Year: 2020

In stock market there is strong relationship between risk and return. Greater the risk, greater the return generally! In financial terminology risk management is the process of identifying and assessing the risk and then developing strategies to manage and minimize the same while maximizing the returns.

Every investment demands a certain amount of risk and for an investor to assume this risk he has to be compensated duly. This compensation is in the form of something called as the risk premium or simply the premium. Risk is therefore central to stock markets or investing because without risk there can be no gains. Successful investors use stock market risk management strategies to minimize the risk and maximize the gain.

In financial markets there are generally two types of risk; first the Market risk and second the Inflation risk. Market risk results from a possibility in increase or decrease of financial markets. The other risk i.e. the Inflation or the purchasing power risk results from rise and fall of prices of goods and services over time.

The inflation risk is an important consideration in long term investments where as the market risk is more relevant in the short term. It is the market risk that can be managed and controlled to a certain extent, inflation risk cannot be controlled.

There are certain strategies that can be employed to mitigate the risk in a stock market. The strategies are as follows:

• Follow the trend of the market: This is one of the proven methods to minimize risks in a stock market. The problem is that, it is difficult to spot trends in the market and trends change very fast. A market trend may last a single day, a month or a year and again short-term trends operate within long term trends.
• Portfolio Diversification: Another useful risk management strategy in the stock market is to diversify your risk by investing in a portfolio. In a portfolio you diversify your investment to several companies, sectors and asset classes. There is a probability that while the market value of a certain investment decreases that of the other may increase. Mutual Funds are yet another means to diversify the impact.
• Stop Loss: Stop loss or trailing tool is yet another device to check that you don’t lose money should the stock go far a fall. In this strategy the investor has the option of making an exit if a certain stock falls below a certain specified limit. Self-discipline is yet another option employed by some investors to sell when the stock falls below a certain level or when there is a steep fall.

Portfolio diversification

Businesses are susceptible to several uncertainties that adversely affect their stock prices. To protect your portfolio from big losses, invest in multiple stocks. This ensures that even if some of your investments do not perform as expected, the others minimise their effect on the overall portfolio. While diversifying, make sure to invest in stocks that don’t have much in common. Investing in similar stocks exposes you to the same risks and defeats the purpose of diversification. For example, automobile and auto ancillary may seem like different sectors, but they are affected by similar factors. Investing in both these sectors may not help much with risk mitigation.

Remember, diversification does not mean investing equally in all sectors. It means investing in more than one asset or sector.

You can invest more in companies you are more optimistic about. But don’t commit so much that you cannot bear the losses if things go bad.

Using stop-losses

A stop-loss order authorizes your broker to automatically sell a stock when it falls to a specific level. This protects you from excessive losses during sharp market corrections. It also checks your tendency to sit on a loss-making stock for too long in the hope that it rebounds. For example, if you bought a stock for Rs.100 with a stop-loss of Rs.90, your broker will automatically sell the stock when it falls to Rs.90. This can protect you from further losses if the stock falls below Rs.90.

Adding non-cyclical to the portfolio

These are stocks of companies that sell essential goods and, as such, are relatively insulated from economic cycles. Examples include pharmaceutical and Fast-Moving Consumer Goods (FMCG) stocks. Why you wonder? This is because people cannot stop spending on healthcare and groceries, irrespective of the state of the economy. At best, they may reduce their spending on some essential goods and services. As such, non-cyclical stocks have relatively stable revenues, which translate into stable stock prices. You may find many experts call them ‘Defensives’.

Hedging

Hedging refers to the use of derivative instruments, such as Futures and Options contracts, for risk management in equity. A futures contract helps you to fix the price for a future buy/sell transaction in the future. This way, you can cut down the risk of price fluctuations. For example, even if the price of your stock falls, you can sell it at the higher price that you fixed. Similarly, you can buy at lower rates even if the price rises thanks to derivatives contracts. There are different types of such derivatives contracts that you can use. We’ll read about these in depth in the Derivatives section.

Investing in dividend-paying stocks

Companies that have a history of consistent dividend payments are usually strong, established companies. Adding them to your portfolio can shield you from equity risk.

Companies are generally reluctant to cut their dividends because the market perceives a dividend cut as a sign of poor financial health. As such, dividend-paying stocks also ensure that you receive a constant stream of returns, even if their prices fall. They reduce risk by bringing more predictability and stability to your portfolio.

Opting for blue-chips

Not all stocks have the same risk. Stocks of smaller or medium-sized companies can be riskier and more volatile in the stock market. This is because such companies are more prone to various business risks. Established companies, meanwhile, can be more stable. This extends to their stock prices too. So, you can reduce risk by opting for such stocks.

Pairs trading

This is a good way to mitigate equity risk when you are anticipating a big price move, but are not sure of its direction. An example is when a big regulatory decision is expected to be made, but you don’t know what the decision will be. In such cases, you simultaneously buy the stock of one company and short sell (i.e. sell first and cover by buying later) the stocks of another company from the same sector. Ensure that both stocks are not related and are likely to benefit in different ways.

Initial Margin

Initial Margin is also called SPAN Margin. NSCCL (Clearing Corporation of NSE) and ICCL (Clearing Corporation of BSE) collects initial margin up-front for all the open positions of a Clearing Member (CM) based on the margins computed by SPAN Software. A CM is in turn required to collect the initial margin from the Trading Member (TMs generally known as Stock Broker) and his respective clients. Similarly, a TM should collect upfront margins from his clients.

Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the case of futures contracts (on index or individual securities), where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin is computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time.

Initial margin requirement for a member:

1. For client positions: Is netted at the level of individual client and grossed across all clients, at the Trading/Clearing Member level, without any setoffs between clients.
2. For proprietary positions: Is netted at Trading/Clearing Member level without any setoffs between client and proprietary positions.

Premium Margin

In addition to Span Margin, Premium Margin is charged to members. The premium margin is the client wise premium amount payable by the buyer of the option and is levied till the completion of pay-in towards the premium settlement.

Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is levied on assigned positions of CMs towards interim and final exercise settlement obligations for option contracts on index and individual securities till the pay-in towards exercise settlement is complete.

The Assignment Margin is the net exercise settlement value payable by a Clearing Member towards interim and final exercise settlement and is deducted from the effective deposits of the Clearing Member available towards margins.

Initial Margin requirement = Total SPAN Margin Requirement + Buy Premium + Assignment Margin

Exposure Margin

The exposure margins for options and futures contracts on index are as follows:

For Index options and Index futures contracts:

3% of the notional value of a futures contract. In case of options it is charged only on short positions and is 3% of the notional value of open positions.

For option contracts and Futures Contract on individual Securities:

The higher of 5% or 1.5 standard deviation of the notional value of gross open position in futures on individual securities and gross short open positions in options on individual securities in a particular underlying. The standard deviation of daily logarithmic returns of prices in the underlying stock in the cash market in the last six months is computed on a rolling and monthly basis at the end of each month.

Additional Exposure Margin

Effective from February 2018, immediately the day after the expiry of February 2018 contracts , levying additional exposure margin based on Market Wide Position Limit has been started. The change in exposure margin shall be applicable from next trading day and shall be applicable till the open interest in the security reduces to below 70% of MWPL at end of the day.

For this purpose notional value means:

• For a futures contract: The contract value at last traded price/closing price.
• For an options contract: The value of an equivalent number of shares as conveyed by the options contract, in the underlying market, based on the last available closing price.

In case of calendar spread positions in futures contract, exposure margins are levied on one third of the value of open position of the far month futures contract. The calendar spread position is granted calendar spread treatment till the expiry of the near month contract.

Initial Margin requirement = Total SPAN Margin Requirement + Buy Premium + Assignment Margin+ Exposure Margin + Additional Exposure Margin

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options’ variables. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option’s strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option’s strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.

Options strategies allow traders to profit from movements in the underlying assets based on market sentiment (i.e., bullish, bearish or neutral). In the case of neutral strategies, they can be further classified into those that are bullish on volatility, measured by the lowercase Greek letter sigma (σ), and those that are bearish on volatility. Traders can also profit off time decay, measured by the uppercase Greek letter theta (Θ), when the stock market has low volatility. The option positions used can be long and/or short positions in calls and puts.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. They can also use Theta (time decay) with a bullish/bearish combo called a Calendar Spread, when sideways movement is expected. The trader may also forecast how high the stock price may go and the time frame in which the rally may occur in order to select the optimum trading strategy for buying a bullish option.

The most bullish of options trading strategies, used by most options traders, is simply buying a call option.

The market is always moving. It’s up to the trader to figure out what strategy fits the markets for that time period. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost or eliminate risk altogether. There is limited risk trading options by using the appropriate strategy. While maximum profit is capped for some of these strategies, they usually cost less to employ for a given nominal amount of exposure. There are options that have unlimited potential to the up or down side with limited risk if done correctly. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options that make money as long as the underlying asset price does not decrease to the strike price by the option’s expiration date. These strategies may provide downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. The purchaser of the covered call is paying a premium for the option to purchase, at the strike price (rather than the market price), the assets you already own. This is how traders hedge a stock that they own when it has gone against them for a period of time.

Bearish strategies

Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy. Selling a Bearish option is also another type of strategy that gives the trader a “credit”. This does require a margin account.

The most bearish of options trading strategies is the simple put buying or selling strategy utilized by most options traders.

The market can make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. This strategy has limited profit potential, but significantly reduces risk when done correctly. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the underlying asset does not rise to the strike price by the options expiration date. However, you can add more options to the current position and move to a more advanced position that relies on Time Decay “Theta”. These strategies may provide a small upside protection as well. In general, bearish strategies yield profit with less risk of loss.

Neutral or non-directional strategies

Neutral strategies in options trading are employed when the options trader does not know whether the underlying asset’s price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying price will increase or decrease. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

• Guts: Buy (long gut) or sell (short gut) a pair of ITM (in the money) put and call (compared to a strangle where OTM puts and calls are traded);
• Butterfly: A neutral option strategy combining bull and bear spreads. Long butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from.
• Straddle: An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums (long straddle)
• Strangle: Where you buy a put below the stock and a call above the stock, with profit if the stock moves outside of either strike price (long strangle).
• Risk reverse: Simulates the motion of an underlying so sometimes these are referred as synthetic long or synthetic short positions depending on which position you are shorting;
• Collar: Buy the underlying and then simultaneous buying of a put option below current price (floor) and selling a call option above the current price (cap);
• Fence: Buy the underlying then simultaneous buying of options either side of the price to limit the range of possible returns;
• Iron butterfly: Sell two overlapping credit vertical spreads but one of the verticals is on the call side and one is on the put side;
• Iron condor: The simultaneous buying of a put spread and a call spread with the same expiration and four different strikes. An iron condor can be thought of as selling a strangle instead of buying and also limiting your risk on both the call side and put side by building a bull put vertical spread and a bear call vertical spread;
• Jade Lizard: A bull vertical spread created using call options, with the addition of a put option sold at a strike price lower than the strike prices of the call spread in the same expiration cycle;
• Calendar spread: The purchase of an option in one month and the simultaneous sale of an option at the same strike price (and underlying) in an earlier month, for a debit

Bullish on volatility

Neutral trading strategies that are bullish on volatility profit when the underlying stock price experiences big moves upwards or downwards. They include the long straddle, long strangle, long condor (Iron Condor), long butterfly, and long Calendar.

Bearish on volatility

Neutral trading strategies that are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, short condor, short butterfly, and short calendar.

Option strategy profit / loss chart

A typical option strategy involves the purchase / selling of at least 2-3 different options (with different strikes and / or time to expiry), and the value of such portfolio may change in a very complex way.

One very useful way to analyze and understand the behavior of a certain option strategy is by drawing its Profit / Loss graph.

An option strategy profit / loss graph shows the dependence of the profit / loss on an option strategy at different base asset price levels and at different moments in time.

Option Strategies

1. Orientation

Setting the context Before we start this module on Option Strategy.

2. Bull Call Spread

Background The spread strategies are some of the simplest option strategies that a trader can implement. Spreads are multi leg strategies involving 2 or more options.

3. Bull Put Spread

Why Bull Put Spread? Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked when the view on the market is ‘moderately bullish’.

4. Call Ratio Back Spread

Background The Call Ratio Back Spread is an interesting options strategy. I call this interesting keeping in mind the simplicity of implementation and the kind of pay off it offers the trader.

5. Bear Call Ladder

Background The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back spr.

6. Synthetic Long & Arbitrage

Background Imagine a situation where you would be required to simultaneously establish a long and short position on Nifty Futures, expiring in the same series.

7. Bear Put Spread

Spreads versus naked positions Over the last five chapters we’ve discussed various multi leg bullish strategies. These strategies ranged to suit an assortment of market outlook – from.

8. Bear Call Spread

Choosing Calls over Puts Similar to the Bear Put Spread, the Bear Call Spread is a two-leg option strategy invoked when the view on the market is ‘moderately bearish’. The Bear Call Spread.

9. Put Ratio Back spread

Background We discussed the “Call Ratio Back spread” strategy extensively in chapter 4 of this module. The Put ratio back spread is similar except that the trader invokes this when he is b ..

10. The Long Straddle

The directional dilemma How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market move.

11. The Short Straddle

Context In the previous chapter we understood that for the long straddle to be profitable, we need a set of things to work in our favor, reposting the same for your quick reference – The vo ..

12. The Long & Short Strangle

Background If you have understood the straddle, then understanding the ‘Strangle’ is quite straightforward. For all practical purposes, the thought process behind the straddle and strangl ..

13. Max Pain & PCR Ratio

My experience with Option Pain theory in the never ending list of controversial market theories, the theory of ‘Option Pain’ certainly finds a spot. Option Pain, or sometimes referred to.

14. Iron Condor

New margin framework These are fascinating times we are living in, especially if you are an options trader in India Starting 1st June 2020, NSE’s new margin framework is live.

In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. Essentially, the model uses a “discrete-time” (lattice based) model of the varying price over time of the underlying financial instrument, addressing cases where the closed-form Black–Scholes formula is wanting.

The binomial model was first proposed by William Sharpe in the 1978 edition of Investments (ISBN 013504605X), and formalized by Cox, Ross and Rubinstein in 1979 and by Rendleman and Bartter in that same year.

For binomial trees as applied to fixed income and interest rate derivatives see Lattice model (finance) #Interest rate derivatives.

Method

The binomial pricing model traces the evolution of the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.

Option valuation using this method is, as described, a three-step process:

• Price tree generation,
• Calculation of option value at each final node,
• Sequential calculation of the option value at each preceding node.

The two assets, which the valuation depends upon, are the call option and the underlying stock. There is an agreement among participants that the underlying stock price can move from the current $100 to either $110 or $90 in one year and there are no other price moves possible.

In an arbitrage-free world, if you have to create a portfolio comprised of these two assets, call option and underlying stock, such that regardless of where the underlying price goes – $110 or $90 – the net return on the portfolio always remains the same. Suppose you buy “d” shares of underlying and short one call options to create this portfolio.

If the price goes to $110, your shares will be worth $110*d, and you’ll lose $10 on the short call payoff. The net value of your portfolio will be (110d – 10).

If the price goes down to $90, your shares will be worth $90*d, and the option will expire worthlessly. The net value of your portfolio will be (90d).

If you want your portfolio’s value to remain the same regardless of where the underlying stock price goes, then your portfolio value should remain the same in either case:

h(d)−m=l(d)

where:

h = Highest potential underlying price

d = Number of underlying shares

m = Money lost on short call payoff

l = Lowest potential underlying price

Use of the model

The Binomial options pricing model approach has been widely used since it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point. As a consequence, it is used to value American options that are exercisable at any time in a given interval as well as Bermudan options that are exercisable at specific instances of time. Being relatively simple, the model is readily implementable in computer software (including a spreadsheet).

Although computationally slower than the Black–Scholes formula, it is more accurate, particularly for longer-dated options on securities with dividend payments. For these reasons, various versions of the binomial model are widely used by practitioners in the options markets.

For options with several sources of uncertainty (e.g., real options) and for options with complicated features (e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo option models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation will be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst-case runtime of BOPM will be O(2n), where n is the number of time steps in the simulation. Monte Carlo simulations will generally have a polynomial time complexity, and will be faster for large numbers of simulation steps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques use discrete time units. This becomes more true the smaller the discrete units become.