So there is another tool available in the market, called option, which can be considered an insurance against such unpredictable outcome.
Options are contracts that give the right but not the obligation to buy or sell an asset. Investors typically use derivatives for three reasons — to hedge a position, to increase leverage, or to speculate on an asset’s movement.
Hedging a position is usually done to protect against or to insure the risk of an asset. For example, the owner of a stock buys a Put option if she wants to protect the portfolio against a decline. The shareholder makes money if the stock rises, but also gains, or loses less money if the stock falls because the Put option pays off.
There are a lot of option strategies, but they’re all based on two fundamental options: Call and Put. From these basics, investors can create a range of strategies that can maximise the payout from a stock price movement.
The most common strategies used are :
The Covered Call
In order to create a Covered Call, the trader sells Call option for shares of the underlying stock which she owns. In this case, the investor expects the stock to remain relatively flat, allowing the Call to expire worthless. This would allow the trader to pocket the premium without having to sell the stock at the strike price.
Let’s understand it with an example. Suppose, you hold ITC in your portfolio and its current market price is Rs 180. The movement in ITC stock is not wide, so one can sell a Call at strike price Rs 195 and receive the premium. The maximum payoff on the Covered Call, in this case, is the premium received.
This would allow the option seller to keep the premium without having to sell the underlying stock or losing any money on it. However, if the stock price rises above the strike price, the investor could have realised those gains, but instead lose any of the upside in the stock.
The Married Put
This is strategy usually followed before any event. It is called the Married Put, which means one can buy a Put to safeguard the stock from falling. The investor suspects that stock may fall in the short term, but wants to continue owning it because it may rise significantly. In this case, the Married Put offers downside protection.
Let’s understand with an example. Suppose, you hold ITC shares and the current market price is Rs 180. You do not want to sell the stock and want to safeguard the downside in any event. In this case, you can buy a Put at strike price Rs 180, which will allow an investor to profit from the decline without having to sell the stock.
There are many more option strategies like Butterfly, Condor, Ladder, Strip and Strap. It totally depends on the risk profile as well as requirement of an individual. Investors looking to protect or assume risk in a portfolio can employ long, short, or neutral derivative strategies that allows one to hedge, speculate, or increase leverage.
(DK Aggarwal is the CMD of SMC Investment and Advisors)