Abstract. Keywords: Equity Options, Investment, S&P CNX Nifty 50, out the money (OTM), at the money (ATM), in the money (ITM)

Transcription

1 Abstract This paper examines the historical time-series performance of trading strategies involving options on the S&P CNX Nifty 50 Index. Each option strategy is examined over different maturities and money-ness, incorporating transaction costs and margin requirements. An initial analysis was constructed by assuming an individual position starting in 2002 and allowing for a continuum of trading comparing historical performance via returns and Sharpe Ratios as compared to the S&P CNX Nifty 50 as a benchmark. A second analysis generated portfolios for a typical investor, using the past 10 years to examine rates of return given certain trading restrictions. The analysis revealed significant profitability in investing in certain option strategies, in particular, market bullish strategy, especially long call and long call spread. Keywords: Equity Options, Investment, S&P CNX Nifty 50, out the money (OTM), at the money (ATM), in the money (ITM) 1

2 1.1 Background Chapter 1 Introduction Option is a financial instrument which is extensively used in share markets, money markets, and commodity markets to hedge the investment risks and acts as financial leverage investment. Option is a kind of derivative instruments along with forwards, futures and swaps, which are used for managing risk of the investors. Though derivatives are theoretically risk management tools and leveraged investment tools, most use them as speculative tools. Most research in the field of option involves the theoretical and empirical estimation of various option-pricing models and the role option play in hedging risk exposure. Although very little attention has been dedicated to the effect options have from an individual investor standpoint. Explicitly, what effect investing in option strategies have on portfolio returns? The purpose of this study is to examine, from an historical perspective, the return and risk to holding various option strategies from a representative investor standpoint. Our representative investor is considered different from an institutional investor, since the individual is constraint with limited net worth and faces the burden of higher transaction costs given bid-ask spreads, taxes and overall relative trade size. The results are formulated and designed to provide investment strategies across various level of risk aversion while maintaining a diversified portfolio. Hopefully, the results will provide new insight into investment options that can actually be utilized in today s market. The underlying asset to which the portfolio will be compared to is the Standard and Poor s CNX Nifty (Nifty 50), which is a capitalization weighted index of 50 Blue- Chip stocks. The S&P CNX Nifty 50 is typically used as the benchmark for the overall performance of the market. From a theoretical point of view, investing directly into the index would eliminate all non-systematic risk. In general, most managers who are active in the market accept beating the market as a measure of positive abnormal returns. As such, utilizing options on the index to examine various option strategies, will allow the comparison relative to this benchmark for a wide array of investor risk preferences. This research further focuses on three types of individual investors: high-risk aversion, medium-risk aversion, and low-risk aversion, where the medium risk averse investor would accept the return and risk associated with the market. Each strategy is compared and generated with the idea of classifying the strategy within a 2

3 risk aversion class. It does not examine the reasons an investor falls into each category, but the results should provide useful alternatives for each of the three types of investors. When discussing risk, it should be clear that this research is not trying to define risk nor is it trying to discover riskless investments. The S&P CNX Nifty 50 Index s level of risk will be the baseline for the medium risk-averse investor. The highly risk averse investor will have a low risk tolerance based primarily on lower standard deviation of returns. Similarly, the low risk averse investor will have a higher risk tolerance, which allows for high volatility in returns. Rates of return and Sharpe ratios will be used in evaluating the strategies but only after classify the strategy to an investor type based on the volatility of that strategy. The options market today in India is liquid, low-transaction-cost, and penetrable market. An individual investor, today, can easily trade small quantities of contracts through a broker or an individual on-line brokerage account. The options market today is nothing like it was ten years ago. Ten years ago the options market barely existed and was primarily an institutional investment vehicle; the options market had just become standardized, allowing an individual investor to invest in index options but at extremely high costs and without out the fluidity of today s market. In today s market, option prices instantly change in value as prices fluctuate in underlying assets, according to market maker s valuation estimates. The ease of entry and exit is as fluid as trading exchange listed stocks. Gains and losses can be easily magnified by the leverage options provide, and through the research, a solution to maximize gains and realize the potential risk of losses will be highlighted for each investor. 1.2 Rationale For The Study The market price reduction of the share is called as downside risk of the investor. The profit from the increase in the share price is known as upside potential. Option strategies help the investors to cap the downside risk at the same time keep the upside potential unlimited. This is the most desired need of the investors. Buying a call option and selling a put option works well in the bull market, limiting the loss to the premium paid but the upside potential in unlimited as market price increases. Similarly, in a bearish situation, selling a call and buying a put are the strategies of capping the downside risk. Apart from the above plain vanilla strategies, bull spread, bear spread, calendar spreads, butterfly spreads, diagonal spreads, straddle, strangle, strips, and straps are some of the famous strategies to cap the downside risks up to any level required by the investors. This property makes the option a unique tool for risk management and a preferred one. 3

4 Option strategies can be used by the investors to bring down their risk from the fluctuations in the market and can also use it to generate a significant return from it. For example Bakshi and Kapadia (2003) and Coval and Shumway (2001) show that selling puts and selling straddles on the S&P 500 offer unusually high returns for their level of risk. For instance, Coval and Shumway show that shorting an at-themoney, near-maturity straddle offered a return of 3.15 percent per week in their sample. Although very little attention has been dedicated to the effect options have from an individual investor standpoint. Explicitly, what effect investing in option strategies have on portfolio returns? Some studies have been done in more developed markets like U.S.A (United State of America) but there are no such studies in Indian context as option market is still in its early stage. This study will try to bridge this gap and will provide the answers to this question. 1.3 Objectives The key objectives of the thesis are as follows:- a) To find effect of writing or holding options have on individual s portfolio returns b) To distinguish the option trading strategies on the basis of investors risk appetite c) To find out strategy that generates a significant return in Indian stock exchange market The results will provide new insight into investment options that can actually be utilized in today s market. 1.4 Data The sample used for construction of portfolio consists of Index Options trading on NSE which satisfy following conditions: a) The options are European Options. b) The period of analysis span from January 2002 until March c) The option price used is the average of daily opening, mid and closing price of the option. d) The risk-free rates are obtained from the Reserve Bank of India. e) The maturity period of options is 3-months but the position in strategies is not established until 45, 37 and 30 days before the expiry so option prices are taken accordingly. The positions are taken only on Thursday and if Thursday is holiday then positions are taken prior to it. 4

5 f) Each of the strategies was evaluated over three levels of money-ness; Out-ofthe money (OTM), at-the money (ATM), and in-the money (ITM). The strategies are all based on leveraging and investing in the S&P CNX Nifty 50 Index. The data were obtained from Bloomberg Data Base (Courtesy: Navam Capital) 1.5 Limitation of the Study The study is limited to National Stock Exchange and limited to index options, which are traded from January 2002 till March 2012 for some strategies and for some strategies period of analysis span from October 2007 till March 2012 due to unavailability of data, as the trades in BSE has been less than one percentage compare to NSE trade. 1.6 Organization of the Study Chapter 2 briefly reviews the literature related to testing methodologies used in past empirical studies on equity option strategies for an individual investor. Chapter 3 contains a detailed description of methodology used in the analysis and its relevance. This is followed by the results of the study. Chapter 4 contains the discussion of results. Chapter 5 contains a brief summary and conclusions of the study. 5

6 Chapter 2 Literature Review This section contains two subsections. The first subsection discusses the theoretical details whereas the second subsection most commonly used methodology used for testing equity option strategies for individual investors and the empirical findings from a number of studies related to the markets all around the world. 2.1 Option Overview Option is a financial instrument whose value depends upon the value of the underlying assets. Option itself has no value without underlying assets. Option gives the right to the buyer either to sell or to buy the specified underlying assets for a particular price (Exercise / Strike price) on or before a particular date (expiration date). If the right is to buy, it is known as call option and if the right is to sell, it is called as put option. The buyer of the option has the right but no obligation either to buy or to sell. The option buyer has to exercise the option on or before the expiration date, otherwise, the option expires automatically at the end of the expiration date. Hence, options are also known as contingent claims. Such an instrument is extensively used in share markets, money markets, and commodity markets to hedge the investment risks and acts as financial leverage investment. Option is a kind of derivative instruments along with forwards, futures and swaps, which are used for managing risk of the investors. Though derivatives are theoretically risk management tools and leveraged investment tools, most use them as speculative tools. Though the derivatives were very old as early as 1630s, the exchange traded derivative market was introduced during 1970s marked the creation of both the Chicago Board Options Exchange and the publication of the most famous formula in finance, the option-pricing model of Fischer Black and Myron Scholes. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of derivatives. Chicago Board Options Exchange (CBOE) was founded as first United States of America (USA) options exchange and trading begins on standardized, listed options. April 26, the first day of trading sees 911 contracts traded on 16 underlying stocks. During 1975, computerized price reporting was introduced and Options 6

7 Clearing Corporation was formed. The Black-Scholes model was adopted for pricing options in CBOE. In the year 2005, CBOE s options contract volume was an all-time record of 468,249,301 contracts (up 30% over the previous year), and the notional value of this volume was more than US$1.2 trillion. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor's and became known as the S&P 100, which remains the most actively traded exchange-listed option. Options have the most peculiar property of capping the downside risk at the same time keeping the unlimited upside potential. Furthermore, the importance of the option trading and the requirement of its correct pricing are far more critical and useful in decision making, which are narrated below. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witness higher trading volumes, because more players participated who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, the speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. In India, derivatives trading was introduced Index Futures Contracts from June 2000 and stock option trading in July 2001 grown very fast to reach an average daily turnover of derivatives at NSE, at Rs.33,745 crores during May 2006 as against cash markets turnover of about Rs crores (as on May 2006), which indicates the 7

8 importance of the derivatives. Normally, the derivative turnover is three to four times the cash market turnover in India. Option, being one of the derivatives is a unique type of hedging tool. Black Scholes formula after mesmerize the western countries also entered into in Indian option market Option Pricing: The price of the option is determined by many methods like binomial method, Black Scholes option pricing formula, Volatility jump model etc. out of which the Black Scholes option pricing model is most popular and widely used throughout the world. The variables and the parameters that determine the call option price are diagrammatically given in Figure 1.1. Future is uncertain and must be expressed in terms of probability distributions. The probability distribution of the price at any particular future time is not dependent on the particular path followed by the price in the past. This states that the present price of a stock impounds all the information contained in a record of past prices. If the weak form of market efficiency were not true, technical analysts could make 8

9 above-average returns by interpreting charts of the past history of stock prices. There is very little evidence that they are in fact able to get above-average returns. It is competition in the marketplace that tends to ensure that weak-form market efficiency holds. There are many, many investors watching the stock market closely. Trying to make a profit from it, leads to a situation where a stock price, at any given time, reflects the information in past prices. Assume that it was discovered a particular pattern in stock prices, which always gave a 65% chance of subsequent steep price rises. Investors would attempt to buy a stock as soon as the pattern was observed, and demand for the stock would immediately rise. This would lead to an immediate rise in its price and the observed effect would be eliminated, as would any profitable trading opportunities Option and the Stock Market The derivatives make the stock market more efficient. The spot, future and option markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly, and keep the prices in alignment. Hence these markets help ensure that prices of the underlying asset reflect true values. Options can be used in a variety of ways to profit from a rise or fall in the underlying asset market. The most basic strategies employ put and call options as a low capital means of garnering a profit on market movements, known as leveraging. Option route enable one to control the shares of a specific company without tying up a large amount of capital in the trading account. A small portion of money say, 20% (margin) is sufficient to get the underlying asset worth 100 percentages. Options can also be used as insurance policies in a wide variety of trading scenarios. One, probably, has insurance on his / her car or house because it is the responsible act and safe thing to do. Options provide the same kind of safety net for trades and investments already committed, which is known as hedging. Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk. 9

10 The amazing versatility that an option offers in today's highly volatile markets is welcome relief from the uncertainties of traditional investing practices. Options can be used to offer protection from a decline in the market price of available underlying stocks or an increase in the market price of uncovered underlying stock. Options can enable the investor to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. One can also uses option strategies to profit from a movement in the price of the underlying asset regardless of market direction. There are three general market directions: market up, market down, and market sideways. It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy stocks. Does one have any other available choices? Yes, one can combine long and short options and underlying assets in a wide variety of strategies. These are some of the strategies that limit your risk while taking advantage of market movement. Table 2.1 Bullish Limited Risk Strategies Bullish Unlimited Risk Strategies Bearish Limited Risk Strategies Bearish Unlimited Risk Strategies Buy Call Buy Stock Buy Put Sell Stock Bull Call Spread Sell Put Bear Put Spread Sell Call Bull Put Spread Covered Call Bear Call Spread Covered Put Table 2.2 Neutral Limited Risk Strategies Long Straddle Long Strangle Long Butterfly Long Condor Neutral Unlimited Risk Strategies Short Straddle Short Strangle Option Strategies (An overview on Strategies to be tested ) 1. LONG CALL If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Market Expectation: Market Bullish/Volatility Bullish 10

11 Volatility: The option value will increase as volatility increases (good) and will fall as volatility falls (bad). Time Decay: As each day passes the value of the option erodes. 2. SHORT CALL A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Market Expectation: Market Bearish/ Volatility Bearish Volatility: The option value will increase as volatility increases (bad) and will decrease as volatility decreases (good). Time Decay: As each day passes the value of the option erodes (good). 11

12 3. LONG PUT A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Market Expectation: Market Bearish/Volatility Bullish Volatility: The option value will increase as volatility increases (good) and will fall as volatility falls (bad). Time Decay: As each day passes the value of the option erodes (bad). 4. SHORT PUT A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option un-exercised and the writer gets to keep the premium. Market Expectation: Market Bullish/Volatility Bearish Volatility: The option value will increase as volatility increases (bad) and will decrease as volatility decreases (good). Time Decay: As each day passes the value of the option erodes (good). 12

13 5. LONG STRADDLE A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index show volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction. Market Expectation: Market neutral/volatility bullish Volatility: The option value will increase as volatility increases which is good for both options. Alternatively a decrease in volatility will be bad for both options. Time Decay: As each day passes the value of the option erodes (bad). 6. SHORT STRADDLE A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index do not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, in case the stock / index moves in either direction, up or down significantly, the investor s losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made. Market Expectation: Market neutral/volatility bearish 13

14 Volatility: The option value will decrease as volatility decreases which is good for both options. Alternatively an increase in volatility will be bad for both options. Time Decay: As each day passes the value of the option erodes (good). 7. LONG STRANGLE A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential. Market Expectation: Market neutral/volatility bullish Volatility: The option value will increase as volatility increases which is good for both options. Alternatively a decrease in volatility will be bad for both options. Time Decay: As each day passes the value of the option erodes (bad). 8. SHORT STRANGLE A Short Strangle is a slight modification to the Short Straddle. It tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date. This typically means that since OTM call and put are sold, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened. The underlying stock has to move significantly for the Call and the Put to be worth exercising. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium. Market Expectation: Market neutral/volatility bearish Volatility: The option value will decrease as volatility decreases which is good for both options. Alternatively an increase in volatility will be bad for both options. Time Decay: As each day passes the value of the option erodes (good). 9. BULL CALL SPREAD STRATEGY: BUY CALL OPTION, SELL CALL OPTION A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will 14

15 be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month. The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is exercised when investor is moderately bullish to bullish, because the investor will make a profit only when the stock price / index rise. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit. Market Expectation: Market Bullish/Volatility Neutral Volatility: You are not affected by volatility. Time Decay: It depends on the underlying share price, if it is below A, then time decay works against you. If it is above B, then it works for you. 10. BULL PUT SPREAD STRATEGY: SELL PUT OPTION, BUY PUT OPTION A bull put spread can be profitable when the stock / index is either range bound or rising. The concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike Put sold ensuring that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income. If the stock / index rise, both Puts expire worthless and the investor can retain the Premium. If the stock / index falls, then the investor are breakeven is the higher strike less the net credit received. Provided the stock remains above that level, the investor makes a profit. Otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received. This strategy should be adopted when the stock / index trend is upward or range bound. Market Expectation: Market bullish/volatility Neutral Volatility: You are not affected by volatility. Time Decay: It depends on the underlying share price, if it is below A, then time decay works against you. If it is above B, then it works for you. 11. BEAR CALL SPREAD STRATEGY: SELL ITM CALL, BUY OTM CALL The Bear Call Spread strategy can be adopted when the investor feels that the stock / index are either range bound or falling. The concept is to protect the downside of a Call Sold by buying a Call of a higher strike price to insure the Call sold. In this strategy the investor receives a net credit because the Call he buys is of a higher strike price than the Call sold. The strategy requires the investor to buy out-of-the-money (OTM) call options while simultaneously selling in-the-money (ITM) call options on the same underlying stock index. This strategy can also be done with both OTM calls with the Call purchased being higher OTM strike than the Call sold. If the stock/index falls both call will expire worthless and the investor can retain the net credit. If the stock/index rises then the breakeven is the lower 15

16 strike plus the net credit. Provided the stock remains below that level, the investor makes a profit. Otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received. 12. BEAR PUT SPREAD STRATEGY: BUY PUT, SELL PUT This strategy requires the investor to buy an in-the-money (higher) put option and sell an out-of-the-money (lower) put option on the same stock with the same expiration date. This strategy creates a net debit for the investor. The net effect of the strategy is to bring down the cost and raise the breakeven on buying a Put (Long Put). The strategy needs a Bearish outlook since the investor will make money only when the stock price / index fall. The bought Puts will have the effect of capping the investor s downside. While the Puts sold will reduce the investors costs, risk and raise breakeven point (from Put exercise point of view). If the stock price closes below the out-of-the-money (lower) put option strike price on the expiration date, then the investor reaches maximum profits. If the stock price increases above the in-the-money (higher) put option strike price at the expiration date, then the investor has a maximum loss potential of the net debit. 13. LONG CALL BUTTERFLY: SELL 2 ATM CALL OPTIONS, BUY 1 ITM CALL OPTION AND BUY 1 OTM CALL OPTION A Long Call Butterfly is to be adopted when the investor is expecting very little movement in the stock price / index. The investor is looking to gain from low volatility at a low cost. The strategy offers a good risk / reward ratio, together with low cost. A long butterfly is similar to a Short Straddle except your losses are limited. The strategy can be done by selling 2 ATM Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistance between the strike prices). The result is positive incase the stock / index remains range bound. The maximum reward in this strategy is however restricted and takes place when the stock / index is at the middle strike at expiration. The maximum losses are also limited. 14. SHORT CALL BUTTERFLY: BUY 2 ATM CALL OPTIONS, SELL 1 ITM CALL OPTION AND SELL 1 OTM CALL OPTION A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call Butterfly, which is a range bound strategy. The Short Call Butterfly can be constructed by Selling one lower striking in-the-money Call, buying two at-the-money Calls and selling another higher strike out-of-the-money Call, giving the investor a net credit (therefore it is an income strategy). There should be equal distance between each strike. The resulting position will be profitable in case there is a big move in the stock / index. The maximum risk occurs if the stock / index is at the middle strike at expiration. The maximum profit occurs if the stock finishes on either side of the upper and lower strike prices at expiration. However, this strategy offers very small returns when compared to straddles, strangles with only slightly less risk. 16

17 15. LONG CALL CONDOR: BUY 1 ITM CALL OPTION (LOWER STRIKE), SELL 1 ITM CALL OPTION (LOWER MIDDLE), SELL 1 OTM CALL OPTION (HIGHER MIDDLE), and BUY 1 OTM CALL OPTION (HIGHER STRIKE) A Long Call Condor is very similar to a long butterfly strategy. The difference is that the two middle sold options have different strikes. The profitable area of the payoff profile is wider than that of the Long Butterfly The strategy is suitable in a range bound market. The Long Call Condor involves buying 1 ITM Call (lower strike), selling 1 ITM Call (lower middle), selling 1 OTM call (higher middle) and buying 1 OTM Call (higher strike). The long options at the outside strikes ensure that the risk is capped on both the sides. The resulting position is profitable if the stock / index remains range bound and shows very little volatility. The maximum profits occur if the stock finishes between the middle strike prices at expiration. 16. SHORT CALL CONDOR: SHORT 1 ITM CALL OPTION (LOWER STRIKE), LONG 1 ITM CALL OPTION (LOWER MIDDLE), LONG 1 OTM CALL OPTION (HIGHER MIDDLE), SHORT 1 OTM CALL OPTION (HIGHER STRIKE) A Short Call Condor is very similar to a short butterfly strategy. The difference is that the two middle bought options have different strikes. The strategy is suitable in a volatile market. The Short Call Condor involves selling 1 ITM Call (lower strike), buying 1 ITM Call (lower middle), buying 1 OTM call (higher middle) and selling 1 OTM Call (higher strike). The resulting position is profitable if the stock / index shows very high volatility and there is a big move in the stock / index. The maximum profits occur if the stock / index finish on either side of the upper or lower strike prices at expiration. 2.2 Empirical Findings Hamernik (2005) examined the historical time-series performance of seventeen trading strategies involving options on the S&P 500 Index. In particular, seventeen separate strategies are examined over multiple time-horizons and holding periods. The selection of these strategies is in-line with the most popular option strategies as per the Chicago Board of Option Exchange and similar to those examined by Santa- Clara and Saretto (2005).. Each option strategy is examined over different maturities and money-ness, incorporating transaction costs and margin requirements. An initial analysis was constructed by assuming a theoretical option starting in 1970 and allowing for a continuum of trading comparing historical performance via returns and Sharpe Ratios as compared to the S&P 500 as a benchmark. A second analysis generated portfolios for a typical investor, using the past 34 years and 10 years to examine rates of return given certain trading restrictions. Each strategy was ranked by the standard deviation and the Sharpe ratio. The standard deviation of the S&P 500 was used as a baseline for determining each 17

18 investor category. A medium risk averse investor s strategies ranged from the S&P 500 s standard deviation to half its value. The highly risk averse investor s strategies were all strategies with half the standard deviation of the S&P 500 s standard deviation or less. The low risk averse investor s strategies were all the strategies with standard deviations greater than the S&P 500 s. All 17 strategies were evaluated despite the outcome of their standard deviation and Sharpe ratio analysis under the Empirical Results. All the strategies were evaluated at the three levels of money-ness and over the two levels of maturity. Then each position was compared on a 34-year run and a 10-year run of a baseline portfolio constructed of investing in the S&P 500 Index. Of note, the buying Put was extremely successful in the one-year investments over the last 10 years because of the recession and massive market decline. The leverage shows a direct reflection as to the profitability of the position. The more leverage the more profitable buying a put was. Because of the recession from 2000 until 2002, the results of the strategy could be considered unrepresentative of the general market. The 34-year run of the one-year investments shows a drastically different picture; however, the 30-day strategy shows the buying OTM puts as a highly profitable investment over the 10- year and 34-year runs. The OTM put is a highly profitable strategy; however, the percentage of the time the investment is profitable would pale and hinder even most of the truly low risk averse investors. In the one-year strategies, the OTM put is profitable around 20% of the time due to the long period and depth of the market decline from 2000 until Despite the large market decline in the latter part of the experiment and due to the length of the periods the experiment was conducted over, a significant number of the strategies proved to be profitable above the S&P 500. In fact, almost a full third of the strategies investigated provided returns higher than that of the S&P 500. In the study done by Hamernik (2005), he concluded for many of the strategies the additional risks in investing in the options are not out weighted by the potential profits. The low risk averse strategies that are profitable have dramatic downside potential. The most significant strategy investigated based on astounding returns and ability for the individual investor to establish the position has to be the ATM Synthetic Stock. A young investor has the ability to absorb large short-term losses to receive the eventually huge gains. The risks of the ATM Synthetic Stock have shown to be very rewarding in the long run; therefore, the individual investor that has the time to benefit from long upward trends in the market that can be maximized from the leverage afforded in the Synthetic Stock. Santa-Clara and Saretto (2004) investigated the risk and return of a wide variety of trading strategies involving options on the S&P 500. We consider naked and covered 18

19 positions, straddles, strangles, and calendar spreads, with different maturities and levels of money-ness. Overall, they found that strategies involving short positions in options generally compensate the investor with very high Sharpe ratios, which are statistically significant even after taking into account the non-normal distribution of returns. Furthermore, they found that the strategies returns are substantially higher than warranted by asset pricing models. They also found that the returns of the strategies could only be justified by jump risk if the probability of market crashes were implausibly higher than it has been historically. They concluded that the returns of option strategies constitute a very good deal. However, exploiting this good deal is extremely difficult. They found that trading costs and margin requirements severely condition the implementation of option strategies. Margin calls force investors out of a trade precisely when it is losing money. They conducted a systematic analysis of the risks and returns of option strategies focusing in particular on the impact that margin requirements and transaction costs have on the execution of these strategies. They considered naked and covered positions, straddles, strangles, and calendar spreads, with different maturities and levels of money-ness. They used data on S&P 500 options from January of 1985 to December of 2002 which is a much longer data set than used in previous studies and encompasses a variety of market conditions. They concluded that the high returns of option strategies cannot be explained as compensation for their risk. However, they found that transaction costs and margin requirements greatly reduce the profitability of option strategies. Consistent with the arguments of Shleifer and Vishny (1997) and Liu and Longstaff (2004) about the limits to arbitrage, their findings explain why the good deals in options prices have not been arbitraged away. Finally, they found evidence that margin requirements may have been set too high by the options exchanges relative to the actual risk of the option positions. This suggests that there is scope for the exchanges to improve the efficiency of option markets by changing the way margin requirements are calculated. Bakshi and Kapadia (2003) and Coval and Shumway (2001) show that selling puts and selling straddles on the S&P 500 offer unusually high returns for their level of risk. For instance, Coval and Shumway show that shorting an at-the-money, nearmaturity straddle with zero beta offered a return of 3.15 percent per week in their sample. Even though the volatility of the strategy was as high as 19 percent per week, the strategy still provided an annualized Sharpe ratio of 1.19, which is more than double the historic Sharpe ratio on the stock market. It is especially puzzling that Sharpe ratios are so high even for delta-neutral (and even crash-neutral) strategies that by construction are not directionally exposed to the stock market. These strategies are mostly exposed to volatility risk which is a risk that does not 19

20 exist in meaningful net supply in the economy and would therefore not seem to warrant a large premium. To summarize it has been found out from the previous studies conducted in developed markets like U.S.A. (on S&P 500) that by investing in certain option strategies an individual investor can generate a decent return from it. Although there is not much of literature available in this field, especially in Indian context, as option (derivative) market is in its early stage. This study will be an attempt to bridge this gap and will try to put some light on it. 20

21 Chapter 3 Methodology To test, I used the Bloomberg Database on NSE S&P CNX Nifty 50 Option price quotes. I examined the returns of European-style call and put options on S&P CNX Nifty 50 index over a ten-year period, from January 2002 to March I focused on the monthly returns of S&P CNX Nifty 50 options as our base case. The Index closing price is taken as proxy for the index value at that particular day. The Index price is then rounded off to multiple of 100 as to get the strike price for the index options as strike prices of index options are multiple of 100. Then on the basis of the strategy strike price were chosen to establish a position. The method used for calculating option returns is as follows. For each option required I identified the closing price. I took options which are to expire during the following calendar month, and therefore are roughly between 25 and 50 days to expiration. For every strategy I assumed that I am establishing the positions 45, 37 and 30 days before the expiration of the options. The positions are hold till the expiration of the option contracts. Our monthly results only use prices observed on Thursdays as the option in NSE (National Stock Exchange) expires on last Thursday of that month and if the last Thursday is a holiday then it expires on last Wednesday. The new position in strategy is also established on Thursday itself. This research s intent is to find investment opportunities that can outperform the S&P CNX Nifty 50 based on risk and rates of return. Therefore, a control group portfolio was created by investing the monthly investment amount straight into the S&P CNX Nifty Index every month to establish a baseline performance for all portfolios. The rates of return are determined by the value in the account at the end of the period compared to the total amount invested during the entire period. Each strategy is evaluated over three levels of maturity for the analysis. The three theoretical maturities are 45 days, 37 days, and 30 days. Each of the theoretical maturity is held as closely as possible to the number of days it specifies that is option is held till expiry. Finally, the margin requirements for selling the Index or writing options were determined using the National Stock Exchange (NSE) minimum requirements formula. Margin = Leverage * (Premium Proceeds +.2* Aggregate Contract Value Amount OTM) 21

22 Many brokerages require higher margin requirements, but the market minimum was used to create consistency in the research. For each of the positions, the rates of return, the standard deviation of returns and the Sharpe ratio was calculated. The rates of return were determined using the cost of the position s establishment as the base compared to the total profit or loss. The standard deviation was determined using all executions; no outliers or exclusion of any data points was made. Both the rates of return and the standard deviations were then annualized. Sharpe Ratio: The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk (and is a deviation risk measure). Where R is the asset return, Rf is the return on a benchmark asset, such as the risk free rate of return, E[R-Rf] is the expected value of the excess of the asset return over the benchmark return, and is the standard deviation of the excess of the asset return. The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken, the higher the Sharpe ratio numbers the better. When comparing two assets each with the expected return E[R} against the same benchmark with return Rf, the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios. Each strategy was then ranked by the standard deviation and the Sharpe ratio. The standard deviation of the S&P CNX Nifty 50 was used as a baseline for determining each investor category. A medium risk averse investor s strategies ranged from the S&P CNX Nifty 50 s standard deviation to half its value. The highly risk averse investor s strategies were all strategies with half the standard deviation of the S&P CNX Nifty 50 s standard deviation or less. The low risk averse investor s strategies were all the strategies with standard deviations greater than the S&P CNX Nifty 50 s. Each strategy was then categorized into this groups based on the condition mentioned above. 22

23 Chapter 4 Results The first phase of the experiment established the strategies position as described in the Chapter 3. The option strategies were tested for different level of money-ness and for different time to maturity. Some of the strategies were evaluated for the period span from January 2002 to March 2012 and some were evaluated for a short period span from October 2007 to March 2012 due to unavailability of the data. The Table 4.1 shows the strategy and time frame in which it was evaluated. Table 4.1 Strategy Span of Analysis Long Call (ATM) January 2002-March 2012 Long Call (ITM) January 2002-March 2012 Long Call (OTM) January 2002-March 2012 Long Put (ATM) January 2002-March 2012 Long Put (ITM) January 2002-March 2012 Long Put (OTM) January 2002-March 2012 Short Straddle January 2002-March 2012 Short Strangle (ITM) October 2007-March 2012 Long Butterfly (Call) January 2002-March 2012 Long Butterfly (Put) January 2002-March 2012 Long Call Spread (ITM) January 2002-March 2012 Long Call Spread (ATM) January 2002-March 2012 Long Call Spread (OTM) January 2002-March 2012 Short Put Spread (ATM) January 2002-March 2012 Short Put Spread (ITM) January 2002-March 2012 Short Put Spread (OTM) January 2002-March 2012 Long Condor (Call) October 2007-March 2012 Long Condor (Put) October 2007-March 2012 Long Calendar Spread (Call) January 2002-March 2012 Long Calendar Spread (Put) January 2002-March 2012 Table 4.2 displays the annualized rate of return and annualized standard deviation of S&P CNX Nifty 50 as this was set as the benchmark. The strategies having return greater than that of S&P CNX Nifty 50 represents that strategy has outperformed the index in the period considered whereas strategies having return less than that of index represents index has outperformed that particular strategy in the period considered in this research. The strategies having standard deviation higher than that of index represents risk involved in it is greater than that of risk involved in investing in market whereas strategies with standard deviation less than that of 23