Derivatives players adopt new hedging strategies

Sujoy Manna

Mumbai, Oct 14: With the cash market getting increasingly volatile, straddle and strangle are the new most preferred hedging strategies for the players in the fledgling derivatives market.

These hedging strategies, new to Indian players, seem to have been the most preferred for options contracts for stocks like Infosys, Satyam, Ranbaxy and even Nifty, which are the most heavily traded counters in the derivatives market on the National Stock Exchange (NSE).

According to market analysts, the recent volatility in the market with stock prices moving in either directions, players prefer to have a combination of both call and put options. Straddle involves buying/selling combination of a call and put options with same strike price and maturity. Strangle (a variant of straddle), on the other hand, involves buying/selling of call and put options with different strike prices.

The position is taken by traders, who are uncertain about the direction of the movement of share prices in the cash market.
For example, if an investor adopts straddle with Infosys. The option contract is entered at a strike price of Rs 2,300 (the option premium is not taken into account to maintain simplicity).

Now, if the cash market price of Infosys is above Rs 2,300, the investor can exercise the call option. In order to benefit from this higher price, the investor would exercise the call option at Rs 2,300 only to sell at higher price in the cash market.

On the other hand, if the cash market price falls below the strike price of Rs 2,300, he can exercise the put option. He sells the option at a higher price to buy stocks at lower price in the cash market. Thus, with price uncertainty in the cash market, straddle is a good hedging instrument for the investor.

Strangle is where the strike prices at which the call and put options are bought and sold.

While the straddle buyer will buy the call and put options at the same strike price, the strangle buyer will buy both the options at different strike prices, thus helping the investor of a stock whose price can move in any direction.

Long position holders in straddle expect that the price would move substantially in either directions. On the other hand, the short straddle holder thinks that either the price will remain stable or
will move marginally in either direction.