Derivative Classroom

Option Strategies Part I- Series VII

October 22, 2009

Derivative Classroom -Series V `
Hedging Strategies
In our earlier derivative classroom- “Portfolio Hedging”, we discussed about
hedging and its need . We discussed in length the mechanism to do portfolio
hedging with Nifty futures.

Today we will be discussing on HEDGING via OPTIONS.

Implied Volatility
In our classroom ‘OPTION BASICS’ we discussed on options and its types-
Call/Put. WE also studied the usefulness of option in term of exposure to risk. As

ssss options are cheaper in terms of premium, it provides good platform to reduce
the risk.

Hedging Strategies:

A) LONG ON STOCK

(i) Long Stock/Future, Buy a Put ( Protective Put)

(ii) Long Stock/Future, Sell a Call (Covered Call)

B) SHORT ON STOCK

(i) Short Stock/Future, Buy a Call

Long on stock, Buy Put (ii) Short Stock/Future, Sell a Put

View: Extremely bullish

Long Stock
I- Protective Put

This strategy can be used when an investor is holding a stock and feels that
correction is due in the short term. But long term view on the stock still remains
bullish. So instead of selling the stock, he can buy a Put. By buying a Put his
900 930 945
downside loss will be minimized.

Long Put Illustration 1

Hedged Suppose Mr. Shah has 1100 shares of Reliance Capital in his portfolio bought at
Rs.930. He is bullish on the stock in the long term but short term trend seems to
be negative. So instead of selling the stock he can buy an OTM Put of strike 900

with the premium outflow of Rs.15 and hedge his position.

Karun Mutha
Sr. Vice President& Head Derivatives
Tel +91-22-67897833
Email: Karun.mutha@hsbcinv.com
Action Scrip Type Strike Price Premium

Tina Khetan Buy Rel Capital Stock @ - -

Analyst - Derivatives 930
Tel +91-22-67897828
Email: Tina.khetan@hsbcinv.com Buy Rel Capital Put 900 15.00

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Derivative Classroom
Option Strategies Part I- Series VII

Derivative Classroom -Series V

Implied Volatility II- Covered Call

Long on stock, sell a call option
View: Neutral/ moderately bullish This strategy can be used when an investor is holding a stock and works best for

ssss the stocks for which investor do not expect a lot of upside or downside.
Essentially, we expect stock to stay sideways so as to collect the premiums and
reduce average cost every month. Thus one can hedge its long position in stock
by writing an option. Writer of an option has a limited profit to the extent of
margin received; however loss is unlimited.

Illustration 1

Long Stock
Suppose Mr. Mehta has 300 shares of Reliance Infra bought at Rs. 1,300. He
feels that Reliance Infra will rise in future. However in the market volatility stock

Short Call
comes down and losses are huge, Mr. Mehta writes a call at 1,350 with the
Hedge position
premium inflow of Rs. 25, so that his average will come down (at Rs.1,275).

. Scrip Type Strike Price Premium

Action Inference
1300
1275 1350 1375 Buy Reliance Stock @ - -
Infra 1300

Sell Reliance Put 1350 25.00

Infra

Directional Strategies

In hedging strategies we discuss how to hedge the position having owned the
stock in cash or in future. However option comes handy in designing the
strategy with defined risk- reward ratio. Directional spread like Bull Call spread
and Bear Call spread is best suited for the conservative investor who wants to
Buying a lower strike Call and selling capitalize on the opportunity available in the market, yet limiting the loss.
higher strike call
View: Bullish

Bull Call Spread

When the investor is bullish on the stock, he goes for creating a spread. The
spread has the advantage of being cheaper to establish than the purchase of a
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single call, as the premium received from the sold call reduces the overall cost.
The spread offers a limited profit potential if the underlying rises and a limited
loss if the underlying falls.
Derivative Classroom
Option Strategies Part I- Series VII

Derivative Classroom -Series V

Implied Volatility

ssss

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 Derivative Classroom
Option Strategies Part I- Series VII

Derivative Classroom -Series V Illustration III

Hedged position
Profit Ms. Kiran is bullish on IT sector and feels that the prices of TCS will move ahead

12 1 therefore she buys one ATM call at 680 with premium outflow of Rs. 15 and
7 Stock price sells one OTM Call at 700 with premium inflow of Rs. 7.

0 Implied Volatility
680 695 700 707
. Scrip Type Strike Price Premium
Action
-8 Long call Short call

-15
ssss
-8
Buy TCS Call (ATM) 680 15.00

Loss
Sell TCS Call (OTM) 700 7.00

Bear Put Spread

An investor who enters in bear spread is bearish and feels that stock price will
Buying a higher strike Put and selling
decline. In a declining market too investor can make profit both by using call
lower strike put
and put. The spread offers a limited profit potential if the underlying falls and a
View:bUBearish
limited loss if the underlying rises.

Illustration IV
Mr. Nitin Joshi is bearish on Banking sector and feels that the prices of ICICI
Bank will move down, therefore he buys one ATM put at strike price of 920 at
with premium outflow of Rs.11.00 and sells one OTM put at the strike of 900
Profit Hedged position
with premium inflow of Rs.4.00

13
. Action Scrip Type Strike Price Premium
Stock
Short put

0 Buy ICICIBANK PUT (ATM) 920 11.00

904 900 931 920
-7
Long put Sell ICICIBANK PUT (OTM) 900 4.00

Loss

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