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Tuesday, Sep 24, 2002

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Buy October puts on HPCL

B. Venkatesh

THE following are some buy/sell strategies based on Monday's trading in the derivatives segment at the NSE:

Equity options

HPCL: The outlook on the stock remains negative. The price projection on the downside is Rs 177, and that on the upside is Rs 207. Though the upside-downside projection appears symmetrical, note that the likelihood of the downside is higher.

Consider buying the October 180 puts. The puts are trading at a 38-per cent discount to the theoretical price. This provides a high margin of error for forecasting volatility (vols). Note, however, that the theoretical edge, and consequently, the margin of error, may well become zero, as the stock volatility could fall sharply.

The directional risk is low, as the option, being deep out-of-the-money, carries low delta. The vega risk is also low, which suggests that puts will not rapidly lose value due to fall in vols. The loss due to time decay, which is the cost for buying the gamma, is high. This means that the puts will rapidly lose value unless the stock moves down fast.

If the stock moves to its downside price projection, the puts will generate 130 per cent profits. If the stock, however, moves up to Rs 207, the puts will loss 55 per cent. That the open interest in the 180 puts has steadily risen since September 12 only adds credence to the estimated payoff matrix. Note that the puts will also lose value if the stock sits still. Do not hold this position for more than 7 days.

HLL: The outlook on this stock appears negative. The price projection on the downside is Rs 166. Consider buying the October 180 puts, which are cheaper than other puts on the stock. Note, however, that all puts are trading rich in terms of implied vols. The 180 puts are currently trading 15 per cent higher than their theoretical price. This provides no margin of error for forecasting vols. The directional risk is high, as the option delta is 64. This means that the puts will approximately lose (gain) 0.64 point for every point for every point increase (decline) in the stock price. The vega risk is low, as also the trade-off between theta and gamma.

If the stock moves to its downside price projection level, the puts will generate nearly 100 per cent returns. If the stock, however, moves up to Rs 191, the puts will tend towards zero. Do not be alarmed with the symmetrical payoff matrix. The puts can generate profits, as the likelihood of the stock moving down is higher. Do not hold the puts for more than 9 days.

Index options: The immediate outlook on the spot index appears negative. If you want to bet on the index falling in the next two days, consider buying the September 960 puts. These puts are cheaper than other puts on the index. The puts are trading rich and therefore do not carry any theoretical edge.

The directional risk is low, as the option delta is only 29. The vega risk is low, but the time decay is very high, as the option has just three days for expiration.

If the spot index falls to 952 by September 25, the 960 puts will generate 165 per cent returns. If the spot index, however, rises, the puts will be worthless. Initiate this position only if you can afford the risk your capital. Do not hold this position for more than one day.

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