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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)
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Chapter 1
Introduction
1.1 Background
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
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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.
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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-the-
money, 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 2012.
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.
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