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Options Trading: Using Techinical Analysis As An Effective Tool For Trading ? A Live Study

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Options Trading: Using Techinical Analysis As An Effective Tool For Trading A Live Study

INTRODUCTION TO OPTIONS AND TECHNICAL ANALYSIS

l Objective

l What is an Option

l Some Important Terms in Options

l An Example

l The Indian Scenario

l Advantages of Option trading over Share trading

l What is Technical Analysis

l Advantages of Technical Analysis

l The Simple Moving Average Method

l A Live Study of Trading in Option Markets using the Simple Moving Average Method

1. Methodology used for the study

2. Illustration

3. Results

4. Caution

OBJECTIVE:

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Page 1 of 9Options Trading: Using Techinical Analysis As An Effective Tool For Trading ? A Live ...

12/6/2002http://www.indiainfoline.com/bisc/opti.html

Disclaimer Objective of this paper is to give an introduction to Options and Technical Analysis and more importantly give an idea as to how Technical Analysis could be used to get handsome returns in the Options market.

WHAT IS AN OPTION:

An Option is a financial asset, which is linked to another physical asset, in our case it is equity shares. A Share Option is a right to buy or sell a share at a particular price and the Option is exercisable at the choice of the Option buyer.

Right to buy is known as a Call Option

Right to sell is known as a Put Option

Thus, for example if Mr. A buys a CALL OPTION from Mr. B and the share price rises Mr. A will exercise the Option and buy the share at the decided price, however if the price falls, Mr. A has the option of not exercising his right.

IMPORTANT TERMS IN OPTIONS:

STRIKE PRICE: the price of the underlying share at which the Option is taken

PREMIUM: the price paid for purchasing the Option

EXPIRY PERIOD: the period for which the Option is valid and can be exercised

CONTRACT SIZE: there is a market lot for each Option , e.g. Infosys 100 shares , Satyam 1200 shares

AN EXAMPLE:

Let us take an example to understand the above terms:

Mr A. buys one contract of call Option of Infosys @ 3700 for a premium of Rs. 120/- for the month of October 2002.

*3700- Strike Price

*October 2002- Expiry Period

Thus, it basically it means that the Option buyer has the right to buy the share of Infosys at a price of Rs. 3700/-, whatever is the actual share price. Thus, if the share price rises to Rs.4000/-, the Option seller will pay him the difference of Rs. 300. However, if the share price falls to Rs. 3400/-, the Option buyer does not have to pay anything and loses the premium, which he initially paid.



THUS, AN OPTION BUYER HAS LIMITED LOSS AND UNLIMITED GAINS WHEREAS AN OPTION SELLER HAS LIMITED GAINS AND UNLIMITED LOSS

Depending upon the difference between the share price and the strike price.

THE INDIAN SCENARIO:

Share Options were introduced in India from July 2001, after the Ketan Parekh Scam. On May 14, 2001 the age-old carry forward system or badla, was banned from July 2, 200, which had basically allowed Ketan Parekh to rig prices. Futures and Options were started in place of the Badla system. This move was SEBIs attempt to adopt practices in line with the norms of developed markets. Also, to provide a hedging tool and to separate the speculators from the cash market, so that only real investors were present in the share market.

The Derivatives market is still in a nascent stage but is rapidly growing. The Current Daily Turnover in Stock Options is approximately Rs. 200 - 300 crores.

Another important feature of the Indian market is that there is only cash settlement of Options. This means that one cannot take or give delivery of shares by exercising his Option.

ADVANTAGES OF BUYING OF OPTIONS OVER BUYING OF SHARES:

1. Limited Loss, Unlimited Gains

Thus we can see that in Options, the loss is restricted.



2. Lesser Investment, Thus Better returns

We can see that to purchase 100 shares of Infosys one would require Rs. 3,60,000/-. However, to purchase the same Option one would require in the range of Rs. 8000 10000. Thus, if the share rises to Rs. 3900, one would get a 8% return, however the same would be a 200% return in Options.

3. Double Sided Protection

A person can buy a Call as well as a Put Option, thus he would make a profit as long as the share moves beyond the premium he has paid.

However, no short selling is permitted in the share market; hence one can make a profit only in case of a share price rise.

Now, Let us know a bit about Technical Analysis:

WHAT IS TECHNICAL ANALYSIS:

It is essentially a tool, which on the basis of past trends in the share price tells an investor whether to buy or sell or hold a share

ADVANTAGES OF TECHNICAL ANALYSIS

With the help of Technical Analysis, the Investors and traders can enter the stock (long or short) when it starts trending, instead of locking their money during the periods of consolidation.



Thus, it as a very good tool for short term investing.

SIMPLE MOVING AVERAGE METHOD:

For my analysis I have considered the simplest method of Technical Analysis, the simple moving average method.

Steps for getting a Buy or Sell signal in the Simple Moving Average Method:

Calculate the moving averages:

Plot the graph for both the share price and the moving average:

Buy signal - the share price line cuts the moving average from below or in the excel worksheet when the difference becomes positive from negative



Sell signal - the share price line cuts the moving average from above or in the excel worksheet when the difference becomes negative from positive

Now let us get to the most important part of the paper:

A LIVE STUDY OF TRADING IN OPTION MARKETS USING SIMPLE MOVING AVERAGE METHOD:

Methodology Followed for the Study:

Selection of stocks:

The ten most actively traded stocks in the Option market on NSE were selected.

Period of Study:

1st August 2001 to 31st July 2002

Technical Analysis Method Used:

10-day simple moving average as explained earlier.

Strategy Used:

l Trading in Options with expiry of ongoing month l Purchase of one contract at a time l Buy a call Option at each buy signal and sell the

already bought put Option

l Buy a put Option at each sell signal and sell the already bought call Option

l The Option is bought and sold at the opening price of the next the day the signal has been received

Illustration:

Let me illustrate to you for the month of October 2001 for Infosys, how the trades would have taken place using the above strategy.

The share prices are given in the above excel table. So we start with a buy signal on 5th October 2001. For Infosys, the market lot is 100 shares.

In the Options market:

BUY SELL

Date Option Strike Price Premium Buy

Value# Date Premium Sell

Value@ Profit / (Loss)

8/10 Call 2500 96.00 9,900 9/10 102.00 9,900 0 9/10 Put 2200 100.20 10,320 10/10 94.00 9,100 (1,220) 10/10 Call 2600 85.00 8,800 24/10 ** 51,950 43,150



# includes brokerage

@ is net off brokerage

** is the expiry date of the Option and the difference between the strike price and the closing price on the expiry date , will be received in cash. In this case 3123.50 (the closing price on 24th) less the strike price i.e. 2600.

Thus, rate of return is approximately 320%. Net Profit of Rs. 41,930/- on an average investment of Rs.10,000 /-.

In the shares market:

# Includes brokerage

@ Is net off brokerage

Thus, rate of return is approximately 20%. Net Profit of Rs.50,300/- on an average investment of Rs.2,46,000/-.

The same has been done for the ten most actively traded Options and for the period August 2001 to July 2002.

Results of the Analysis:

In the Options market:

Total 29,020 Total 70,950 41,930

BUY SELL Date Buy

Price Buy

Value# Date Sell

Price Sell

Value@ Profit / (Loss)

8/10 2,375 2,37,800 9/10 2,402 2,40,500 2,700 10/10 2,540 2,54,300 24/10 3,022 3,01,900 (1,220)

Total 4,92,100 Total 5,42,400 50,300

Scrip Market

Lot Total Annual

Profit

Avg Monthly

Investment Monthly Rate

of Return

A B C D E = ( C / 12 ) /

D * 100 Hindustan Petroluem 1300 202,520 10,146 166 Infosys 100 194,042 10,293 157 Digital 400 144,840 9,345 129 Satyam 1200 121,740 12,044 84 Telco 3300 118,995 9,568 104 Tisco 1800 60,390 6,480 78 Bharat Petroleum 1100 37,805 7,880 40 Sterlite Optical 600 32,892 4,224 65 Reliance Industries 600 32,010 7,183 37 L&T 1000 20,600 9,472 18 TOTAL 965,834 86,635 93



In the shares market:

Thus, we see that although the profits are high in both cases , the investment required for shares is almost twenty five times.

Lets see a graphical presentation of the annual profit and the above rate of returns.

ANNUAL PROFIT:

MONTHLY RETURN:

Scrip Market

Lot Total Annual

Profit

Avg Monthly

Investment Monthly Rate

of Return

A B C D E = ( C / 12 ) /

D * 100 Hindustan Petroluem 1300 1,74,135 2,70,845 5 Infosys 100 18,975 3,54,570 0.5 Digital 400 58,080 2,08,623 2 Satyam 1200 72,360 2,67,227 2 Telco 3300 2,07,900 3,76,411 5 Tisco 1800 1,02,420 1,82,484 5 Bharat Petroleum 1100 1,16,600 2,60,976 4 Sterlite Optical 600 -5,580 82,505 - Reliance Industries 600 5,670 1,73,800 0.2 L&T 1000 35,850 1,87,370 2 TOTAL 7,86,410 23,64,811 3



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Copyright 2002 India Infoline Ltd. All rights reserved.Regd. Off: 24, Nirlon Complex, Off W E Highway, Goregaon(E) Mumbai-400 063. Tel.: +(91 22) 685 0101/0505 Fax: 685 0585

A Word of Caution:

Although the above profits have been calculated using actual market data, there is no certainty that the same trends will continue in the future and one needs to keep on revising their strategy.

HAPPY TRADING ON OPTIONS

SOURCES OF DATA FOR ANALYSIS

www.nseindia.com

www.icicidirect.com

Sandeep Nene, IIM Indore



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