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Derivatives – Options for Action

The ability of Thales to decipher actions in nature and create a derivative that made him wagonloads of money we have seen, and maybe envied. The earliest recorded derivatives transaction was in a commodity, and used options, a product that is considered more complex than futures.

Using the KISS principle that surely worked well for Thales, we could look at 2 strategies that can work brilliantly with options. (Oh, by the way, nothing romantic about the KISS. It’s just Keep It Simple, Stupid).

Keeping it simple, we take an event in the near future, could be some weeks, or even a month or two from now, which we expect will raise a lot of dust in the capital markets. The event could be the Union Budget, RBI Monetary Policy, election results, a corporate announcement in an economic atmosphere that sets expectations very high.

There is an old dictum that suggests “buy on expectations, sell on news”; high expectations when met may cause a price reversal. Or the news could be better than expected and lead to an explosive boom. Either way the security we have our eyes on moves - a lot. And the movement could be a lot, either way – up or down.

Using a futures contract here leaves us open to the price action, but naked in our exposure to risk. If the bet goes our way we make a killing, and die a thousand deaths if the price moves away from our expectations.

Another way out is to buy some insurance – through options. The simplest strategy to buy 2 lottery tickets, of which one will definitely be a winner is a straddle. Just like sitting astride on a horse, and seeing it upside down, a straddle involves buying 2 options. The pair of options will be at the same strike price, but one is a call option (with the pay-off being when the security price shoots up) and the other a put option (expecting a collapse in the security price). The pay-off looks like this:

While the break-even on each leg is the premium paid (as shown in the diagram), the sum of premium paid on both legs must be considered for the profits on the entire strategy to be calculated.

A related strategy is for those with less deep pockets, or those who boldly expect the markets to fly way, but do not know which the direction will be (as with the straddle buyer). The strangle. A physical strangle can lead to killing and severe punishment. A derivative strangle can lead to a monetary killing!

The premium on a ‘out-of-the-money’ option is very low. If the market’s reaction to the event is very large, then so will the pay-off be. Just as in a straddle, 2 opposite options are bought – one call and the other put. Both will be at strike prices that are at a loss at the moment. If the event creates an extremely large price movement, there is money to be made, whether the movement is upwards, or downwards. The strangle pay-off diagram:

As with the straddle, the total pay-off on the strangle needs to consider the premium paid on both the call and put options.

With both straddle and strangle the risk is limited to the premium, with the potential profit being in proportion to the price action of the underlying.

Such simple strategies can be tweaked, or complicated into various complex strategies. But like all good education starts with the basics and a sound foundation, the straddle is the basic, smart option strategy. It is effective in all financial markets that offer options.

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