Are options different?

India's financial markets are about to see something truly new: options trading. For all these years, the Indian ``spot market'' for equity has operated as a futures market, so the understanding and intuition into futures is widespread. Hence, when futures trading appeared, it was easy for India's traders to switch from trading futures on stocks to futures on index. In contrast, options are interesting, and new, in important ways. One common idea that has been often expressed is that ``selling options is very dangerous''.

In order to think about this question, let us start with futures. Futures positions have ``unbounded payoffs'', which means that a buyer of a futures can have profits ranging from -100% to infinity. The same is the case with the futures seller.

In the case of options, there is one remarkable and new case: the option buyer can only have profits ranging from 0 to infinity. Once an option has been fully paid for, the worst loss which can take place is that the option can prove to be worthless. Things cannot get worse than that.

In contrast, the option seller is exactly like the futures buyer or seller in terms of the losses. The option seller can have losses as bad as a futures buyer or a futures seller.

Hence, the resolution to the question ``Is option selling profoundly different?'' is as follows. There are two groups of positions. One group of positions are those which (in principle) can have extremely large losses. These are :

The second group of positions contains only one member: it is the buy position on options. Buying options is unique, in that large losses cannot take place.

Now, in India, we have plenty of experience with futures, with both buy or sell positions with futures. If we are willing to accept buy or sell positions on futures, where very large losses can take place, then we should equally be willing to accept sell positions on options. There is no rationale which favours regulatory strictures against sell positions on options.

There have been proposals that only large institutions should be allowed to ``write options'' (i.e. sell options). This is as justified as a view that only large institutions should be allowed to buy or sell futures, i.e. to trade on the existing Indian spot market for equity. If India's retail market participants can buy or sell futures (i.e. trade on the equity spot market), then they should surely be allowed to sell options.

How should options be margined? That brings us to the next question: how should margins be calculated for options positions?

India is at the cutting edge, globally, in terms of the application of sound quantitative finance into the risk containment of the derivatives market. The index futures market explicitly uses the principle of ``Value at Risk'', at the client level, in calculating collateral requirements which have to be met.

This same idea is analytically sound and should be applied to options. The two principles which have been used on the index futures market should continue to be applied in the future: VaR should be computed on a portfolio basis, and it should be computed at the client level.

  Position 99% Value at Risk
1 Buy 200 Nifty futures 11,108
2 Buy 200 calls on Nifty (X=1200) 8,909
3 Buy 200 calls on Nifty (X=1400) 1,836
4 Sell 200 calls on Nifty (X=1200) 9,817
5 Sell 200 calls on Nifty (X=1400) 3,235
6 Buy 200 Nifty futures + Buy 200 puts @ 1500 + Sell 200 calls @ 1500 0

How much margin will be required? It all depends on the position. A few examples are shown in the table and explained here. All these use VaR calculations based on monte carlo simulation. Nifty is assumed to be at 1300. All positions expire in one month.

  1. Simple futures position We buy 200 Nifty futures. This proves to require an initial margin of around 4.3%.
  2. Simple in-the-money call We buy 200 Nifty calls with a strike of 1200. A deep in-the-money option is like a futures, so the margin is similar.
  3. Simple out-of-the-money call We buy 200 Nifty calls with a strike of 1400. Here, the margin becomes much smaller, reflecting the low variation of the option price when Nifty moves.
  4. Sell the in-the-money call Here we are ``selling options'' or ``writing options''. This is like a futures position since it is in-the-money.
  5. Sell the out-of-the-money call This is the opposite of the buy position for the Nifty call at 1400. Here, we get a low margin requirement.
  6. Illustrate portfolio margining. Portfolios generate interesting effects. For example, when we buy the futures, protect ourselves against the down-side through a put, and sell off the upside through a call, we get something that is riskless: i.e. it has a VaR of 0. The position shown here is a bond issued by NSCC that pays Rs.1500 at option expiration.
    This position is based on the idea of ``put-call parity'', a simple relationship between put and call option prices. It also serves as a litmus test of the margin system. A sensible margin system should generate a zero margin requirement for this position.

In conclusion, options are a truly interesting and important new product on India's financial markets. Options are the first nonlinear product. They make possible new and important kinds of risk management. For example, India's love of ``assured returns'' on mutual funds will finally be met using sensibly designed products, which combine index funds with insurance obtained through put options.

The recent announcement that options trading will commence soon is a step in the right direction. This is especially because derivatives on Nifty will start trading in Singapore on 25 September, so SEBI and NSE need to act quickly to ensure that liquidity builds up in India quickly.

There are concerns about how margins should be calculated for options. The ideas used in India's index futures market, based on `Value at risk', are analytically sound and cutting-edge by world standards. They should be consistently applied to the market for index futures and index options, on a portfolio basis, at the client level.

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