there are various static strategies.
Based on a view on all three factors, a strategy involving
combination of options can be formed. The research aims to test at
least 4 basic static strategies starting on a particular fixed day
of the expiry and squaring off on the closing price of the last day
of the expiry. The objective of the back testing will be to know if
there is any static strategy which can yield profits in every
month. Since the strategies are static, they can be back tested
from the secondary data available from the Bhav copies of past
trading days, available from NSE.
Last Friday
Third Friday
2nd fri
ANALYSIS AND FINDINGS
This strategy attracts margins since there are short options.
However, the margin investments are not considered as investments
as margins are allowed to be in the form of any collateral. Hence
only the cash outflow is considered as the new investment.
Out of the 7 years (84 months) in the back testing experiment,
it is observed that
No. of profit months:58No. of loss months:26Maximum loss months
in a year:05Maximum absolute loss in a month:Rs. 139No. of months
with loss more than Rs.100 06Net amount of only losses:Rs.
1520Maximum cumulative loss at any point:Rs. 0Initial
investment:Rs. 128.70Cumulative profit at the end of the period:Rs.
1375
Looking at the data, one can observe that the market has behaved
in quite random manner. In some months there had been extreme
movements and in some there was no movement at all. The direction
of the market has been up in 46 months and down in 38 months from
its starting point of the expiry period. In these 7 years, markets
have behaved in all risky scenarios and hence it can be called an
optimum sample for capital markets.
SURVEY: A survey was conducted to study investors psychology
towards derivatives. It was a qualitative research wherein 30
investors were interviewed. Investment behavior of the respondents
was recorded and their response to the option strategy was
assessed. The research explored the reasons why the retail investor
distances himself from derivatives and its strategies. From the 30
respondents, majority were reluctant from investing in derivatives
since they assume derivatives to be risky and complicated. It was
found that majority of them associated derivatives with share
market without willing to understand the concept of futures and
options. After studying their risk profile the above strategy named
as Iron Butterfly Spread was introduced and explained to those
investors. This strategy was selected since it was a mechanical
strategy with limited risk. This strategy was able to overcome
major fear which retail investors face. This strategy was able to
convince 24 out of 30 respondents (80%) for trial. The other 6
respondents had inherent phobia for derivatives and hence they
restricted themselves.
FINDINGS AND ANALYSISReasons behind derivative phobia:
24 respondents who were ready for trial were asked the
percentage of total investment portfolio they would invest in the
above strategy :
