Question :How do I use Put Options?

Answer :You would, in most circumstances, think of buying Put Options when you are bearish about a scrip. For example, if Satyam is currently quoting at Rs 262 and you are bearish about Satyam, you would buy a Put.

Question :What would happen when I buy a Put?

Answer :You would first decide a certain strike price, say Rs 260. It would carry a premium as quoted in the market, say Rs 11. When you buy this Put, it gives you a right to sell Satyam at the strike price of Rs 260. Thus, if Satyam were to go down to Rs 235 at expiry time, you can still sell Satyam at Rs 260 (your strike price).

Question :Do I need to have Satyam with me in the first place?

Answer :At the moment, transactions in Options are cash settled. Hence, you do not need to possess Satyam to buy Satyam Puts.

Question :What is the meaning of Cash settled?

Answer :Cash settled means the difference between the strike price (Rs 260) and the market price on expiry (Rs 235) will be paid to you. In this case, you would earn Rs 25 per unit. As you are aware, the lot size for Satyam is 1,200. Hence, you would earn Rs 30,000 on expiry. After deducting the premium of Rs 11 per unit (i.e. Rs 13,200), your net profit will be Rs 16,800.

The cash settlement process applies to calls as well.

Question :Is there any other kind of settlement?

Answer :Yes. There is delivery based settlement, which is expected to be introduced in India in the next 3 to 4 months. In that case, you, as a Put buyer, have to deliver Satyam on the day of expiry and you would be paid Rs 260 per share. Thus you would effectively make a profit of the same Rs 25 per share.

The physical settlement system would apply to calls as well. As a buyer of a call, you would pay the strike price and would get shares delivered to you at the strike price.

Question :What are Index Puts?

Answer :You would use Index Puts when you are bearish about the market as a whole. Thus you would buy Nifty Puts or Sensex Puts and if the market actually moves down, you can pocket the difference.

Question :How would these be settled?

Answer :Index Options (both Calls and Puts) will always be cash settled. Physical settlement of the index itself is impractical.

Question :How else can I use Put Options?

Answer :Apart from buying Puts on the basis of a bearish view, you can view puts as Insurance on shares. If you are already holding Satyam and you are nervous about Satyam in the short run, you should consider buying Puts on Satyam.

Question :I could sell the shares also?

Answer :Yes, you can sell the shares. But in many cases, your view could be wrong and you may find Satyam has actually up instead of down. In that case, having sold off Satyam, most people never buy it back at a higher price.

Secondly, there could be capital gains on such transactions.

Question :What happens if buy these Puts?

Answer :If Satyam goes down (as per your belief), you will find that your Put will generate a profit. This profit will compensate for your losses on Satyam. Let us take an example. The current price of Satyam is Rs 262 and you bought a 260 Put paying a premium of Rs 11. Satyam actually goes down to Rs 235.

You will make a loss of Rs 27 on Satyam shares and a profit of Rs 25 on Puts. Thus the net loss will be Rs 2. Adding the premium also, the total loss is Rs 13.

If Satyam actually goes up to say Rs 300, you will forget about the Put and write off the loss of Rs 11 on premium. In fact, you might even sell the Put at some low price of Rs 2 or so reducing your losses partly.

This strategy is called is ‘put hedge’.

Question :Which Puts should I buy?

Answer :At any point, several Puts will be quoted. You might find Satyam 300 Puts, Satyam 280 Puts, Satyam 260 Puts, Satyam 240 Puts and Satyam 220 Puts in the market. The higher strike prices will carry a heavy premium and the lower strikes will be cheaper.

If you buy lower strike Puts, your protection will start late. For example, if you buy a Satyam 220 put for Rs 3, you must be willing to bear losses till Satyam reaches Rs 220 (from the current level of Rs 262), i.e. Rs 42 per share.

If you buy a Satyam 300 Put (which might typically quote for Rs 50), your protection starts the moment Satyam quotes below Rs 300.

Question :So what should I do?

Answer :Consider this as a Mediclaim Policy. You can go for a higher coverage at a higher premium or low coverage at a low premium.

You should ask yourself the following questions:

What is the probability of Satyam going down to that level?

How much loss am I willing to bear myself?

How much value for money do I see in the premium?

What if I hold shares other than the 31 Scrips on which derivatives are allowed?

If you hold other shares, you should consider buying Index Puts if you are nervous about them. You would pay a similar premium for protection and make some profits if the market moves down.

Question :How much of Index Puts should I buy?

Answer :This is slightly tedious and you need to understand how your portfolio moves vis-à-vis the market index (say Sensex). The relationship between the two is called ‘beta’. Statistically the number is generally between 0 to 2. For example, if the beta of your portfolio is 1.2, it means your portfolio will move by 1.2 times the movement in the Sensex. If the Sensex were to move up by 10%, your portfolio will move up by 12%.

You should therefore work out the value of your portfolio and multiply it with the beta and buy Index Puts of that amount.

This will work out to be a good insurance.

There are more intricacies on Index Put insurance which institutions holding large equity volumes might consider, but for a retail investor, this strategy is generally good.

You should however note that your protection might not be as precise as in the case of individual stock Puts, as the past beta may not exactly match with future beta. You should, in my opinion, be happy if you are able to cover even 80% of your losses.