Learn to buy the stock by reading the options trading table

Sep.01, 2008 in Investment Opinions

VERY DIFFICULT FOR ME TO EXPLAIN IN SIMPLE MANNER, YOU SHOULD GO ALL THROUGH THIS, AND BELIEVE ME THIS IS INTERESTING.

Understanding Derivatives (Futures and Options)

A futures or options contract which is based on a set of underlying securities is called a Stock Index Futures or Options Contract. When trading takes place in stock index futures, it means that market participants are taking a view on the way the index will move. By trading in Index-based Futures and Options you buy or sell the entire stock market as a single entity.

S&P CNX NIFTY

S&P CNX NIFTY is a scientifically developed index. Top 50 blue chip companies have been selected to form part of the index. The index covers more than 25 industry sectors and is professionally managed by India Index & Services Ltd (IISL). IISL has a licensing and co-branding arrangement with Standard & Poor’s (S&P), the World’s leading provider of investable equity indices, for co-branding IISL’s equity indices. Daily derivatives trading based on S&P 500 index is over US $ 50 billion.

Uses of S&P CNX NIFTY

S&P CNX NIFTY can be used for the purpose of speculation, hedging as well as an arbitrage tool.

Think market will go up?

Do you sometimes think that the market index is going to rise? That you could make a profit by adopting a position on the index? After a good budget, or good corporate results, or the onset of a stable government, many people feel that the index would go up. How does one implement a trading strategy to benefit from an upward movement in the index? Today, you have two choices:

Buy selected liquid securities, which move with the index, and sell them at a later date,

Buy the entire index portfolio and them sell it at a later date.

The first alternative is widely used a lot of the trading volume on stocks like HINDLEVER is based on using HINDLEVER as an index proxy. However, these positions run the risk of making losses owing to HINDLEVER-specific news; they are not purely focussed upon the index.

The second alternative is hard to implement. An investor needs to buy all the stocks in S&P CNX Nifty in their correct proportions. Most retail investors do not have such large portfolios. This strategy is also cumbersome and expensive in terms of transactions costs.

Taking a position on the index is effortless using the index futures market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a person buys S&P CNX NIFTY using the futures market, he gains if the index rises and loses if the index falls.

Example

5/1/2000 - You feel the market will rise
Buy 100 S&P CNX NIFTY January futures contract at 1450 costing Rs.145000 (100*1450)
expiration date - 28/1/2000
14/1/2000 Nifty January futures have risen to 1470
You sell off your position at 1470
Make a profit of Rs. 2000 (100* 20)
Think the market will go down?
Do you sometimes think that the market index is going to fall? That you could make a profit by adopting a position on the index? After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index? Today, you have two choices:

Sell selected liquid securities which move with the index, and buy them at a later date,

Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used a lot of the trading volume on stocks like ITC is based on using ITC as an index proxy (ITC has the highest correlation with S&P CNX Nifty amongst all the stocks in India). However, these position run the risk of making losses owing to ITC-specific news; they are not purely focussed upon the index.

The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transaction costs.

Taking a position on the index is effortless using the index futures market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a person sells S&P CNX NIFTY using the futures market, he gains if the index falls and loses if the index rises.

Example

8/2/2000 - You feel the market will fall
Sell 100 S&P CNX NIFTY February expiry contract
Expiration date 25/2/2000
Nifty February contract is trading at 1560
Your position is worth Rs. 156000
15/1/2000 - Nifty February futures have fallen to 1520
You squares off your position at 1520
Make a profit of Rs.4000 (100*40)
Have you bought a share hoping it will go up?
Have you ever felt that a stock was intrinsically undervalued?

That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a “stockpicker” and carefully purchased a stock based on a sense that it was worth more than the market price?

When doing this, you face two kinds of risks:

Your understanding can be wrong, and the company is really not worth more than the market price,

The entire market moves against you and generates losses even though the underlying idea was correct.

The second outcome happens all the time. A person may buy Infosys thinking that Infosys will announce good results and the stock price would rise. A few days later, S&P CNX Nifty drops, so he makes losses, even if his intrinsic understanding of Infosys was correct. There is a peculiar problem here. Every buy position on a stock is simultaneously a buy position on S&P CNX Nifty. This is because a buy Infosys position generally gains if S&P CNX Nifty rises and generally loses if S&P CNX Nifty drops. It is useful to ask: does the person feel bullish about Infosys or about the Index?

Those who are bullish about the index should just buy S&P CNX Nifty futures; they need not trade individual stocks
Those who are bullish about the Infosys do wrong by carrying along a long position on S&P CNX Nifty as well.
There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of S&P CNX Nifty futures. When this is done, the stockpicker has “hedged away” his index exposure. How do you do this?

We need to know the “beta” of the stock, i.e. the average impact of a 1% move in S&P CNX Nifty, upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, where the beta is 1.2, and suppose we have a LONG LUPINLAB position of Rs. 200,000.
The size of the position that we need on the index futures market, to completely remove the hidden S&P CNX Nifty exposure, is 1.2 * 200,000, i.e. Rs. 240,000.
Suppose S&P CNX Nifty is at 1200, and the market lot on the futures market is 100. Hence each market lot of S&P CNX Nifty is Rs. 120.000. To sell Rs.240,000 of S&P CNX Nifty we need to sell two market lots.
We sell two market lots of S&P CNX Nifty (200 Nifties) to get the position:
Long LUPINLAB Rs. 200,000
Short S&P CNX NIFTY Rs. 240,000
Example

01/10/1999 - You buy INFOSYS of Rs. 10 lakhs
The expiry date of Nifty June futures is 29/10/1999
Nifty spot is at 1403.20 and Nifty futures is at 1420
The beta of INFOSYS is 1.2
You need to sell 1.2*10 lakhs = 12 lakhs on the index futures i.e., 12 market lots
29/10/1999 - Nifty fell 5.5%
29/10/1999 Nifty spot at 1325.45 and settlement price of Nifty October futures is also 1325.45
You close both positions earning Rs. 9640. i.e., your position on INFOSYS drops by Rs. 66,000 and your short position on Nifty gains Rs. 75,640
Have you sold a share hoping it will go down?

Have you ever felt that a stock was intrinsically overvalued? That the profits and the quality of the company made it worth a lot less as compared with what the market thinks? Have you ever been a “stockpicker” and carefully sold a stock based on a sense that it was worthy less than the market price?

His understanding can be wrong, and the company is really worth more than the market price,

Or
The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may sell Reliance, expecting that Reliance would announce poor results and the stock price would fall. A few days later, S&P CNX Nifty rises, so you make losses, even if your intrinsic understanding of Reliance was correct.

There is a peculiar problem here. Every sell position on a stock is simultaneously a sell position on S&P CNX Nifty. This is because a SHORT RELIANCE position generally gains if S&P CNX Nifty falls and generally loses if S&P CNX Nifty rises. It is useful to ask: does the person fell bearish about Infosys or about the index?

Those who are bearish about the index should just sell S&P CNX Nifty futures; they need not trade individual stocks.
Those who are bearish about Reliance do wrong by carrying along a sell position on S&P CNX Nifty as well.
There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of S&P CNX Nifty futures. When this is done, the stockpicker has “hedged away” his index exposure. The basic point of this hedging strategy is that the stockpicker proceeds with his core skill, i.e. picking stocks, at the cost of lower risk

How do you do this?

We need to know the “beta” of the stock, i.e. the average impact of a 1% move in S&P CNX Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, where the beta is 1.2, and suppose we have a SHORT LUPINLAB position of Rs. 200,000.
The size of the position that we need on the index futures market, to completely remove the hidden S&P CNX Nifty exposure, is 1.2* 200,000, i.e. Rs. 240,000.
Suppose S&P CNX Nifty is at 12

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