Thursday, December 24, 2015

Selling put options: An approach at reducing the purchase cost of a stock...

A Big Note: Author do not encourage a retail investor to trade in Options. 
Most of the retail investors use the facility of 'Limits' to buy the stock at a lower value. Here is how it works.
Let us say that you have a short term bearish view on ICICI Bank. The share is trading at 265 and your target purchase price is 260. So you place a 'Limit Buy' order to buy ICICI Bank at 260. If the price falls to 260 your order is automatically executed.
This is the simple method. The problem in this approach is that if the price do not fall to 260, you do not gain anything.
There is a better, albeit (a word which is so much better than 'but') riskier approach. It involves selling options. This is a method often used by Warren Buffet to lower his purchase cost.
Assume that ICICI Bank Rs.260 Put Option is trading at a premium of 8 rupees. You sell Put Option. This will immediately get 8 rupees in your account. If the price of ICICI Bank do not touch 260 in that month, you are richer by 8 rupees. Assume that the price falls to 258 at the end of the month. You will be expected to close your Option Sell by buying ICICI Bank share at a price of 260 which was your original purchase price. 
Net-net, you paid 260 rupees for a share of ICICI Bank and received 8 rupees. That makes your purchase cost for ICICI Bank share to Rupees 252 per share.
If you had used Limits, your purchase price is Rs.260. By using Options, you have reduced it further by another 8 rupees. 
This is simple process but with a few Caveats.
One, if you are working with options, you have to transact in a given lot size. For example, the lot size of ICICI Bank is 1700. This means that if your option is exercised (share price falls below 260) you have to buy 1700 shares of ICICI Bank. This will make this approach unattractive for many small investors.
Two, having an open 'Sell' position in options is very risky. Theoretically you can incur huge losses with an open position in options. Be very careful.
Three, I have not considered brokerage charges. Normally, brokerage is very high for option transactions. Brokerage could make the above trade unattractive. 
Four, Options are highly knowledge intensive and concepts intensive. Never venture into Options trading without having a rigorous conceptual understanding of Options and the risks involved.
For taxation purposes, Option trading is considered to be speculative transaction and the income is considered to be speculative income and is treated as such. Get a clear understanding of the tax implications before trading actively in Options. 
A Big Note: Author do not encourage a retail investor to trade in Options.