Conserving capital in options trading

There has been discernible investor interest in options trading in recent times. One reason for the rising interest is the volatility in the stock market; higher volatility makes options more valuable. The problem, however, is that most options expire worthless, leading to loss in capital. How then should investor gainfully use options trading in a portfolio framework?

This article explains the risks associated with options trading. It then discusses why investors should define risk budgets to contain such risks. It then shows how such budgets along with risk management rules help conserve investment capital.

Options carry asymmetric payoffs. The maximum loss for a call option buyer is the premium paid; the maximum profit is unlimited. For put buyers, the maximum loss is the premium paid; the maximum profit is high.

The problem, however, is that options are wasting assets. That is, they have finite life and rapidly lose value if the underlying does not move in the required direction.

Suppose an investor buys the Nifty 4,900 call option on February 12 when the underlying index is at 4,830. The option at 25 per cent volatility will be worth Rs 64. If the underlying does not move for a week, the option will decline to Rs 39. And if the underlying instead declines to 4,750 after a week, the option would be worth only Rs 18. The option rapidly loses value because of time decay; with each passing day, the option has less time to generate gains before expiry.

The option also loses value due to volatility; decline in volatility leads to fall in option value. If the Nifty index stays at 4,830 for a week but volatility declines to 15 per cent, the Nifty 4,900 call will fall to Rs 3.

Time decay and volatility factors explain why most options expire worthless every month.

The strategy then should be to conserve capital. Otherwise, investors would exhaust investment capital every month with each expiring option.

Risk budget

It is, hence, important to define a risk budget. That is, the investor should define the investment capital allocated for options trading. And then frame risk management rules to prevent losses due to time decay and volatility factors.

Risk budget, for instance, can be allocating 5 per cent of the total portfolio to the options market. Suppose the total investment portfolio is Rs 25 lakh. The allocation to options trading would then be Rs 1.25 lakh.

Just allocating risk capital does not help. An investor buying option contracts will lose sizable capital in several months if options she buys expire worthless. That is why the two per cent risk management rule is important. This rule requires that the investor should not expose more than 2 per cent of the options risk capital to each trade.

Suppose an investor buys one contract of the 4,900 call option for Rs 64 for a total outlay of Rs 3,200 (Rs 64 times 50). Two per cent of the options risk budget of Rs 1.25 lakh is Rs 2,500. The investor, therefore, cannot risk more than Rs 2,500 in this trade. Given the contract size of 50, this translates into a maximum loss of Rs 50 per option. So, the investor has to close the position if the 4,900 call declines to Rs 14 (Rs 64 less Rs 50). The next trade will carry lower risk because the risk capital will be Rs 1.25 lakh less the loss of the previous trade. This rule forces the investor to engage in only one trade at a time.

Conclusion

Options, because of asymmetric payoff, fit well within the satellite portfolio in a core-satellite framework. Time decay and volatility factors, however, lead to frequent small losses and infrequent large gains. Risk budget, therefore, helps investors stretch their investment capital despite the likelihood of options expiring worthless.

Bulk Deal vs Block Deal

In 2008, when the stock markets were bearish, many foreign institutional investors (FIIs) and other big investors chose to keep away from the 'block deals' in stocks plunging the trading volumes through such deals by 30 per cent.
However, things changed for good and when the Sensex raised by over 47 per cent since March 2009 the long term institutional investors and minority shareholders have started showing interest to raise funds through block deals. Between January 2009 and February 2009, there were six block deals worth Rs 232 crore. Recently, several big companies like Dish TV, UltraTech Cement [ Get Quote ], Ambuja Cements and Tata Steel [ Get Quote ] like have carried out block deals to name a few.
But what are these block deals? How does it happen? And why is it being talked about now? How is it different from bulk deal? Let us see.
What is block deal?
According to Securities and Exchange Board of India a block deal is a single transaction of a minimum quantity of five lakh shares or a minimum value of Rs 5 crore and is done between two parties through a separate window of the stock exchange that is open for only 35 minutes in the beginning of the trading hours.
SEBI has also made it mandatory for the stock brokers to disclose on a daily basis the block deals made through DUS or Data Upload Software.
Difference between block deal and bulk deal
Unlike a block deal that happens through a separate window that is open for only 35 minutes in the beginning of the trading hours at the stock exchange, bulk deals happen all through the trading day. Another major difference is that a bulk deal is said to have happened if under a single client code and in a single or multiple transactions more than 0.5 per cent of a company's number of equity shares is traded.
Also, bulk deals are market driven while two parties are required for a block deal to take place. Bulk deals carried out for the day should be revealed by a broker on the same day to the stock exchange using the DUS.
Who can go for these deals?
Generally, only the institutional players including the foreign institutional investors are the major participants in this type of deals. This also includes mutual funds, the various financial institutions, and companies carrying out insurance business, banks, and venture capitalists. Sometimes, many promoters use this window to arrange the issues that are related to cross holdings.

Statutory requirements that must be followed for block deals
SEBI has rules in place certain rules for carrying out block deals. It is mandatory that block deals should happen only through a separate window and for a period of 35 minutes only in the beginning of the trading hours. Also SEBI rules state that block deal orders should be placed for a price not exceeding +1 per cent to -1 per cent of the previous day's closing or the current market price. Delivery must be made for every trade executed and cannot be squared off or reversed. All details like the name of the scrip, the client's name, number of shares and traded price should be disclosed to the public through the DUS every day after market hours.

Interpretation of such deals
Investors often rely upon the block and bulk deals and their movements for trading cues. However, this might not be completely true. A block or bulk deal in a particular scrip doesn't necessarily mean that the stock price of the specific stock will increase as there are buyers and sellers involved in every deal. Understanding the profiles of the institutions involved in the deal and their strategies is required. However in case of bulk deals happening on a continuous basis in a counter or share with high volumes and high pending shares it could be a sign of appreciation in price in the future. Yet this could also happen in an operator driven counters.
So the block or bulk deals can be considered only as a first level of investigation and an investor before investing in a share should look for more details like specific information about the company like its fundamentals, its performance and ranking in its industry, and its future plans and prospects.