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Protecting the downside: Three Option Strategies
When markets go down, it may be useful to protect your downside with a “hedge” of sorts. There are strategies to cover yourself against what might be temporary moves to the downside.
Concept: Buy Put Options to hedge against downside risk
Put options are available on the NSE, both on individual stocks and on the index. If I thought that the Nifty was going down below the 5,000 levels then I might choose to buy a 5000 put. For a portfolio of Rs. 10 lakhs, the Nifty needed to cover it is around 200 options (Nifty options trade in a lot size of 50).
But the premium matters – in disturbed times, put options cost a lot of money. A Nifty 5,000 put cost Rs. 156 today with the Nifty at 4947. That means the Nifty put doesn’t protect you till Nifty reaches (5000 minus the premium of 156) or 4844, which is 100 points below today’s close.
That means you will not be covered for the first 100 points of any subsequent fall, since that is the cost of the “insurance”. This is equivalent to about 2% of your portfolio; which is the “cost of insurance”.
Look at the payoff curve (Option plus long position together):
Understanding F&O Margins
When you trade the futures market, you get charged a margin for each trade. (For more information on what they are, read Futures and Options: an Introduction) If you were to buy a Reliance future, the lot size is 250 shares – at a price of Rs. 820 per share, your future should cost you Rs. 205,000.
But you don’t get charged Rs. 205,000. You get charged a percentage of it; this amount is called a “margin”. The margin you get charged depends on the “underlying” security on which the futures is based and the volatility at the time. Why? Because if you don’t pay the full cash at the time, the exchange has to protect itself from your running away in case the trade doesn’t work out for you – the margin is your skin in the game.
Let’s illustrate with an example. Take the Reliance future. If I try to buy a single lot – 250 shares – at Rs. 800 – I placed a dummy order, the stock’s at 820 – the exchange demands a margin of approximately Rs. 35,000. What’s in it?
There is an upfront initial margin which is applicable at the time of the trade. The actual number is calculated using technology called SPAN (Standard Portfolio Analysis of Risk) which was developed by the Chicago Mercantile Exchange (CME). The idea is that a lot of complex (and shady) mathematics happens behind the scenes to tell you, for an F&O portfolio, what the total margin should be. SPAN generates the number using the price and volatility of the underlying security – In the Reliance case above, the margin determined was around 17% of the stock price. Additional to the SPAN margin is an exposure margin – about 3% of total value of the position. (5% for stock futures)
Let’s say I buy at Rs. 800, and the stock goes to Rs.750 on some bad news. I now have to pay two elements of charges.
One: a mark-to-market amount, which is the difference from my buy price. This is calculated constantly, but charged only at the end of the day. So if Reliance fell to 750, my mark-to-market loss would be Rs. 50 (difference from buy price) x 250 (lot size) = Rs. 12,500. That’s a lot of money (compared to the initial margin of Rs. 35,000, it’s 30%+!)