Dear All,
Two of the best features of options is that they afford an investor or trader the opportunity to achieve certain objectives and/or play the market in certain ways that they might not otherwise be able to. For example, if an investor is bearish on a particular stock or index, one of his or her choices is to sell short shares of the stock. While this is a perfectly viable investment alternative, it does have some negatives attached. First off, there are fairly sizable capital requirements. Secondly, there is technically unlimited risk, because there is no limit as to how far the stock could rise in price after the investor sold short the shares. Fortunately, options offer alternatives to this scenario.
The Put OptionOne alternative to shorting a stock is to purchase a put option, which gives the buyer the option, but not the obligation, to sell short 100 shares of the underlying stock at a specific price - known as the strike price - up until a specific date in the future (known as the expiration date ). To purchase a put option, the investor pays a premium to the option seller. This is the entire amount of risk associated with this trade. The bottom line is that the buyer of a put option has limited risk and essentially unlimited profit potential (profit potential is limited only by the fact that a stock can only go to zero). Nevertheless, despite these advantages, buying a put option is not always the best alternative for a bearish trader or investor who desires limited risk and minimal capital requirements.
Mechanics of the Bear Put SpreadOne of the most common alternatives to buying a put option is a strategy known as a bear put spread . This strategy involves buying one put option with a higher strike price and simultaneously selling the same number of put options at a lower strike price. As an example, consider the possibility of buying a put option with a strike price of Rs 50 on a stock trading at Rs. 51 a share.
Let's assume that there are 60 days left until option expiration and that the price of the 50 strike price put option is Rs. 2.50. In order to purchase this option, a trader would pay a premium of Rs 250. Then, for the next 60 days he would have the right to sell short 100 shares of the underlying stock at a price of Rs 50 a share. So, if the price of the stock fell to 45, or 40, or 30, or even lower, the buyer of the put option could exercise his put option and sell short 100 shares at Rs 50 a share. He could then buy back the shares at the current price and pocket the difference between Rs 50 a share and the price he paid to buy back the shares.
The other, more common, alternative would be to sell the put option itself and pocket the profit. For example, if the stock fell to Rs 40 a share, the buyer who bought the 50 put option at Rs 2.50 would be able to sell the put option for Rs 10 or more, resulting in a substantial profit.
Advantages of the Bear Put Spread AlternativeThe problem with buying or selling a put option is that the breakeven price for the trade in the example above is Rs 47.50 per share, which is calculated by subtracting the put premium paid (Rs 2.50) from the strike price (Rs 50). To look at it another way, the stock must decline. Also, a trader may not be looking for a substantial decline in the price of the stock, but rather something more modest.
In this case, an individual might consider the bear put spread as an alternative. Building on the same example, an individual may buy the same 50 strike price put option for Rs 2.50 but will also simultaneously sell the 45 strike price put option and receive Rs 1.10 of premium. As a result, the trader only pays a net cost of $140 to purchase the spread (Rs 2.50 - Rs 1.40 x 100 shares). There are two positives and one negative associated with this alternative compared to simply buying the 50 strike price put for Rs 250
Advantage No.1: The trader has reduced the cost of the trade by 44% (from Rs 250 to Rs 140).
Advantage No.2: The breakeven price rises from Rs 47.50 for the long put trade to Rs 48.60 for the bear put spread (the breakeven price for the put spread is arrived at by subtracting the price of the spread (Rs 1.40) from the higher strike price (Rs 50 - Rs 1.40 = 48.60).
As a result of entering the bear put spread, this trader has less dollar risk and a higher probability of profit. If the trader does not expect the price of the stock to decline much below 45 by option expiration, this may be an outstanding alternative.
Disadvantage of the Bear Put SpreadThere is one important negative associated with this trade compared to the long put trade: The bear put trade has limited profit potential. The potential is limited to the difference between the two strikes minus the price paid to purchase the spread.
In this case, the maximum profit potential is Rs 360 (5-point spread - 1.40 points paid = Rs 3.60). This trade will show a profit at option expiration if the stock is at any price below the breakeven price of Rs 48.60 a share. The maximum profit of Rs 360 will be reached if the stock is at or below the lower strike price of Rs 45 a share at expiration. While profit potential is not unlimited, the trader still has the potential to make a profit of 257% (Rs 360 profit on a Rs 140 investment) if the stock declines roughly 12% (from Rs 51 to Rs 45).
SummaryThe bear put spread offers an outstanding alternative to selling short stock or buying put options in those instances when a trader or investor wants to speculate on lower prices, but does not want to commit a great deal of capital to a trade and/or does not necessarily expect a massive decline in price. In either of these cases, a trader may give him or herself an advantage by trading a bear put spread, rather than simply buying a naked put option.
Zandu suggest try to use derivative strategies to trade highly volatile market, for any suggestion on trading strategies , derivative strategies and portfolio management kindly mail to me at equitytrader10@yahoo.in, equitytrader@in.com, niftytrader@in.com,equitychartguru@yahoo.co.in
For technical trading calls please visit ttp://www.equitychartguru.blogspot.com
For portfolio management advice please visit http://www.fundootechnicals.blogspot.com
Thanks & happy trading
your's zandu
Friday, February 20, 2009
Monday, February 16, 2009
Investing During Uncertainty
Dear All,
After a long we are back due to some personal reason i was not active on the blog. In today's post we are discussing how to invest during Uncertainty.
Every day it seems like the world is getting smaller. If you watch any financial television station or read the newspaper, you are most likely aware of how events in one country seem to have an ever-increasing affect on other countries around the world. We are more interconnected now than at any other time in history. It goes without mention that globalization definitely has its positives, but when threats of financial crisis, war, global recession, trade imbalances, etc, do occur it often leads to talk of moving money to safer investments and increasing government deficits. This rising uncertainty can confuse even the well-informed investor.
Uncertainty: Any time you put money at risk for the chance of profit there is an inherent level of uncertainty. When new threats such as war or recession arise, the level of uncertainty increases significantly as companies can no longer accurately predict their future earnings. As a result, institutional investors will reduce their holdings in stocks considered unsafe and move the funds to other sources like precious metals, government bonds and money-market instruments. This sell-off, which occurs as large portfolios reposition themselves, can cause the stock market to depreciate.
Effects of Uncertainty: Uncertainty is the inability to forecast future events; people can't predict the extent of a possible recession, when it's going to start/end, how much it will cost, or what companies will be able to make it through unscathed. Most companies normally predict sales and production trends for the investing public to follow assuming normal market conditions, but increasing levels of uncertainty can make these numbers significantly inaccurate.
Uncertainty itself can affect the economy on both the micro and macro level; a description of uncertainty on a micro level focuses on the effect on individual companies within an economy faced with the threat of war or recession, whereas the view of uncertainty on a macro level looks at the economy as a whole
From a company-specific point of view, uncertainty provides a major concern for those that produce consumer goods every day. For example, consumption may fall on the threat of a recession as individuals refrain from purchasing new cars, computers and other non-essentials. This uncertainty may force the companies in certain sectors to layoff some of its employees so that it can combat the impacts of lower sales. The level of uncertainty that surrounds a company's sales also extends into the stock market. Consequently, stock prices of companies that produce non-essential goods sometimes experience a selloff when levels of uncertainty rise
On a macro level, uncertainty is magnified if the countries at war are major suppliers or consumers of goods. A good example is a country that supplies a large portion of the world's oil. Should this country go to war, uncertainty regarding the level of the world's oil reserves would grow. Because the demand for oil would be high and the supply uncertain, a country unable to produce enough oil within its own borders would be required to ensure that enough oil was stored to cover operations. As a result, the price of oil would increase.
Another macro-level event that affects companies and investors is the flight of capital and devaluation of exchange rates. When a country faces the threat of war or recession, its economy is considered uncertain. Investors attempt to move their currency away from unstable sources to stable ones; the currency of a country under a threat of war is sold and the currencies from countries without the threat are bought. The average investor probably would not do this; however, the large institutional investors and currency futures traders would. These actions translate into a devaluation of exchange rates.
What's an Investor to Do?When situations of heightened uncertainty arise, the best defense is to be as well informed as possible. Keep updated by reading the newspaper and researching individual companies. Analyze which sectors have more to gain and lose with a war and decide on a long-term plan. Times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it. Some investors might decide to be offensive and search for companies that provide goods or services that will lead to great returns when things turn around. It is difficult to commit capital during uncertain times, but it can often reap huge rewards in the longer run. Those who want to mitigate uncertainty and risk might be content leaving their money where it is or perhaps moving it to safer securities. Regardless of which strategy you decide to take (if any), you can't go wrong over the long term by keeping yourself well informed and getting into a position so that you can take advantage of prices when the things reverse.
For Accurate Nifty analysis please visit www.zandusmartchartcalls.blogspot.com
For portfolio management advice please visit http://www.fundootechnicals.blogspot.com/
For getting portfolio management advice and trading and investments calls please mail to me at equitychartguru@yahoo.co.in or fundootechnicals@yahoo.co.in
Thanks & happy trading
your's zandu
After a long we are back due to some personal reason i was not active on the blog. In today's post we are discussing how to invest during Uncertainty.
Every day it seems like the world is getting smaller. If you watch any financial television station or read the newspaper, you are most likely aware of how events in one country seem to have an ever-increasing affect on other countries around the world. We are more interconnected now than at any other time in history. It goes without mention that globalization definitely has its positives, but when threats of financial crisis, war, global recession, trade imbalances, etc, do occur it often leads to talk of moving money to safer investments and increasing government deficits. This rising uncertainty can confuse even the well-informed investor.
Uncertainty: Any time you put money at risk for the chance of profit there is an inherent level of uncertainty. When new threats such as war or recession arise, the level of uncertainty increases significantly as companies can no longer accurately predict their future earnings. As a result, institutional investors will reduce their holdings in stocks considered unsafe and move the funds to other sources like precious metals, government bonds and money-market instruments. This sell-off, which occurs as large portfolios reposition themselves, can cause the stock market to depreciate.
Effects of Uncertainty: Uncertainty is the inability to forecast future events; people can't predict the extent of a possible recession, when it's going to start/end, how much it will cost, or what companies will be able to make it through unscathed. Most companies normally predict sales and production trends for the investing public to follow assuming normal market conditions, but increasing levels of uncertainty can make these numbers significantly inaccurate.
Uncertainty itself can affect the economy on both the micro and macro level; a description of uncertainty on a micro level focuses on the effect on individual companies within an economy faced with the threat of war or recession, whereas the view of uncertainty on a macro level looks at the economy as a whole
From a company-specific point of view, uncertainty provides a major concern for those that produce consumer goods every day. For example, consumption may fall on the threat of a recession as individuals refrain from purchasing new cars, computers and other non-essentials. This uncertainty may force the companies in certain sectors to layoff some of its employees so that it can combat the impacts of lower sales. The level of uncertainty that surrounds a company's sales also extends into the stock market. Consequently, stock prices of companies that produce non-essential goods sometimes experience a selloff when levels of uncertainty rise
On a macro level, uncertainty is magnified if the countries at war are major suppliers or consumers of goods. A good example is a country that supplies a large portion of the world's oil. Should this country go to war, uncertainty regarding the level of the world's oil reserves would grow. Because the demand for oil would be high and the supply uncertain, a country unable to produce enough oil within its own borders would be required to ensure that enough oil was stored to cover operations. As a result, the price of oil would increase.
Another macro-level event that affects companies and investors is the flight of capital and devaluation of exchange rates. When a country faces the threat of war or recession, its economy is considered uncertain. Investors attempt to move their currency away from unstable sources to stable ones; the currency of a country under a threat of war is sold and the currencies from countries without the threat are bought. The average investor probably would not do this; however, the large institutional investors and currency futures traders would. These actions translate into a devaluation of exchange rates.
What's an Investor to Do?When situations of heightened uncertainty arise, the best defense is to be as well informed as possible. Keep updated by reading the newspaper and researching individual companies. Analyze which sectors have more to gain and lose with a war and decide on a long-term plan. Times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it. Some investors might decide to be offensive and search for companies that provide goods or services that will lead to great returns when things turn around. It is difficult to commit capital during uncertain times, but it can often reap huge rewards in the longer run. Those who want to mitigate uncertainty and risk might be content leaving their money where it is or perhaps moving it to safer securities. Regardless of which strategy you decide to take (if any), you can't go wrong over the long term by keeping yourself well informed and getting into a position so that you can take advantage of prices when the things reverse.
For Accurate Nifty analysis please visit www.zandusmartchartcalls.blogspot.com
For portfolio management advice please visit http://www.fundootechnicals.blogspot.com/
For getting portfolio management advice and trading and investments calls please mail to me at equitychartguru@yahoo.co.in or fundootechnicals@yahoo.co.in
Thanks & happy trading
your's zandu
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