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Lies Lies and Damn Lies

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									                                 LIES, LIES AND DAMN LIES - 1

My friend Jackie Klein and Jacotte are staunch Socialists. They are French citizens. They are
outright anti- American and firmly believe that stock markets are the creation of capitalists. They
also firmly are of the opinion that stock markets are gambling dens where no real wealth is
created. I on my part was a great advocate of stock markets and we used to argue vehemently
about them when we were in a relaxed mood. When ever we parted the couple used to warn me
about my adventures with stocks and derivatives. I never took them seriously and always thought
them as purely uninformed or misinformed. Subsequent events in my life taught me the hard truth
that there are real risks in investing in stock markets and derivatives and that only a few people
really make money from stock markets. This is an attempt to show the why and where for of it.

There are many who believe that money put on stocks is likely to be lost. If investing in stock
markets is so risky why lots of people enter the stock market? So something must be wrong
somewhere. There are stories of people who have made billions from stock markets by investing
or by trading. There are also stories of people getting ruined by trading in stock. Contradictory
advices given by people with long experience in this field remind me of the story of five blind men
defining an elephant. Each one had a different perception and each was right in some aspects.
This holds well about stock markets too. It is a fact that young men entering the work force with
high ambitions seek to achieve their goals at the earliest. Most of the goals have some connection
with money. Therefore all goal- oriented persons will try to maximize his earnings one-way or
other. The choices in front of such a person are many. My mother, born and bought up in a village.
never had much money. In her old age, she used to put the pocket money she got from us under
her pillow. She often complained about money missing from under her pillows. In times of
emergency my wife sometimes borrowed money from her. My mother used to accuse my wife of
having forgotten to repay her. We can see that the practice of .keeping money under pillows is not
wise. Money can be lost by theft, fire, floods and in so many ways. Inflation can reduce the value
of the money. Hoarding money like this does not serve the purpose.

My father was a conservative person who believed in saving his money in banks. He knew little
about alternate avenues of investments like stocks, commodities and derivative products. He
advised us to keep our savings in bank accounts. This may seem to be sensible advice for a
person wary of taking big risks with his hard earned money. In fact banks normally do not fail.
Even if they fail there is limited protection to the capital. However the returns one gets from bank
deposits are very low. In addition inflation will take away almost all the interest provided by the
banks. Some times the net return may become negative. This happens often in countries like
India. Consumer price indexes clearly show how inflation is making real interest rates negative.
Thus keeping money in bank accounts also is not wise. Americans have recently become wiser
and have given up the habit of saving money. They never save and their saving rate has gone
negative of late. Instead they spend all their money and use credit cards liberally. Only people in
third world countries like China, India, Korea and other South Asian countries save and buy
American bonds making American consumerism the driving engine of the world.

The old- generation rich liked to invest in real estate. Buying real estate with one‟s savings only is
not that easy. It is true that land is a scarce commodity. In the long run the price of land can only
go up. However, timing of purchase of landed property is very important. How the funds for buying
properties are raised is also equally important. All those who bought houses using loan funds have
seen the consequences when interest rate went up. Moreover property investments are not liquid
and can cause losses when the need arises to cash property investments in periods of slump. It is
also a false notion that prices of real estate can only go up. In fact property prices can remain flat
or even go down for prolonged periods. Thus there is a speculative element in dealing with landed
properties too.
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com
                      LIES, LIES AND DAMN LIES-2

It is said, “If dreams are horses, beggars would ride them”. This suits an ordinary investor who
hopes to get rich through stock marketing. Equity markets are considered to be very risky by some
people. On the other hand they are proclaimed as solutions for inflation and the last tool for
creating sustained returns for investors. Both these views are half-truths or lies. The hard truth is
that very few investors and traders make money from stock markets. Rather most of the investors
and traders lose their money irrespective of whether they are long term or short term investors.
By investing in stocks an investor becomes part of a venture or business over which he has very
little control. Every business has some promoters who have major stakes in the business where an
ordinary investor is only a minority stakeholder who gets only hands out from the promoters.
Press releases and balance sheets are creations of the managements to mislead the common
man. Think of what happened to Enron, Satyam Computers and Bernie Madoff„s schemes.
Financial papers, TV and other media create news that exaggerates the working of particular
companies creating false impressions about their profits and losses. What Goldman Sachs did in
2007-2008 periods is a typical example. This company created portfolios that are likely to fail in
future and sold them to investors after getting good rating from reputed rating agencies by
misguiding them. They and a big hedge fund manager then betted ans even big institutions have
no methods to find out what is good or bad. Poor investors are misled by these news items and
buy their stocks. Promoters and major shareholders unload their shares on the unsuspected public
after that and the poor public holds the useless shares without any means of escape. Ordinary
investors have no means to research a company except to relay on company reports and research
papers created by others. They never visit a company or under stand what the business is. The
public never understood the dot-com business and everybody knows what happened in 2000‟s.All
investors will fall into such traps at some time or other. They may hold some good shares.
However they will also have a bunch of rotten stuff that drag the return on the over all portfolio.
The definition of a good stock is also an imaginary one. A blue chip company will not remain a blue
chip company forever. If one looks at the companies that originally constituted Dow Jones
Industrial average 130 years back, there may be a very few now in the present DOW. This is the
case in all indices. This shows that long term investing may or may not be productive. It is a matter
of luck that ordinary investors owns a good stock because ordinary investor books profits on good
stock when he gets profits and holds bad stock for ever without exit. This is true of short of traders
and investors. Most of them have no escape route, because a big portion of their portfolio consists
of companies that have no quotations in any stock exchange. This happens because those
companies they had invested might have gone bankrupt or disappeared due to bad performance.
Those investors who had made their own research and experience might get out of companies
that fail in time. But ordinary investors fail to do that because they never know what happened to
their companies till stock prices crash. Diversification is said to be a solution to this problem. If the
investor is not lucky, his diversification can also land him in more trouble due to wrong choices.
Stock markets are cyclical in nature and prices can crash due to problems that have no relations to
a particular company or industry. Recent crash in stock markets in 2008 is a typical example. It is
to be noted that DOW had fallen from 15000 points to 7500 points within a short period of time
wiping out trillions of dollars of investor‟s wealth. Those who invested during 2008 period are still
waiting for an opportunity to recoup their losses. Investors like Buffet are rather exceptions and
comparing an ordinary investor to such personalities is irrational.


CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com
                       LIES, LIES AND DAMN LIES-3
Investment avenues discussed so far have risks beyond the full grasp of by ordinary investors.
They have very little idea about how to protect their portfolios in the event of a market- crash. Quite
often they enter the market at the wrong time and exit too at the wrong time. Lured by reports
about people having made huge amounts of money from stock market, some people buy stocks at
a time when stocks are on the verge of a deep correction after a big bull rally. The mistake here is
the wrong timing. Some times an investor waits for a recovery after a big fall to exit his stock
bought at the highest price. After a long wait he gets fed up and fears he will lose all his capital. So
he exits probably at the bottom of the fall and finds to his dismay his stock recovering to its full
glory once he is out of it.
It is not true that people have not made money from stock markets. But a majority of the investors
are losers due to the way they are investing. First of all they have no idea at all about the need to
buy quality stock at high prices. They buy cheap–quality stock at the recommendations of others.
Most of the stocks they buy are penny stocks and these stocks rarely reward the investors in the
long run. Ordinary investors never understand why a stock is going cheap and they never go for
expensive stock. They believe in numbers rather than quality. They also have the tendency to
trade rather than remain invested for long. Nor do they get out when the going gets tough. Most of
the stories of people getting rich overnight from stocks are false propaganda made by people with
vested interests such as brokers to lure innocent people into this game.
Day trading or trading for a short term is another big folly people indulge in. It is quite irrational to
think that people with no special skills can make money by trading stocks on their intuition. Even
the brightest of the lot will lose in the long run because it is statistically impossible that more than
50% decisions out of 1000 decisions taken by a person can become correct. Most of the short-
term traders keep the shares they could not dispose of for a few days if they find it difficult to get
out of them with profit on the day of buying. Sometimes they may be able to exit the stock with
profit. More often they will be forced to hold on to them for a considerable period of time. Their
capital gets stuck. Ultimately a short-term trader will be stuck with bad stock when he gets out of
his good stock with small profits. Ultimately all his capital will be lost in worthless stocks.
Ordinary investors forget the sad truth that every trade involves two people, a buyer and a seller.
When a person sells a stock he must have his reasons. The same will be the case of a buyer who
buys a stock .He must have his own reasons too. Subsequent market action proves one of them
wrong. Ordinary investors are mostly lured to buy a stock getting information from newspapers and
other media. Sellers some times plant news favourable to the company‟s from which they want to
exit. Some analysts also advise investors to buy stock after being bribed by parties who want to be
rid of certain stocks.
This happens often with new share issues. These new issues are called IPOs (Initial Public
Offers). Promoters of these companies want to get their issues subscribed fully. They employ paid
writers and put up attractive advertisements to lure the unsuspecting public to subscribe to their
issues. Once the shares are in the investor‟s portfolio it is luck that matters more.
Therefore all the talk about people making money from investing in stocks or trading in stock
should be taken with a grain of salt. Long term investors with idle money may get rich if they are
lucky in their choice of blue chips. But every investor may not be lucky in his choice because no
blue chip company remains a blue chip forever. Just think of people who invested in GM, AIG and
Enron and what happened to their long-term investments.


CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com
                               THE HOLY GRAIL
All the investment options discussed above have either low returns or high risks. The chances of
ordinary investors getting high returns without some risk containment from investment in shares
are rather slim. Low return investments like bank deposits or bond purchases would give negative
real returns while investments in stocks and other instruments may result in the erosion of capital
unless of course the investor is extraordinarily lucky.
Luck is not some thing that can be defined or depended upon. Therefore investing one‟s hard-
earned money in high-risk instruments without risk reducing provisions is sheer foolishness.
It is at this point that I wish to introduce the instruments under the name Derivatives. They are not
sophisticated instruments, as everybody knows. In subsequent articles I will introduce the various
instruments under derivatives and explain how to effectively use them to reduce risk and finally
come to a strategy that gives a return of more than 100% per year in the US markets

 A derivative is something derived from something else. For example petrol is a derivative of crude
oil. Derivatives are designed to reduce risks in all sorts of situations. For example there are
weather derivatives that reduce risk from changes of temperature. Naturally the question arises.
„How does a derivative reduce risk?‟ Risk is some thing that can be measured. Therefore it can be
quantified and transferred to others who wish to buy it for a reward. A typical example of
transferring risk is insurance. Every one of us has taken insurance of one sort or another. When
we buy insurance on our car we are transferring the risk and consequent losses from an accident
to an insurance company. The insurance company receives a premium for taking our risk.
Derivatives are doing exactly the same. They help you to transfer the risks to others who are ready
to purchase them for a payment of some sort. Similarly when you buy a share, derivative
instruments related to shares offer you a means to reduce your risks associated with the shares.
When you have foreign exchange- related instruments, derivatives associated with them offer you
a means to reduce the risks associated with them by transferring them to others who want to buy
the risk for a return
It should be understood clearly that risk is not eliminated by derivatives. Derivative instruments
transfer risk from investors to others who want to take them. The comparison of insurance
premium paid to an insurance company and your car accident is very pertinent here. We reduce
our risks from derivatives; some one else takes the risk from us for a price. In certain situations the
risks associated with some instruments are unlimited and those who buy the risks may be making
misjudgements on the quantum of risk they buy. The case of LTCM is a typical example. People
who floated LTCM that included Myron Scholes and Robert Metron, the Nobel Laureates for
Economics in 1997 for their contribution on Derivative instruments failed to assess the risk
associated with their position. Similarly AIG misjudged the risks associated with the insurance they
provided against sub-prime home loans and paid for that dearly. At the same time Goldman Sachs
and Paul Johnson betted against these instruments and made profits by billions of dollars from
their derivative positions.
Derivatives make a lot of headlines on the failure of big institutions that buy the risks without fully
realizing the implications. Most of the time the most unimaginable and impossible happens and
those who insured them go under. Titanic was said to be unsinkable, but it sank on its maiden
voyage itself making headlines.
Even Buffet called derivatives as the financial weapons of mass destruction. However the potential
of these instruments to reduce risks can never be undermined.

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com
Derivatives are derived from some other asset; they can take many forms. Risks occur in several
forms. When we buy stocks the prices can go up or down in future. When we buy a car, accidents
can occur in future. When we have receivables in foreign exchange at a future date its value can
change in future. Prices of commodities can fall at the time of harvests. This is a risk a farmer
faces. Prices of commodities may go up upsetting the budgets when actual purchases are made.
Change in weather patterns can affect the profitability of companies that depend on weather. Thus
there are risks in every investment. All these risks are related to events that may occur in future.
Derivative instruments are concerned with future and have a future date of expiry. As there are
thousands of investment avenues there are thousands of derivative products that are designed to
reduce the risks associated with them. Some derivative products are traded in derivative
exchanges. Some of the products are custom made and traded between two parties. Exchange-
traded derivatives have some contract specifications. Exchange will specify contract sizes, quality
specifications, and date of expiry and margin requirements. Only bargaining will be on the prices.
In an exchange buyers and sellers are not known to each other. The exchange will have a
clearinghouse that stands between the buyer and seller. From the buyer the clearinghouse buys
the asset and sells it to the seller. The clearinghouse collects margins from the parties depending
on the risk associated with their positions, and guarantees against defaults. Margins collected will
be changed depending on the risks due to change in volatility in prices. Losses and profits will be
made mark to market every day. ( Explain Mark to Market) But contracts made between two
parties are designed to suit the requirements of both parties. For example a trader needs 1550
tons of rubber of certain quality on 22nd September 2010. A rubber farmer agrees to supply the
rubber at an agreed price on that day. Here it is a private agreement. This contract is a future
contract. The delivery is at a future date. The quantity is the actual requirement and is not a
standard size. Had this contract been made in a commodity exchange the quantity would have
been 1550 tons instead of 1551.50 tons. There are no margin payments between parties. There is
no central place to execute such contracts. Large numbers of such contracts are executed
between private parties everywhere every day especially in commodities and foreign exchange.
These are called forward contracts. These contracts are also known as OTC contracts (Over The
Counter contracts). These contracts have many defects.
1 As there are no margin requirements defaults could arise
2 As there is no central place to trade finding counter parties are not easy
3 As there are only two parties involved, agreeing to a mutually agreeable price is not easy.
4 There is no liquidity for such contracts. Bid and ask prices can vary widely increasing the cost of
These contracts reduce risks as follows.
A US exporter is to receive one million Euros after three months. He has no clue about the
Euro/Dollar rate after three months. He is satisfied by the existing rate. He wants to sell his one
million Euros in the forward market. He approaches his bank with this request. His banker finds a
buyer of dollars (probably an importer from Germany) who requires them after three months. The
US exporter sells one million Euros to the German exporter near the then current rates. Both will
have the money only after three months. Both parties make a forward contract immediately. Now,
suppose Euro goes down with respect to dollar. It means that one needs to pay more Euros to get
one dollar. This also means that the US exporter gets fewer dollars if Euro depreciates with
respect to dollar. Due to his forward contract the US exporter still gets the same number of
contracted dollars after three months. In the case of the German importer, he needs to pay the
same contracted dollars to get his 1 million Euros. He could have paid fewer dollars to get his 1
million Euros had he not made a forward contract. It may look that the German importer lost. But it
is not so. Exchange rate movement could have been in the reverse too. Then the US exporter
would have been a loser. Both these parties have removed the variability of their returns by
entering into a forward contract.
By selling their receivables in the forward markets both parties removed their risks..
                             FUTURES CONTRACTS HAVE A GREAT FUTURE
While forward contracts are traded between two parties or two firms, futures contracts are traded in
exchanges with counter parties remaining unknown to each other. Here the term exchange is
introduced. Exchanges are independent institutions regulated by Government- appointed bodies
with rules and regulations enforceable by law. These are places where stocks, commodities and
their derivatives could be bought or sold. Companies that have public share holding must enlist
their shares in these exchanges so that shareholders get a chance to trade their shares without
the intervention of the companies concerned. These institutions are highly essential because
without these shareholders have to find counter parties by themselves or approach directly the
companies for selling the shares. Both these methods of trading are time consuming and costly
and hence act as inhibiting factors for fund raising and investments.
These exchanges provide a central place to trade. They guarantee trades avoiding defaults by
taking margins depending on risk. They design sensible contracts with clear specifications so that
the only variable is price and they enable smooth trading. All exchanges have a Clearing House
that acts as intermediary between buyers and sellers.
Therefore forward contracts when traded in exchanges have very few drawbacks. In exchanges
there will be thousands of participants buying and selling. These traders have information about
the assets they are trading on. Therefore they have some idea about the worth of an asset at a
future point of time. This creates liquidity and price recovery. Exchanges and clearing houses
collect margins I order to prevent default. However there is a problem with exchange-designed
contracts. Contracts are stream lined and quantity, quality, expiration and other variables are fixed,
except price. Therefore one individual cannot create a contract with a specific quantity to hedge his
specific position. (This is not clear to me)
Availability of futures contracts on stocks, commodities and indices is very convenient for investors
to hedge their positions in the spot market or the cash markets. These can be used for reducing
risks in derivative markets too. Here a new term indices is introduced. A stock index is a number
based on stock prices. A commodity index is computed using commodity prices. These have a
Base Year and a Present Value. The index figure shows how many times the present value has
gone up or down when compared to base year. Indices too are derivatives because their values
are derived from other assets like stock or commodity prices. Dow Jones Industrial Average is
derived from 30 stocks. S&P 500 is derived from 500 stocks. Russell2000 has 2000 shares and
Nasdaq Composite includes more than 3000 shares listed on Nasdaq. Dow is a very old index of
American stocks whose value is based on the prices of 30 major companies in the US. The base
value is adjusted to compensate for the effects of stock splits and other adjustments. Dow is a
minor representative of the US markets. Buying Dow Jones futures (DJX) is equivalent to buying
30 shares in the Dow for a future delivery. Similarly when an investor buys S&P 500 futures(SPX)
he is buying an equivalent of 500 shares included in that index. Because of this useful role buying
and selling of index futures are allowed in many US derivative exchanges. After 2000, individual
stock futures are also allowed to be traded in the US. Thus US investors have hundreds of futures
contracts on indices and stock futures to hedge against spot or derivative positions. As each index
represents a particular group of shares these could be utilized to hedge a specific sector. In
addition to all these index -based derivatives, many exchange- traded funds (ETFs) are floated by
many institutions. ETFs on indices are mainly miniature indices that can be bought instead of an
index. For example SPY is an ETF that has one tenth the value of S&P500. Instead of buying 500
shares in S&P500, an investor can buy SPY and own the shares in S&P500. As the basic unit is
only 1/10 of the S&P500 it requires less money to own a unit of SPY.
As S&P500 has 500 shares, it is a widely diversified index. Therefore company specific risks are
totally eliminated in this index due to negative correlations among various companies. Thus S&P
500 has only risks related to market as a whole. Hence S&P500 derivatives can be used to hedge
against systematic risks.
There are serial methods by which futures contracts could be used to hedge risks in stock markets
and commodity markets. (The last Part about indices is not easy to understand)
Before discussing these methods it is pertinent to find out the type of participants who operate in
these futures markets.
                             FUTURES CONTRACTS HAVE A GREAT FUTURE
There are four types of traders in futures exchanges.
Farmers are producers of farm products. Oil drilling companies are producers of oil. Food product
companies are consumers of farm products. Oil refineries are consumers of crude oil. But
speculators and arbitragers are two different groups. Among the four groups speculators are in the
majority. These people assess the likely prices of assets in the future and take positions on them
to buy or sell them at a future date. Suppose crude oil is trading at $80 per barrel in the spot
markets. A group of people having information on oil may feel that oil prices may go up after 3
months. There may be another group who feels that oil prices may fall after three months. The first
category might push up the oil prices with huge demands while others might sell oil to this group.
One of these groups is definitely in the wrong. As oil does not get transferred immediately and both
these two groups have no other interest in oil other than taking profit from their guess work they
are called speculators. As transfer of assets does not take place immediately futures exchanges
charge the traders only the risk margins. The maximum risk in the positions is determined every
day using computer soft ware and margin money collected through brokers. As fluctuations in
prices are not a very big risk, margins normally come below 25% of asset prices. Therefore
speculators need to raise only a maximum of 25% of asset prices to take positions in the futures
When the producer of an asset like wheat wants to sell his future wheat production (produce or
product?), there will be plenty of speculators ready to bid for the production (?). Consumers may
also bid for the asset. Apart from producers, speculators will also try to buy and sell futures on
wheat depending on their perceptions. A speculator who feels that the future prices will fall, will sell
future contracts while a speculator who feels that prices will go up, will buy them. Here producers
and consumers are transferring their price risks to speculators. Arbitragers are a group of traders
who watch the price difference of an asset in different exchanges. Price difference is a rare
occurrence due to efficient communicational facilities. However if such a thing happens, this group
will buy from where the asset is priced less and sell to where the asset is priced higher. Most often
cost of transactions and other levies nullify any advantages in arbitrage trades.
In the case of financial assets like stocks, investors can reduce risk by using futures. Suppose a
mutual fund has $2 billion assets in stocks. Suppose the portfolio has one to one correlation to
SPX. This means that if S&P 500 falls by one percent, the portfolio will also lose 1% in value.
Asset managers of the mutual fund fear greater volatility in the markets due to political events
abroad. As this risk is systemic in nature they will sell $2 billion worth of SPX in the futures
markets. If markets crash by 2%, the portfolio will lose 0.04billion in value. At the same time SPX
will also lose $0.04 billion in value. As the portfolio managers have short positions in SPX any fall
in portfolio value will be compensated by the profit from SPX short positions.
 Suppose an investor or a mutual fund will receive some funds after three months. However
markets had a big crash and price earning ratios fell considerably before the receipt of funds.
These investors can then choose the futures market to accumulate their preferred stock by paying
margin to stock exchanges. Suppose a mutual fund receive $2 billion after three months from sale
of units. If the price earning ratios fall considerably, the stocks will become very cheap. The mutual
fund can buy the required portfolio in the futures market by paying a small margin. If prices go up
by the time the fund gets money from sale of units it can sell the futures. It can buy the shares from
spot markets at current prices and their sale of futures will provide them profits to compensate for
the rise in spot prices.
 Speculators in futures markets play altogether a different game. They buy and sell huge quantities
with thin spreads paying small amounts of margins. They may not even hold their positions to the
next trading day. It is speculators who create most of the volume in the derivative markets. As they
are ultimately the carriers of someone else‟s risks, most of them end up with huge losses. Broker‟s
charges and other levies are very heavy for them due to their huge trading volumes. Even though
speculators do a useful job of creating volumes, price recovery and liquidity, buying and selling
futures as a speculative activity is sheer foolishness. Most often individuals take speculative
positions without knowing the direction of the markets. Their risks are unlimited and ultimately
Murphy‟s Law will catch up with them unless of course they are blessed by the goddess of Luck.

To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

                             OPTIONS HAVE MORE FUTURE THAN FUTURES
Options are the most versatile financial instruments. Though they are the simplest of financial
instruments, they are considered to be mysterious and complicated. As a result most of the set
backs in financial markets are attributed to options most often mistakenly.. Options are actually
designed to hedge risks and transfer the risks to speculators. Their bad side comes up when
speculators take positions beyond their capabilities.( capacities?) We all buy many options in
everyday life without being aware of it.. For instance, we reserve seats for travel. A reservation
gives a right to occupy a particular seat on a bus or a train. What ever amount we pay in excess to
reserve a seat is insurance premium for the assurance of a seat. If allowed, this reservation could
be sold to others who are more needy and ready to pay more. Here we are transferring the right to
travel. If no one travels on the date specified the money paid for reservation is lost. This clears two
things. An option has a price and valid period
 In financial markets also there are many options. You may park your savings in a bank. You can
buy shares. You can buy property. You can buy mutual fund units. You can buy government
bonds. Each option has its own merits and demerits. Each has its pay off also. Thus options are
not something related to financial markets only. They are part of our every day life. The only
difference is that they are carefully analysed in financial markets. Options are derivatives because
they derive their value from some other asset. For example an airline buys an option to purchase a
Boeing 747 at specified price after a year by paying 1 million dollars. The air line can sell this
option for 2 million to another airline. Here the asset is Boeing 747. The option‟s price is related to
the value of the asset. This option can change hands many times before the actual delivery with
each airline taking some profit on the sale. In the case of stocks too, there are options like these.
For example, a person who wants to invest in stocks tells a seller that he would buy his stock only
after a month and that too only shares that trade above a stipulated price. This is an unusual
request. He selects a price of $20 for a share trading at 15 in the spot markets as his choice. In an
exchange trading options, there may be many choices of prices fixed by the exchange. They are
called strike prices. The stock selected may be trading at $25 at that time in the cash market or it
may be trading at $15 on the particular day. Here the investor can choose his strike price. In such
an exchange an option seller may agree to sell the share at $20 if the price remains above $20 on
the expiration of the contract. Here the seller of the options takes some risks. He needs to hold his
shares for a month and will sell them only if the price is above $20. If the price crashes, he will be
holding his shares. This is a big risk He also takes another bigger risk. The share can go up to any
extent, say $50 per share within the contract period and close at that price on the expiration date.
The seller of the option then will have to sell the shares at $20 foregoing a huge profit of $30.
Therefore an option seller will not write such a contract without proper reward. Like an insurance
company he will estimate his likely losses and charge a premium on the risk he takes. This extra
money demanded by the option seller is called Option Premium. By paying this premium, the
buyer gets a right to „call‟ for the shares if they close above $20 at the end of the contract period.
This right to „call for the asset‟ is called a Call Option. If the price of the asset is below the strike
price on which contract is made, the buyer of the option will not buy the asset. But the risk
premium he paid to the seller will be lost. Thus the buyer of the Call Option gets the right to call the
shares and loses a maximum of the premium he paid, if share price remains below the strike price
on the last date. But the seller of the Call Option (parts missing) contracts on different rates. Fixed
strike prices increase the liquidity of contracts, making off setting trades easy. If a share is trading
at $100 per share, the exchange trading the options on that share may fix strike prices and 105. As the asset is trading at $100 in the spot market, a
person buying an option at 95 strike price is trying to buy the asset at $5 discount. However the
seller will take into account this factor also when he prices the option. These types of options are
said to be ITM (In The Money). Here and99 are in the money options. Options at 100
are ATM (At The Money) and options at strikes 101.102.103, 104 and 105 are OTM (Out of The
As the seller of options bears big risks in case the share price moves up considerably, exchanges
ask him to pay margins to avoid defaults. The margin is estimated by exchanges after assessing
the risks related to his total positions at a point of time. Exchanges collects only option premium
from buyers because it is the maximum amount of loss. It may seem that the seller is taking big
risks. However, if he sells the option carefully estimating the maximum rise the asset can make, he
can pocket the premium free. It is found that buyers of calls are usually losers. Sellers can also
lose heavily if prices jump out of the seller‟s estimates. Thus buying and selling of calls taken as a
speculative activity is risky.


BY now, it may be clear that a Call Option is a separate instrument derived out of the price of an
asset. Therefore options become a tradable instrument. A call option on stocks is a right to buy
stocks in future at a stipulated strike price. This right can be traded among option traders. For
example, if an option trader buys a call option on MSFT at strike25 paying $2 premium, he can sell
that option to others. If price of MSFT goes up, the value of his options too goes up. For example
MSFT rises to $30. This means that a call at 25 strike price has an intrinsic value of $5 now.
Therefore the premium on the call must reflect this increase in the asset price. A seller of 25 strike
call at that price ($30) will ask for a $5 increase in option premium. Therefore prices of call options
can go up or down depending on the stock prices. Our original buyer now sees the premium on the
call he bought going above $5. He can sell that call at the higher price and take his profit.
Speculators take this opportunity to make some quick money.
Suppose a speculator buys 1000MSFT call options at the strike price25 paying $2 premium when
it is trading at $25 in the cash market. His total cost of options is $2000. If he wants to buy 1000
MSFT shares from the spot market he must pay $25000. If the share price goes to 30 after a few
days and his call option has buyers at $6.75 he can sell his calls and take a profit of 6.75-2=4.75
per share. Then his profit will be 4750 before paying brokerage. In the cash market the buyer of
MSFT pays 25000 and gets $5000 profit. The percentage profit in the option market is very high
(4750/2000*100). This is a very attractive proposition for speculators. Therefore a large number of
option traders buy and sell options assuming a likely (profitable?) direction. However there is an
opposite side to this story. The call options bought will have a contract expiration period. If the
share price of MSFT does not move above $25 in the cash market, he can wait for the shares to
move up for any number of months. It should be clearly understood that the option buyer assumes
a directional movement on MSFT. He can be totally wrong. At each month of waiting, his capital is
eroded and finally he may lose all his capital. Another problem for the buyer of call options is that
the premium of the call is related to risks faced by the seller. The risk to the seller depends on
volatility and time to expiration. As the time to expiration approaches, risk related to time goes
down exponentially. If MSFT closes at $30 on expiration and our buyer of the call waits till the last
date he receives just $5 from the exchange. The premium he has paid is lost. If MSFT remains at
$25 he loses $2000.
                      Option prices are related to many variables. If MSFT is trading at $25 in the
cash markets and calls at 25 strike price,( who?) receives $2 premium. A call at 20 strike price may
have a premium in excess of $5 because the seller receives $25 even otherwise when he sells his
share. $2 he paid for 25 strike call is purely time value. Similarly premiums on all the calls above
25 strike price consist only of time value. The risk faced by the seller on calls above 25 strike price
goes on diminishing as the strike prices go up. This happens because the probability of out of the
money call option reaching in the money is comparatively less. Thus premiums on calls depend on
strike prices and spot prices.
Another factor that influences the option prices is the time to expiration. The probability of a call
option reaching in the money increases if time to expiration of the contracts is more.
Volatility in the stock prices can affect option prices too. Volatility increases due to specific and
systemic factors. Higher volatility increases risks for writing options. Therefore there will be
increase in option premiums.
Interest rates also affect option premiums. Call premiums are seen to go up when interest rates in
an economy increases
The ratio between change in option price and change spot price is called delta of an option. At the
money options have delta of 0.5. Deep in the money options have delta of one. Out of the money
options have deltas less than 0.5 depending on how far they are from current spot price. It is found
that delta is actually the probability of an option reaching in the money

To be continued

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com
                                       SELLING CALL OPTIONS

A call option on a stock is a contract in which the seller agrees to sell shares at a promised price if
the share price remains above the strike price at which contract is made. If the share price remain
below the strike price on expiration of the contract the seller gets the premium received free. It is
this free cash that prompts the speculator to write such contracts. More over his risk is reduced by
the premium on hand. For example an option seller who sells MSFT at 25 strike price receives $2
premium. Therefore his loses start only when MSFT closes above $27 on expiry. However the
seller often forgets that he is buying the risks of some else who may be more knowledgeable than
him. However selling call options looks slightly better than buying a call option. But there is a
higher risk lurking behind the seller. Share price of MSFT can move up above $25 to any higher
price within the period of contract. For every dollar rise above 27 the seller loses 100 dollars
because one lot of an option contract is 100. There is no limit to the losses. Therefore a seller of a
call option is required to provide ample margins to the exchange to avoid default in case of big
flare up in prices. Under normal conditions big flare up may not occur. However nothing is
impossible in stock markets and a seller of such naked call options will face an uncontrollable price
rise once in a while at least once his life. This results in heavy losses and he will probably lose all
his profits and capital in one such incident. Therefore selling call options as a speculative activity
should never be done. It should be noted that the seller is assuming a direction when he sells call
options. That is why it becomes a speculative activity.
However, selling call options can be a very profitable activity with no risk, when it is done with the
asset in hand. Suppose an investor has 1000 MSFT in his possession, bought at $25. He can sell
1000 calls at strike25 for a premium of $2 now. If MSFT remains below $25 on the day of
expiration he gets the premium free. Then his cost of MSFT becomes $23. This can be repeated
any number of times. An astute option trader may even make his cost of MSFT zero by this
method. Suppose MSFT closes at $30 on expiration at some month. Then the option trader sells
his shares in the spot markets at $30 and pays the derivative exchange $5 as his loss. However
he has received $2 as premium on the calls bought. His profit is limited to $2. Clever option sellers
select strike prices in such a way that chances of shares moving over their strike prices are made
very unlikely. For these option sellers, option premium is a steady income every month for an
asset that remains in his account. This type of call option selling with asset in hand is called
Covered call. When an option seller resorts to this strategy his margins are not much because
there is no risk of default. There are millions of households that have good shares kept as
investment. These house holds can make steady income by selling covered calls. Most of these
house holds refrain from such activity due to ignorance or due to fear of losing their shares. It is
wrong to think so. Shares are bought to get capital appreciation. A covered call writer never sells
his shares at a loss. More over there are strategies to make money from cash received from selling
the shares. It will be explained at a later stage.
It should be noted that a covered call is initiated when the share price has a limited chance of
going up much. If there is a big flare up in prices the shareholder will lose his potential profits.
However, no one has lost by booking profits. Therefore covered call strategy should be executed
by all share holders. Gradually he will find the cost of shares becoming nil. As he has shares in
hand he gets dividends, bonuses and splits. It is easy money without effort.
                            HEDGING STRATEGIES BY CALLS
Options are derivatives as they derive their value from other assets. Options are also used to
reduce risks in asset markets. There are excellent methods to reduce risks by using calls.
As has been explained before writing naked calls is a very risky strategy. However speculators
often do that lured by the easy money. There is a method to reduce the risk in naked calls by
buying calls at a higher price. Let an option writer sell 1000MSFT calls at $2 at the strike price $25
with out possessing the shares. The derivative exchange credits $2000 in his account and asks for
a huge margin as the risk in this position is unlimited. To reduce this risk let the option writer buy
1000 MSFT calls at 27 strike price paying $1. If MSFT remains below $25 on the day of expiration
the seller of the options gets $1 per share as profit. If the share price at closing is above $27 the
option writer loses one dollar per share, whatever be the rise. Here his loss is limited to $1000 by
buying the calls at 27 strike price. As his maximum loss is $1000 the exchange collects only $1000
from him as margin. When such a strategy is executed the option seller assumes a direction to the
movement of share price. He assumes that MSFT will fall. In such a case his maximum profit is
$1000 and maximum loss is also $1000. Most often maximum losses will be more than maximum
profit. More over the chances of MSFT remaining below $25 is often less than 50%. Therefore
executing this strategy is not wise. When one execute a strategy one should have a pay out ratio
greater than 1.Also the probability of getting profit must be greater than 50%. Still many experts
advise this strategy. This strategy is called a bear spread. The name comes up because the seller
expects the share price to fall.
Most of the speculators are reckless and assumes a direction to the market. Some times he may
be correct and more often he may be wrong. Most reckless speculators buy and sell future
contracts depending on their assumed direction. If they feel that market is bullish they buy future
contracts. Here the losses can be unlimited if markets crash unexpectedly. Most of the losses from
crashes result from over night positions. The losses from such positions can be reduced by selling
calls. For example let a speculator buy 1000 MSFT futures at $25. He can lose a lot of money if
the share price falls. However the speculator can sell 25 strike calls at $2on MSFT against the
futures he bought. If share price falls he is protected by this $2 cushion. It is an 8% cushion which
is quite reasonable under normal conditions.
If a speculator sells 1000 futures contracts on MSFT at $25 he can lose huge amounts if share
price goes up. He can reduce his losses by buying calls at 25 strike paying $2.If share price falls
below $23 he gets profits. His maximum loss is limited to $2 per share.
Many speculators buy calls when they are moderately bullish on a stock or an index. He will lose
his premium paid if the share price remains below his strike price on expiration. With speculators
this happen more often. His losses can be reduced by selling calls at a higher strike. For example
a speculator buys 1000 MSFT calls at 25 strike paying $2 premium. If the share price remains
below 25 on the day of expiration he loses the investment. He can reduce the loss by selling 1000
MSFT calls at strike 27 receiving $1 as premium. Then his maximum loss is limited to $1000. This
strategy is called bull spread because the option buyer expects the share price to go up
In all these strategies the risk reward ratio is below 1. Probability of getting a profit also is less than
0.5. Therefore these types of strategies are not advised. However most of the experts recommend
these strategies without any accountability about the outcome.
 There is a strategy named ratio call spread which is a modification of bull spread using calls. Here
a speculator buys an out of the money call and sells twice or thrice the number of the first call.
Suppose a speculator buys a call at 27strike price on MSFT when it was trading at a spot price of
25 paying a premium of $0.75.He then sells two calls at a strike price 29 receiving a premium of
$0.5 each. If MSFT closes below 31.25 there are no losses. It looks like a very safe strategy.
Normally it is very safe. However when share prices move above 31.25 losses can be prohibitively
high. It can happen once in a while causing immense damage. Losses can be unlimited if big
moves appear over the period of the contract. Hence these kind of strategies are never advised by
prudent strategists.

To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com


A call option is a right to buy assets at a future date. Therefore they are for potential investors. It is
quite natural that there exist options for holders of assets too. All those who have bought assets for
investment fear that the prices of their asset might fall in future. This fear is true and there are
options to reduce this risk also. Consider an investor who has bought 1000MSFT at $25. He wants
to get some protection if price of MSFT falls in future. In the derivative markets there are traders
who will take this risk for a price. As the price demanded by the seller is related to his risk, amount
received by the seller is in the form of a premium. The seller of this option gives the buyer a right to
sell his asset at his stipulated strike price if the price of the asset falls below that contract price. In
effect buyer of this option gets a right to put his shares on the seller of this option if the price falls
below the strike price at which option is written. Therefore such options are called put options. Put
options are derivatives because they derive their value from some other asset. In our example the
asset is MSFT.
When a put option is sold the seller takes some big risks. If the price of the asset falls below the
strike price on the expiration date, he will be forced to take it at the contracted price. This will result
in big losses as he purchases an asset that has fallen considerably from the contracted price.
Therefore seller of put options will assess his risks well and estimate the likely losses before he
attempts to write a put option.
The choice of the strike price is also with the buyer of the put option. If MSFT is trading at $25 in
the spot markets, many strike prices above and below 25 will be provided by the exchanges. For
example our investor can buy put options at 24strike price. As the asset is trading at 25, writer of a
put option at 24 has less risk writing this contract. If the investor chooses a strike price 26 the
writer of the put option takes more risks because the asset is trading one dollar above the strike
price. This results in more premiums.
Therefore premium of a put is related to variables like spot price, strike price, interest rates and
time to expiration. Option at strike price at 25 is called ATM (At The Money). All options above 25
are called OTM (Out of The Money). Put options below 25 are called ITM (In The Money).
Put options are meant to reduce risks to holders of assets. When put options are bought by
investors of assets, they transfer the risk to sellers for a fee. Most of the writers of put options are
speculators. They estimate the probable level to which the asset price may fall and sell puts below
that. If the asset price remains as per their expectations they get their premiums free. This is easy
money. Even far out of the money put options would have some premiums. Astute option sellers
write such puts every month and get interest on the money they pay to exchange as margins. This
is very lucrative as long as it works. However all the profits and their capital will vanish when the
share price plunges sharply. This happens at least once or twice in ones life. As the consequences
are deadly writing even far out of naked puts is very risky.
Similarly speculators buy puts assuming that asset prices will fall. Here they are taking a direction
to the markets. It should be noted that there are speculative buyers and sellers of puts and they
can not be right at the same time. If a speculator buys puts and market goes up he loses the
premium he paid. If this is repeated many times he will lose all his capital. Thus buying puts as a
speculative activity is also very foolish. However brokers and advisers generally publish their
achievements in taking directional calls with no accountability. Poor investors and traders naturally
fall for these claims.
However, selling put options can be utilised by investors to buy their stocks at very low prices with
no risk. This strategy is popularly known as covered put strategy. Suppose an investor wants buy
1000 MSFT. MSFT is trading at $25 in the spot market at that time. The investor wants to buy
MSFT at a price of $23. He has money in the bank. He has two options. He can wait for MSFT to
come down to 23 and buy it then and there. He may have to wait many months to get it at that
price. Instead of that he could sell put options on MSFT at strike$23 getting a premium of $1. If
MSFT does not close below $23 the investor gets $1 premium free. Writing of puts at $23 can be
undertaken every month till MSFT closes below$23. Suppose it took ten months for MSFT to close
below$ 23. By this time he would have received $10 as premium free. Then the cost of his MSFT
would have fallen to $23-$10=$13. This is a highly attractive price. Had he not written puts at $23
strike price his MSFT would have cost him $23 after ten months. There is no risk in this trade
because the investor is ready to buy the asset and has the funds for that. He could also have
selected his price at $21 and wrote puts at strike 21. However the premium on strike$ 21 would
have been very less. This strategy can be used to generate interest on margins by investors on
idle money in the bank.

Speculators buying puts and selling puts are usually losers because they assume a direction to the
market. This assumption has only 50% chance of being correct. However there are methods to
reduce the losses by using puts in such cases also. Suppose a speculator sells 1000 puts on
MSFT at srike25 at a premium of $2 when its spot rate was $25. His losses can be substantial if
MSFT falls considerably. Therefore he will be asked to pay a big sum as margin by the exchange.
However his potential losses can be reduced and margins too brought to very small amounts by
hedging his sold puts by buying puts at a lower strike price. For example the trader can buy 23
strike price puts at a premium of $1.when a speculator does this, the puts bought will take care of
what ever fall MSFT makes after 23. He already has a receipt of $2 from the sale of put options.
Therefore his maximum loss is now reduced to $1000 paid for the put at strike price23. Therefore
his margin will also be reduced to $1000. Here the speculator assumes an upward direction to the
share price. Hence this strategy is called a bull spread by puts. His maximum profit is now reduced
from $2000 to$1000. It will be seen that risk reward ratio is below 1 in all such hedging strategies.
Probability of getting some profit also is less than 50% in such strategies. Therefore this is not a
good strategy.
In the case of speculator buying puts he will lose his premium if share remains above the strike
price. He expects the share price to fall. By selling puts at a higher strike price he can reduce his
losses if share price remain above his strike price. Suppose a speculator bought 1000MSFT puts
at strike price 25 paying $2. His maximum loss is $2000 and occurs when MSFT remains at 25 or
above 25 on expiration. This loss could be reduced by selling 1000 MSFT puts at 27 strike price
receiving a premium of $1. If MSFT closes above 25 on expiration date the speculator losses
$2000-$1000=$1000 from his position. By selling the puts he reduced his losses to $1000. Here
also risk reward ratio is less than one and probability of profit is below0.50. Therefore this strategy
is also not advised. As speculator expects the share price to fall this is called bear spread using
Most speculators are quite reckless and never think of the consequences of their trading methods.
Most of the them believe strongly in Technical Analysis. Some may have charting software also.
Their blind faith in Technical Analysis might lead them to ruin on many occasions. These
speculators buy futures in indices and single stock assuming a direction based on Technical
analysis. Since trading in futures is very risky puts can be used to reduce risks in their positions.
Suppose a speculator is long on 10 contracts of SPY futures at 110. If SPY goes down he loses
money. There is no limit to his losses. However his losses can be reduced by buying puts on SPY.
There are puts at 110 available on SPY. Suppose SPY puts at 110 strike is available at $3. If he
buys 10 SPY put contracts at strike price 110 he pays $3000. If SPY goes down below 107, all
loses below that will be taken up by the puts. Thus buying puts at 110 strike converted his
unlimited losses to a loss of $3000. As he is long in SPY, he gets unlimited profits if SPY goes up
considerably. Thus spending $3000 provides him a certain amount of insurance.
Similarly many speculators sell futures contracts based on Technical Analysis. These people also
face unlimited losses if asset prices move up considerably. Suppose a speculator has shorted 10
contracts(1000) on SPY at 110. He gets unlimited profits if SPY falls considerably. He faces
unlimited loses if SPY moves against him. Here the speculator can sell 10 contracts of SPY puts at
strike 110 receiving$3as premium. If SPY moves up above 110 he is protected up to 113 by these
There is a strategy called ratio put spread which is a modification of bull spread using puts. Here
the speculator expects a limited downward direction to the market. He buys an out of the money
put and sells twice or thrice the number of far out of the money puts. Suppose MSFT is trading at
$25. He buys a 10 put contracts at 23 strike paying $0.75. He also sells 20 put contracts on MSFT
at 21 receiving $0.5 per put as premium. Here his receipts are $1000 and payments are $750. If
SPY goes up above 23 he gets $250 as profit. If SPY goes down he gets his maximum profit at 21.
He receives a profit of $1250 from his 23 put and $1000 from his 21 puts. His loses start at 18.75.
This strategy may look very safe as losses start only far below the current price. However the
losses can be considerable if MSFT falls below 18.75. These unusual happenings are quite usual
in stock markets and even a careful speculator will lose his capital when such events happen.
Therefore this strategy is not advised.

To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

Sellers of naked calls face unlimited loses if the price of asset they sold goes up. For example if a
speculator sells 1000 MSFT calls at strike 25 for a premium of $2, his loses starts when MSFT
closes above 27 on expiration date. For every dollar rise in price above27 he loses $1000.
Similarly if a speculator sells 1000 MSFT puts at strike 25 for a premium of $2 his losses will start
when MSFT closes below 23 on expiration date. Every dollar fall below 23 will cost him $1000.
Suppose our speculator sells 1000MSFT calls and puts together at strike 25, he gets $4 as
premium. Now his loses start at 29 on higher end and at 21 on lower end. It is easy to see that his
risk is now reduced. Thus selling a call and put at the same on the same strike price will actually
reduce the risk. Therefore exchange will ask for lesser margin when a speculator does it. This
strategy is called short straddle. A lot of speculators execute this strategy because of its many
It has less risk
It requires less margins
The speculator receives$4 premium free if MSFT closes at 25 on expiration date.
There are no losses if MSFT closes between 21 and 29.
It is this wide protection that makes speculators go easy on this strategy. When volatility is low this
strategy might work very well and speculators will have a field day executing it. However when
prices move violently due to unknown reasons, this strategy fails miserably and causing big losses
to speculators. Here the losses are unlimited below 21 and above 29. All speculators should
always be careful not execute any strategy that has unlimited risk even when the chances of an
event precipitating it is very low. It is always true that all those execute this strategy will be
strangled once at least in their lives.
                     There is another equally foolish strategy called long straddle. As the name
suggests it is the reverse of short straddle. Here the speculator expects the share prices to move
either up or down widely due to some price sensitive news. For example the failure of a merger
between two big companies can produce violent gyrations in their prices. It is quite an expensive
strategy and its failure will cost the speculator a lot of money.
For example some news is expected on MSFT, say court verdict. If the verdict is adverse share
price can crash. If it is in favour price may shoot up. A speculator buying a put and call at strike 25
pays $4. It is quite risky to take chance like that. But once in a while it works. But once in a while is
not always. A good strategy is that one works always. Therefore long straddle is not a good
              There are many strategies like the above that are very dangerous. One such strategy is
a modification of short straddle. However this is executed using a futures contract and two calls.
Suppose a speculator sells two calls at 25strike on MSFT receiving $4 as total premium and buys
a futures contract at 25. This strategy produces losses when MSFT moves over 29 or goes below
21 on the expiry date. This has the same risk profile of a short straddle and hence should be
           The strategy above can be executed by using puts too. Here the speculators sells 2 puts
on MSFT at 25 receiving $4 as premium and sells a contract of futures at 25. Here also losses
come when MSFT falls below 21 and above 29. Thus all these have the same risk profiles that
make them quite dangerous when markets go up or down widely. As everybody knows volatility
appears without any warning and those have the habit of executing strategies like short straddles
will be caught unawares of and lose all their profits and capital at one go.
The point is that in stock markets if something can go wrong it will go wrong. It is only a matter of
time that one gets caught in the tsunami. A good strategist always distances himself from potential
ruin whatever thin chances that have. However advisors and analysts have no such compulsions
when they suggest all sorts of strategies. Accountability is not a word in their Dictionary

Straddles are very risky strategies while strangles are a bit less risky. Returns from strangles are
also lesser. In our example of short straddle MSFT calls and puts at 25strike price were sold
receiving $4 premium. MSFT was trading at $25 when such a strategy was executed. In the case
of short strangle the speculators sells out of the money calls and puts. Here a speculator sells 21
strike price puts and 29 strike price calls instead of 25 strike call and put. His receipt is now $1.0
(0.5+0.5). Here his loses will start only when MST falls below 20 or MSFT closes above 30 on the
expiration date. It can be seen that short strangle is lesser risky. But one should note that MSFT
was trading at $25 when this strategy was executed. The contract period was one month with say
22 trading days. Expecting MSFT falling $5 is not be expected normally. In fact it is a
5/20*100=25% fall. Therefore loses in this strategy normally do not occur. However his profit is
only $1 and for 10 contracts on MSFT he gets a maximum of $1000. What happens when
abnormal things happen?
 A 50% fall can wipe his capital out easily. Amateurs will say that is impossible. Well that is a
foolish belief that comes out of immaturity and lack of experience. It comes many times in ones life
time. Capital once gone is not going to come back unless one can print notes like the US
Government. Therefore short strangle is another strategy that create dangerous out comes for
those listen to brokers and derivative strategists.
 Long strangle is a strategy that works well when wide variations in prices are expected. A typical
example can be illustrated from India. India‟s premier stock Exchange is the National Stock
Exchange of India (NSE) and its index is called S&P CNX NIFTY. Election results of India were
supposed to come out on a Saturday and NIFTY closed at 3683 on Friday. Till that time left parties
were playing the Old Man of the Sea preventing the previous Government doing anything
sensible. A hung parliament was expected after the results. No one has any idea about the out
come of the results. Many smart speculators bought 3200 puts and 4000 calls paying small
premiums totalling Rs40. The results were totally unexpected. Left parties were annihilated and the
previous Government got a mandate to rule independently without the help of left parties. NIFTY
on Monday after elections opened above 4300 levels and went for a sealing.
Every one who bought 3200 puts and 4000 calls got more than Rs260 profit per NIFTY on that
day. It was like a lottery for the smart speculators. Thus buying far out of the money calls and puts
on occasions like that may produce windfall gains. Such occasions like that comes once in a
lifetime. Proclaiming such strategies as fool proof is beyond reason and speculator will lose in nine
out of ten occasions when such wide movements do not occur.
Thus short strangles and long strangles have some minor advantages when compared straddles.
But that does not qualify them as good strategies. Short straddles and short strangles are good
when volatility is low. Long straddles and long strangles are good when volatility is high. But high
implied volatility is appears all on a sudden with no advance knowledge. It comes as the out come
of some specific news about a share or markets as a whole. In every market big gyrations appear
once in a while and those who have positions at the wrong end usually end up bankrupt. But those
who execute long strangles and long straddles may get some windfalls once in a while. But the
cost of executing them in failed cases will be much more than what they gain in cases of success.
Therefore executing strategies like these is not advised.
                            THE END OF THE TUNNEL
 The search for a strategy that works under all conditions of volatility has led us to the analysis of
almost all text book strategies. Except for two strategies namely covered call and covered put
strategies, all are found to have serious risks under high implied volatility conditions. As has been
repeatedly emphasised, high volatility destroys speculators who are at the wrong end and those
who execute strategies that have any chance of big losses will come across then inevitably at
some point of time.
 Therefore a perfect strategy must overcome big losses under any volatility conditions. In addition
it should have high profit/loss ratio. The probability of profits must also be high.
There are four strategies that qualify for the above conditions. These are also text book strategies.
All text books describe them as best for conditions where volatility is low. In the over all pay off
analysis also they would look to be perfect under low volatility conditions. As these are
complicated strategies ordinary speculators never attempt them. Therefore they are not well
known and are seldom used. I will explain each of these strategies with examples and show how
much risk is involved in executing them
1 Short Iron Condor
Short iron butterfly is a textbook strategy and is considered to be a very safe strategy and usually
executed by experts in option strategies. However I will show that this strategy is not that safe
when high volatility occurs in the markets.
A condor is a South American Vulture with a very wide wingspan. This strategy is executed with
out of the money calls and puts. Suppose a speculator sells 27strike price MSFT at a premium of
$1 and buys 30strike price call at 0.40. For 10 contracts he will get a profit of $600 if MSFT
remains below $27 on the date of expiration. His losses will be $2400 if MSFT closes above $30.
This is a short strangle with calls.
Suppose the speculator sells10 contracts of MSFT at 23strike price puts at $1 and buys 10
contracts at strike 20 puts at $0.40. His maximum profit is $600 when MSFT closes above 23 on
expiration. His maximum loss is $2400 when MSFT closes below $20 on expiration date. This is a
short strangle with puts.
Suppose the speculator executes both the strategies together. When he executes these together
he is hedging the upsides and downsides by buying calls at 30 strike price and puts at $20 strike
price. He is in receipt of $2 from calls sold at 27 strike and puts sold at $23. He loses $0.8 for the
calls bought at strike $30 and puts bought at strike 20. Therefore he has a net receipt of $1.2 per
MSFT. Therefore this spread is a credit spread and requires margin.The calls bought at strike price
30 will take the responsibility of the calls short at strike 27. If MSFT moves over $30, call premiums
of 27 strike calls and call premiums of 30 strike calls will move up. However their rates of increase
will not be equal because 27strike call is ITM (In The Money) where 30 call is only ATM. Former
has a delta of 1 and latter has a delta of 0.50. But on the closing date of options closing price in the
spot market is taken for the closure of futures and options in the derivative markets. If MSFT
closed at 35 on the date of expiration, call at 27strike price will result in a loss of $8 and call at 30
strike price will produce a profit of 5. Put at strike 23 and 20 will expire worthless because MSFT
closed above 23. Now this will result in a net loss of $3. But he has received a net premium of $0.6
from the call sold at 27strike and another $0.6 from the put sold at 23strike. Hence maximum loss
from this strategy is 1.8 per share.
Now his maximum profit is $1200. This occurs when MSFT closes in between $23 and $27 on
expiration date. His maximum loss is now $1800. It can be seen that profit has doubled to $1200
and loses reduced to $1800. Thus combining these two strategies has increased his profitability
and reduced his losses.
                             His loses start when MSFT closes above$28.2. Similarly his loses start
when MSFT closes below $21.80. This is quite a big spread. It can be seen that profit/loss = 0.67.
Also probability of profit is very high. But abnormal circumstances some times occur and then
there will be big losses.
Major difficulty with this strategy is that the trader should hold the positions till expiry to get profits.
Holding positions for longer times invite more risk and chance of loses is higher. It should be noted
that all the options involved are far out of the money and their sensitivity to changes in spot prices
is not much. In short the deltas of all options are very low. Therefore normal changes in spot prices
have not much influence in the prices of options except changes due to time value. As the deltas
are low, loss in time values affects all options almost equally. Therefore closing the positions with
profit before expiration is difficult.
 As there are calls bought to hedge the calls sold at 27 strike price, no spikes in prices in spot
market will cause big losses to the speculator. Similarly there are puts bought at strike 20 to hedge
against puts sold at 23 strike price, no big fall in MSFT prices can cause any big damage to the
speculator. The maximum loses are already fixed.
There is a possibility of reducing the spread to say 27-29 on the upper side and 23-21 on the lower
side. Instead 28-30 spread at higher end and 22-20 spread at lower end can also be tried.
However, these may reduce loses. But the probability of profit will come down too.
Therefore, short iron condor is not considered a good strategy.

To be continued

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

2. Butterfly spread using calls

Butterfly spread is a good strategy when there is not volatility. This strategy also has self protection
against big moves. However this can also produce limited amount of loses when market makes big
moves. This strategy can be executed with calls and puts.
First let me take the execution of the butterfly spread using calls.
In this case the strategist sells two calls at 25 strike price on MSFT and at the same time buys one
call at 21 strike and another at 29 strike. Since the spot price of MSFT is $25, the call at 21strike
price is deep in the money and call at 29 strike price is deep out of the money. Intrinsic value of a
call at 21strike price is $4. With time value added this call will have a premium above $6 at the
beginning of a new series. Call at 29 strike price will have a premium of $0.5. Therefore the
strategist will be paying $6.5 for the calls he bought. He will be receiving $4 for two calls he sold at
25 strike price. It should be noted that the strategist is a net payer to the exchange and hence this
spread is a debit spread. No margin is therefore required.
If MSFT closes at 29 on the date of expiration, his call at 21 strike price will give him a profit of $2.
The calls sold at strike price 25 will produce a loss of $4(8-4). Call bought at strike price 29 will
expire worthless giving him an additional loss of $0.5. Therefore his maximum loss if MSFT closes
above 29 on the date of expiration is $2.5. In the case of MSFT closing at 21 on the date of
expiration his calls bought at 21 strike price and 29 strike price expires worthless giving him a loss
of $6.5. Similarly the calls sold at 25 strike price will also expire providing him with a profit of $4.
Thus his maximum loss if MSFT closes below 21 is $2.50. His maximum profit comes when MSFT
closes at 25 on expiry date. In that case his call bought at 21 will give him a loss of $2(6-4). His
call bought at 29strike price expires worthless giving a loss of $0.5. But he gets the premium on 25
strike price free because MSFT closes at 25.Therefore maximum profit he gets is $1.5. For 10
contracts on MSFT his maximum profit will be $1500 and maximum loss $2500. This is not a good
risk reward ratio.
There is another defect for this strategy. Since call at 21 strike price is deep in the money its delta
is 1. If the share price goes up its delta remains the same. Call at 29 strike price is far out of the
money. Therefore its delta is very small. Therefore it will not move up much even if MSFT goes up
above 25.
But consider the delta of 25 strike price calls. When MSFT is trading at 25, its delta is 0.50. If
MSFT goes up its delta starts increasing because it is becoming more in the money. Since there
are two calls sold at 25strike price, cumulative increase in premiums on them will be much more
than the premium on call at strike 20. Premium on call at 29 remains static because its delta is
very small.
This results in a situation where the strategist finds himself stuck with this positions till expiration if
MSFT moves up above 25. It will become difficult to get out of the positions with moderate profit, if
MSFT is above 25. Therefore the strategist is left to a chance of MSFT closing near 25 at
expiration. The probability for the same is very low.
A similar situation arises when MSFT trades below 25. Call at 20 strike price has a delta of 1 and
is deep in the money. Therefore when MSFT trades below 25 ,its delta remains nearly one and
premium goes down faster than 25 strike price calls. In fact delta of 25 strike calls starts going
down because they are becoming out of the money. Hence premium on 25 strike price calls will
not diminish much as the share price goes down. This also creates a situation in which the
strategist is forced to hold the position till expiration. His chances of MSFT closing near 25 are very
 Considering the risk reward ratio and the low probability of getting any profit, this strategy is not
very useful in the practical situation.
Therefore this strategy also is not advised.

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com

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