All About Options

When the Greek emperor asked the famous mathematician, Euclid, if Geometry could be made simpler, his answer was, “Your honour, there is no royal route to geometry”. Similarly, there is no royal route to picking the right stock for options trading. It has to be a combination of analysis, back testing and iterations. However, there are some basic rules that you can follow to make the task more purposeful.

• Do I need to trade options on stocks at all?

Remember, any decision to buy or sell an option is a trade-off. For example, if you think that stock-X is going to move up over 2 years, then options are not the right answer. In India, the best you can get is a 3-month option and that is also normally not liquid. So, if you need to create a strategy for your 1-year or 2-year bullish view on a stock, then stock options are not the answer. You can buy the stock or you can buy the futures and keep rolling it over. In the case of futures, you must also keep an eye on the cost of rolling it each month.

So that is where the whole story begins. You must first convince yourself that stock options are the best way to play your view. Only after that, you get into the specifics of deciding the next steps. Normally, stock options, especially the buying of stock options, work best when the stock is able to show substantial movement in a space of 1-2 months. If you by the stock option too close to the event, it is tough to make profits as it would already be in the price.

 

• Are you trading direction / anti-direction / protection?

This looks like a complicated question, but actually it is not. Let us encapsulate this story with a small illustration.

Purpose of the Option	What is the view	How to use stock options
Trading Direction	I expect the price of stock A to move up by 10% in a month	Buy a call option that can gain from the up move
Trading Direction	I expect the price of stock B to move down by 10% in a month	Buy a put option that can gain from the down move
Trading Anti-direction	I expect that price of stock C will not go above Rs.1800 in 1 month	Sell a call option of strike 1800 but ensure good premium income
Trading Anti-direction	I expect the price of stock D will not fall below Rs.1300 in a month	Sell a put option of strike 1300 and ensure reasonable premium
Trading Protection	I hold stock E but I am worried it could correct 12% from here	Buy a slightly lower put option of strike below the buy price
Trading protection	I hold stock F, which is down 10% and I don’t see upsides for now	Sell a higher call option to reduce holding cost and keep repeating

 

Broadly, there are 3 reasons for you to buy or to sell a stock option. It is essential to be clear about where your decision to by or sell stock options actually fits in.

 

• Are you buying momentum or are you buying a theme?

How do you distinguish between momentum and a theme? The answer is time. Momentum is for the very short-term while theme could for longer-term. For example, if your view is that the budget will be positive for agriculture, then buying call options on fertilizer stocks and agrochemical stocks is a momentum play. That is a good way to use stock options and in fact, stock options are actually meant to play momentum.

However, if you view is that automobile stocks could correct by 50-60% over next 3 year due to the advent of electric cars, then it is a medium-term theme. Three years is a very long time to be able to play with options and so there is no point buying put options now. In such cases, you can sell futures and roll over or just exit the stock that you are holding.

 

• How confident are you about your view?

It is one thing to say that you expect the stock price to go up in the one month. That is a good case to buy a call option. But that brings us to the second question. How confident are you about your view? You may find the question to be too subjective but there are surely some proof you should be able to look at. Your view could be right, but what is the assurance that the market will move.

Firstly, don’t buy call options when the markets are at the peak. Option prices will be very expensive and upsides could be capped. If there are signals of a likely correction in the overall market, avoid buying call options. That may be a good time to sell call options, but that depends on your risk appetite.

Another thing you can do is to buy calls after a correction in a strong stock. For example, just go back to the last 5 years prices and see how much HDFC Bank has jumped in price each time it corrected 10%. Such data points do not give assurance, but give you comfort level.

 

• How has the stock typically reacted to news?

As we discussed early, stock options are normally bought to play the momentum in the stock. Here, you have to look at two things. Firstly, how close are you to the trigger event or news that you are anticipating? But the more important question is how do such stocks react to news. Do they react strongly or in a tepid manner?

For example, every quarter when the results are announced, Infosys typically tends to react strongly. That has been the tendency with Infosys all along. So, if you have a clear positive or negative view on the Infosys results, it is a good stock to buy a call option or put options. Similarly, Reliance reacts very strongly to AGM announcements, capital raising, fund utilization announcements etc. Here is again a stock where you can play your view with call options or put options.

How confident would you be playing NTPC with options? The stock hardly shows any appreciable movement. Similarly, ACC normally does not move for long periods of time so any option view has to be only taken during periods of cement price rise when the stock moves rapidly. Thus, timing the momentum in the right socks is the key to options.

 

• Are the options liquid enough

How do you judge the liquidity of an option? In a way, you judge the liquidity of an option in the same way as you judge the liquidity of a stock. Liquidity is all about how easy it is to get in and get out of an options contract, especially when you have to trade large quantities. That is the real test of any options contract. Check below the Reliance Call Option Chain when the stock price is Rs.2055.

Open Interest	Traded Volumes	Traded Price	Bid Quantity	Bid Price	Ask Price	Ask Quantity	Strike Price
256	178	167.25	5,000	153.05	168.15	250	1,900.00
27	-	-	3,000	108.20	161.1	3,000	1,920.00
28	8	127.30	3,500	118.00	133.15	500	1,940.00
39	18	109.65	500	109.25	113.65	250	1,960.00
75	28	97.25	250	92.65	111.8	1,250	1,980.00
1,078	1,671	80.00	250	78.40	80.65	1,250	2,000.00
108	244	65.50	500	61.80	66.25	1,500	2,020.00
508	1,737	51.00	3,250	51.00	54.8	250	2,040.00

 

There are 3 ways to test liquidity in stock options. Firstly, look at the total volumes in lots. Prefer the options that have higher volumes as you can get easy exit. Secondly, look at open interest as that is a sign that there are enough people holding positions and not just doing intraday trades. Lastly, look at the bid-ask price spread. For example, the 2040 call and the 2020 call which are near the price, the spreads are small. But if you go to lower strikes, bid ask spreads widen. Prefer smaller bid-ask spreads.

So, I hope you got a hang when I said that options should be liquid enough. It basically means, you should be able to get in and get out of these options without too much of an additional cost. That is what liquidity of an options contract is all about.

 

• What is the risk reward ratio?

That is the last part of selecting the stock option. It all boils down to risk reward. Let me give you a simple example of risk reward with the SBI example. You expect the price of SBI to go up from the CMP of Rs.362 to Rs.400 over the next 3 months. However, you are not sure about the extent of movement you will get in the next one month.

Normally, it is a good idea to buy a slight out of the money option. For example, if you buy 365 call option at say Rs.8, then what would be the risk reward? If you have only 10 days to expiry, the risk reward is doubtful but if you have a 30-day time frame, you can be more confident about the risk-reward. Risk reward is all about how much you are likely to lose for how much you are intending to gain. The lower the risk reward ratio, the better it is.

References: 

Fundamentals of Futures and Options Markets by John Hull: Click here to buy now

Options Trading Crash Course by Frank Richmond: Click here to buy now