Options Market

In an interview on CNBC-TV18's The Derivative Show, Hemant Thukral, National-Head Derivatives Desk at Aditya Birla Money explains the dos and don’ts of investing in the options market.

According to Thukral, options pricing gets decided on two parameters: 1) intrinsic value and 2) time value.

He also talked about how beta works for stocks. Higher beta means higher volatility. On capitalisation basis, he says midcaps are much higher beta than largecap stocks.

Below is the verbatim transcript of Thukral's interview to CNBC-TV18

Q: Tell us Option premium is determined by intrinsic value and time value. Explain time value?

A: You have just suggested that there are two main things, which are incorporated in Option value, so one thing is intrinsic value, the other is the time value. Intrinsic value as we all know is much simpler to understand because it is a difference between the strike price and the underlying price. So, if the difference is higher than zero then that much is the intrinsic value in that Option pricing.

If one goes ahead and explain time value, which I feel it is a more of a complex thing to understand it comprises of things which you have just explained underlying price movement. These two are actually the main, but you have interest rates, dividend, corporate announcements, so there are number of things. That is why it becomes slightly complex.

However, the main thing to understand is a term called as time decay. That means this time value is one thing which is constant that it will depreciate with each passing day, as it approaches expiry. So, if we are saying the time value will be highest at the first day of the contract and as we go on passing by the time value depreciates. It will be the maximum depreciation you will see post two weeks of an expiry. I am assuming all the expiries are four weeks, so post two weeks or a mid of an expiry you will start to see the depreciation faster in that time value.

So, clearly, it is a friend of Option Writer, a person who is selling Options, whereas it goes against you if you are a buyer, an Option. So, buying an Option has to be very much credited or has to be paid more attention then a selling of an Option if you are considering that time value into it. So, time decay is one of the main factors.

Q: Explain to us how does time value work for different stocks and how does it work for even the same stock, but at different strike prices?

A: Let us take the first question. Let us take an example of Reliance; it is a highly owned stock. Now supposing I feel that Reliance will be bullish in coming one month in July series and if I look at two options. One is an intrinsic value that is today Reliance is at 800, so I buy a 780 Call. The second example I buy an 820 Call, which is slightly out of the money. Now 780 Call for example is quoting today at Rs 35, whereas 820 Call is quoting at Rs 20. Now, if you see 780 Call, 780 minus 800 (780-800), that means Rs 20 is intrinsic value in it, the time value is 15, whereas 820 has zero intrinsic value, Rs 20 is the time value in it.

So, clearly on time value basis the in the money Option 780 Call is more cheaper than out of the money Call. The basic difference that comes in both of them is purely on the basis of expectation, the time and the volatility. If you expect Reliance to move faster on the upside that is why you are ready to pay that premium for an 820 Call also. That means the buyer is expecting a faster movement in Reliance. If a buyer would not have expected a faster movement this time value in 780 Call would have been Rs 12 and 820 would have been 15.

So, totally depending upon that how much I am ready to bet as a buyer? How much expectations I have? How much the bullish sentiment is on the underlying will lead to that time value and the second factor is then inter-stock, that is then the volatility question comes in. Reliance will always be having a higher time value than Ashok Leyland or for that matter any low beta stocks. If you want to compare you can compare with an ITC, which is a defensive stock. So, ITC a movement expected from 330 to 340 will take more time than a Reliance movement from 800 to maybe 825. So that is why Reliance has a higher time value or a higher quotation premium in 820 Call than an ITC 340 even when the ITC is quoting at 330.

So, because the expectation of volatility movement on the underlying is lower in ITC. The defensive stocks or low volatile stocks have a lower time value than high aggressive stocks or high beta stocks have a higher time value attached to it.

Q: You have mentioned beta, so just to dejargonise that for our viewers. Can you briefly explain how does beta work for stocks? What category of stocks as in largecaps, midcaps, smallcaps correspond to different betas?

A: When we term beta, as a terminology if you use it is basically change of underlying with respect to the Underlying Index. So, if you are talking about largecaps I will take an example that Nifty comprises of 50 stocks, so how much beta of that one stock is?

Supposedly, we say this term is utilised that Reliance beta is 1.2 that clearly means that if Reliance moves by Rs 1.20, Nifty should move up by Rs 1, that is the general meaning of beta or we categorise stocks on basis of beta. We say that ITC is defensive, fast moving consumer goods (FMCG) is a generally defensive, that does not means that ITC cannot move five percent in a day.

However, the idea here is that an FMCG stock has a low beta or it moves on a general basis with smaller volatilities. So, Reliance can move five percent, that quantifies as a high beta stock. An ITC in an average day does not move more than two percent. So, it is a low beta stock. On the same category if you see midcap stocks are much more high beta than largecap ones. So, if you are counting an example like a midcap real estate stock, an Indiabulls or a Unitech they can move 10-12 percent in a day, whereas if you compare the same stock, real estate stock like a DLF it is low beta than its own midcap.

So, largecaps are considered to be low beta stocks if you compare them with midcap stocks. So, higher beta means higher volatility and on cap basis midcaps are much higher beta than largecap stocks.

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Q: We were talking about the pricing of options and volatility is a factor why we have derivatives in the first place. How does volatility impact the pricing of the options that we decide to purchase?

A: If we discuss time value and we discuss number of factors let me put this way- volatility is like a spinal cord in the pricing of options that means it is one of the major factors. To put it in very crisp form which we always use for our own investors - volatility is uncertainty. A higher volatile environment just means a high uncertain environment. What volatility leads to is expectation of higher stock movement. Whether it is a low beta or a high beta, in a high volatile environment both of them can move very sharply.

If I take an example of Reliance at Rs 800 and if I ask a gentleman his view on this, he may say Reliance may cross Rs 820 from this end, but after 10 minutes seeing the volatility, the way the markets behave he may say Reliance may even go below Rs 780. What will happen – dual result is both the options that is Rs 780 and Rs 820 remember on the Put side on the call side both are out of the money, so, zero intrinsic value will become very expensive because this guy is confused. He is uncertain about the environment. So, he is not ready to take a bet in one direction.

Both the expensive (not sure) of time value will become higher expensive. Volatility adds to the time value just because the expectations or the uncertainty of the environment, nobody as an individual investor can take a bet on the directions. You are trying to either hedge positions on the short side or on the long side and as a result you increase the time value of the options.

Q: There is implied volatility and historical volatility. What can you tell us about that? When we are looking at options how do we keep that in perspective?

A: For a layman investor what do these two terms mean? Historical volatility is an average of past volatilities. Whereas implied volatility is what is expected in next two to three sessions, so, coming back to my first question, what is your view, is it for 2-3 days or it is for a longer duration or a full contract, will answer your question that what investors should be looking for.

If he is looking for immediately or 2-3 days then one should only watch implied volatilities because implied volatility will have a far more impact on the option pricing for coming 3-4 days. If he is looking for a full contract then he should judge option pricing by historical volatility of that underlying basically.

Hence, you have to judge from yourself but implied volatility is more used in option trading because options naturally you are trading for a very short term duration or you are taking a call for 5-7 days. So, implied volatility can be used as a much better indicator to understand that how much time value is getting affected by it rather than going with historical volatility.

Q: How is volatility measured because we have a volatility index as well which we frequently see as VIX. Does that also give me an indication of the behavior that my options would have?

A: One has to understand that we are on a path of maturity as a market. I will take you one step behind, if you see US markets, it doesn't have a volatility index. They have a trading volatility index. That means you can trade on that volatility index. In India we are still on the verge of it. We have introduced what is called as India VIX. We can't trade, but we can see it on intraday basis which was not the case one year back. So, we are developing those tools but volatility as an index gives you a picture of the uncertainty behaviour in the market.

If VIX is moving up that means more of investors are getting uncertain. That means option pricing is getting expensive. In that case a call has to be taken by you, whether you want to buy at a higher premium or you want that volatility to ease first and then buy into that premium. A higher volatile environment will get more money out of you.

The result can be sharper because movements can be very sharp, but what we have to understand as an underlying here is that premiums will be paid out higher if that VIX is moving high. So, if you are looking for an option pricing behaviour, look at India VIX. If that is moving up then options across the board is moving up. Unfortunately we don’t have VIX for individual stocks listed I am saying, though we can study at end of the day. But then we have to be a very profound investor to understand every VIX stock in that case.

Q: So, is it fair to say that volatility is actually a friend of the trader, the speculator and not so much for the investor?

A: I would say that 110 percent it favours a trader or a person who wants to trade for very short term durations. It is not for a guy who is looking for investment or looking for a longer duration buy. I would say if you had a months view of a particular stock then volatility is not your friend because it is increasing the time value and thus increasing the time decade which we were discussing in the last question.

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Q: Tell us interest rate corporate announcements these also have an impact on the price of the Option that investors would like to purchase. What is the impact of each of them?

A: These are factors of time value apart from volatility, which can affect (not sure, in this and the following sentences he says effect) time value. In corporate actions leaving apart the dividends that have to be paid out, rest all something like a bonus or a rights issue don’t have too much affect on the pricing of Options. So, we will just throw lights on how the dividend payouts affect the options first.

In a corporate action when somebody announces a dividend what happens is that Future for that month is already discounted. He have to understand that, for example, that is a common question which everybody ask, why is next month Infosys in a discount? Is everybody building a short? That is not the entire study base. You have to check if a stock is paying a dividend say a Rs 50 dividend, the next month Future has to be adjusted for Rs 50, so it will automatically be Rs 50 discount there.

Now how much it happens in impact on Option is that the Puts become expensive and the Call becomes cheaper, because it is already factoring in the cash versus Future discount premium ratio in the Option pricing. So, if you are trying to buy a Put Option thinking that Infosys is in a discount, so a lot of short positions have been built up you maybe making a mistake because Puts are deliberately expensive trying to adjust that dividend. Now the moment that dividend is adjusted, cash will get adjusted to Futures, automatically the Puts get adjusted. So, one has to be beware of these things.

You can’t buy Puts thinking that Infosys is in a discount because Puts will start factoring in dividend right from the first day of the contract when it opens. So, Puts becomes very expensive. So, unless and until you have a very hardcore view that the stock is going to go down, please don’t buy Puts because Puts are very expensive, moment a dividend is declared in that stock.

Q: And once you are already holding a Put and there is a dividend declaration, how would you then, would you alter your strategy?

A: No, if I am holding a Put, I think I will get benefited and specially if a dividend is announced and automatically dividends will get factored in. If I am a buyer of a Call, I would be slightly worried because in spite of stock not moving in any direction my Call premiums will start to come down. So, for a call buyer if a dividend is announced it is better to look or alter the strategy on immediate basis, but if you are a Put buyer you can hold for a longer time in fact because that gives you a leeway that the pricing is getting adjusted towards the dividend quotient.

Q: Also, an explanation of how interest rates which do contribute to the time value would play out over the span of a series?

A: In Indian markets interest rates do not play such a big factor because our government securities are not traded by common investors, but if you go to the matured markets and I am assuming that India will be the next one in next one year, the impact is that if your interest rates are increasing the Call Options should get expensive. The idea is that if I am trying to buy a stock instead of buying a stock I will buy the Call Option and put the remaining money in the interest bearing bonds, so that I get an advantage of both the sides. My direction is going right because I have bought a Call.

I have to put in less money, so remaining money goes into the interest bearing bonds. So, if the interest rate regime is on an increasing basis then Calls will be expensive. Now if you check usually when the stock market is moving up and interest rates are coming down always the Call premiums are slightly lower, so interest rates have a direct bearing on Calls, the Call premiums will increase if the interest rate will increase. Otherwise, in a normal market the Call rates are lesser than the Put rates. So, Call rates are following the interest rates regime usually, but interest rate regime higher will means that Calls are expensive.

Q: Explain this to us, if you already hold a Call and there is an announcement of a dividend like you say that, that is a slightly riskier scenario what would your next step be?

A: I will put it this way that if you are a Call buyer and a dividend has been announced, there are two steps that you can take on immediate basis. One thing is if it is a completely out of the money Call, square it off because the time value will come down on immediate basis, so it is better to buy an in the money Call or atleast at the money Call. If you hold the view still the same of the underlying then it would be better.

If you are a high risk trader, I don’t mind if you sell the Call and buy the Future of the next month because remember next month Future will be at a discount now, trying to adjust the premium, so it will give you an edge basically, so the next month discount will be equivalent to the dividend that has been announced, so buying a next month Future makes more sense provided you are a high risk trader.

Q: To what extent would you understand your loss, in this case as well you would have paid an Option premium, so here again you would lose only as much money as you have paid, is that correct?

A: Correct, the final loss will always remain as much as the premium, but what I am trying to make you understand is this - take an example that if Reliance is at 800 and it announces a Rs 10 dividend today and you have bought a 820 Call for 14, so without Reliance moving from 800 your 14 will become 9. So you are virtually losing 50 percent or at least 40 percent of the capital that you have put in.

Hence, it is better to shift out of that Call because that Call time decay will happen on the immediate basis. So, this is my recommendation, but rest remains the choice of the investor. If he is a low risk investor, I would prefer that he buys now a 780 Call or an 800 Call, don’t stick with that 820 Call.