Case 055Option strategies and trade ideasWarm up
A client with Rs 10 lakh is bullish on a Rs 2,000 stock, lot 250. Two lots of futures, or ten lots of the one-month 2,100 call at Rs 40? Show the outcomes at 1,900, 2,050 and 2,300.
1The situation
A client of Prabhavali Broking has Rs 10 lakh to put behind a view that Vasota Chemicals, trading at Rs 2,000 with a lot size of 250 shares, will rise over the next month. Her dealer lays out two ways to express it. Buy two lots of the one-month futures, 500 shares of exposure, Rs 10 lakh of notional. Or buy ten lots of the one-month call struck at Rs 2,100 at Rs 40 a share, 2,500 shares of exposure, for a premium of Rs 100,000.
She asks what each choice makes or loses if the stock expires at Rs 1,900, Rs 2,050 or Rs 2,300, and what each one risks that the other does not.
2Your task
Tabulate the two outcomes at each price, then say what the client should understand about the call's chance of total loss and the future's margin risk.
Quick check
Before working it: at Rs 2,050, the stock is up 2.5%. The call position:
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
At 1,900 the futures lose Rs 50,000 and the calls lose Rs 1 lakh; at 2,050 the futures make Rs 25,000 and the calls still lose Rs 1 lakh; at 2,300 the futures make Rs 1.5 lakh and the calls Rs 4 lakh. The calls need the stock above Rs 2,140 to break even, a 7% rise in a month, and lose everything below Rs 2,100. The futures lose rupee for rupee on 500 shares and carry daily margin calls, so a 10% fall costs Rs 1 lakh.
Step 1What does each instrument actually buy?
A season ticket and a lottery ticket are both bets on the team. The season ticket costs the full price and pays off in proportion to how good the season is; the lottery ticket is cheap, pays enormously if the exact number comes up and is otherwise worthless. Two lots of futures are the season ticket: 500 shares of exposure that gain and lose Rs 500 for every rupee the stock moves. Ten lots of a 5% out-of-the-money call are the lottery ticket: 2,500 shares of exposure that pay only above Rs 2,100 and cost Rs 100,000 whether or not they ever pay.
| Stock at expiry | Move | Futures, 500 shares | Calls, 2,500 x 2,100 strike |
|---|---|---|---|
| Rs 1,900 | -5% | Rs -50,000 | Rs -1,00,000 |
| Rs 2,050 | +2.5% | Rs 25,000 | Rs -1,00,000 |
| Rs 2,300 | +15% | Rs 1,50,000 | Rs 4,00,000 |
Step 2Why do the calls lose in two of the three cases when the view was right in two?
Because a call's price has two parts, and the client is paying for the part that evaporates. At Rs 2,000 the 2,100 call has no intrinsic value; the whole Rs 40 is time value, the market's price for the chance of a 5% rise within a month. If the stock rises 2.5%, the view is right and the call is still worthless at expiry, because right is not enough: the stock has to be above the strike plus the premium, Rs 2,140, which is a 7% rise. The futures do not have this problem; any rise at all is a gain.
Step 3What does each choice risk that the other does not?
The calls risk total loss of the premium, and that loss is not rare: it happens in every outcome below Rs 2,100, which a one-month 5% out-of-the-money option will see more often than not. The cap on the loss is Rs 1 lakh, a tenth of her capital, which is the honest attraction. The futures risk more money and risk it every day: a 10% fall to Rs 1,800 loses Rs 1 lakh, a fifth of her capital, and the broker will call for variation margin each evening as the loss builds, so she can be forced out before the month ends. The Rs 10 lakh is also not idle: the exchange's initial margin, a figure the dealer must confirm, locks part of it, and if she had used the full amount as margin she would be running far more than 500 shares.
A dealer's honest closing line is that the two choices express the same view with different shapes, not different quality. The futures win on moderate rises and lose gradually; the calls lose completely on anything short of a 7% rise and win big beyond it. Which suits her depends on how large a move she expects and how much she can afford to lose outright, and the dealer's job is to show the table, not to pick for her.
Where candidates lose it
Candidates say the calls are safer because the loss is capped at Rs 1 lakh, and stop. The interviewer wants to hear that the capped loss is also the most likely outcome: an out-of-the-money one-month call expires worthless more often than it pays.
The second miss is forgetting the breakeven. Rs 2,100 is the strike; the position needs Rs 2,140 to get the premium back, and the table at Rs 2,050 shows what happens in between.
What the interviewer asks next
- She buys two lots of the 2,000 call at Rs 90 instead. Redo the three outcomes.
- How does the futures position's margin requirement change her effective leverage, and what should the dealer check before she trades?
- The stock's implied volatility is 35%. Roughly how often would you expect a 7% rise within a month?
Company names and figures are illustrative.