The Options are a popular trading instrument in developed stock markets. From New York to Singapore, the stock exchanges represent significant trading volumes and serve a variety of investors. In the US market, turnover in the Options is as much as 10 per cent of the turnover in the underlying cash markets.
Currently at the Karachi bourses one can invest in stocks, can obtain or provide financing for investment in stocks through Badla; and can also invest in the Futures. Each opportunity offers some similar and some different benefits to the investor. However, the Options are missing at the Karachi Stock Exchange (KSE), even though they can add to the market width because of their unique features. We wish to look into what the Options are, and how desirable and feasible it is to introduce the Options at the KSE.
The Options: There are two types of options, Call and Put. In simple terms, if you have a Call on a stock, you buy that stock at a pre-specified price within a specified time period. For instance, you think that the price of the PSO is going to increase. Now, instead of buying the PSO, say at Rs175, you would buy a Call on the PSO, say with an exercise price of Rs200 and an expiry of three months. It means that you can buy a share of the PSO at Rs200 from the seller within three months. If the PSO hits 225, you would make Rs25 per share. If the Option cost you Rs10, you’d still net a neat Rs10 per option, a return on investment of 100 per cent.
If instead you had bought the PSO, you would have made only 29 per cent return. On the other hand, if the PSO did not move beyond 200, you lose your Rs10 investment in the Call, i.e. a return of 100 per cent whereas, if you had bought the stock, you would have lost nothing.
The Puts are like a mirror image of the stock. You would buy a Put if you think the stock would go down so that you can sell it at a higher price.
The Options can be on the stocks, market index, or on the Futures. Some are exercisable only at maturity (the European Options), others maybe exercised at any time during their life (the American Options). Their uniqueness lies in the fact that unlike stocks and Futures, the Options offer buyers greater chances of large absolute gains than losses.
Benefits to the investor: The Options offer a number of benefits to investors. These help you manage your risk by hedging in a unique way. Lets say you fear that the Rs225 per share of the PSO stocks you own might incur a steep fall. You would buy a Put Option on the PSO say for Rs10 with an exercise price of Rs200. So if the stock falls below Rs200, you would still be able to sell it at Rs200. In other words, you have obtained insurance against losses by paying the price of the Option. Your chances of gains are still open — if the PSO hits Rs250, you would still benefit from it.
The Options give you an opportunity for leveraged speculation. Trading in the Options magnifies your return. Instead of buying a PSO stock for Rs200, you can buy a call on the stock, by spending probably a few rupees. Your downside is limited to those few rupees and your gains can be anything depending on how high the PSO soars.
The Options can help you generate income. If you expect that the underlying asset (the stock, index, and the Future) is unlikely to go up, you might want to write a Call Option on it. If it does not go up, you keep the money. Similarly, you can write a Put and generate income if you think the underlying asset is not going down. You can also construct synthetic portfolios with the Options. You can combine different combinations of the Options and the Futures that could give you the same payoffs as if you had invested in stocks.
Once there is sufficient liquidity in the Option, they become a market in their own right. You do not have to exercise your Options or wait for their exercise to close your position; you can simply reverse your transaction.
Benefits to the exchange: The benefits of Options are not confined to those trading in them. The exchange also stands to gain from the introduction of Options.
The Options help sort investors and speculators. Speculation is a normal activity in stock markets. But speculators differ from the common investors and they should be given instruments that suit them. In our stock market, there are not enough suitable avenues for the risk takers so they carry out their manoeuvres in the ready market. The high degree of speculative activity causes technical bubbles and excess volatility in our narrow market. By giving room for leveraged speculation, the Options separate investors from speculators. Derivatives offer room for leveraged speculation and still make things safer for the exchange. The Options can also be marked to market for the sellers on a daily basis, thus making clearing house safer than what might be the case with other instruments.
By creating a new market, the Options generate incremental revenue for the exchange. Even though these take away some volume from the Cash and Futures market, on the whole they create incremental trading volumes that increase the revenues for the exchange. Options help further market development. The Options can be on the Futures as well, which would expand both the Options and the Futures market.
Benefits to listed companies: Listed companies can use the Call Options as a part of their employee compensation to motivate or reward them. They give the incentive to the employees to direct their efforts towards increasing the stock price above the exercise price without subjecting them to the risk of a fall in the stock price.
Risks in the Options for investor: No investment instrument, including the Options, is risky or otherwise on its own. The relevant risk of the Options is what they would add to the portfolio. Still it is important to understand the stand-alone risk because it has a bearing on what risk the asset is going to add to the portfolio. As the table shows, a buyer of a Call has limited downward risk and unlimited potential of gain, while it’s the other way round for the seller.
Is the KSE ready for the Options: More has happened in the last few years at the KSE than had in decades, such as the introduction of automated trading, digital immobile securities, T+3 settlement cycle, Futures and so on. The market took all these development in its stride and is thriving. We must not underestimate the ability of our investors and of our exchanges. No doubt that options are relatively complex, but then everything is complex in the beginning. With the passage of time, even the most complex trading instruments and strategies become a part of the every day life. The KSE has a solid track record of being able to modernize at a fast pace and absorbing Options should not be a problem for it. Note that regional markets, such as the Bombay Stock Exchange, has already taken the lead in Option trading. It was back in June 2001 that the Options were introduced in India. Currently, they have options on more than 30 stocks as well on two indexes, the BSE Sensex & NSE Nifty.
Conclusion: It is both desirable and feasible to introduce the Options at the KSE. They offer a number of benefits to the investor, the exchange, and the listed companies. Some of the benefits of Options are not offered by investing in the Ready, Badla, and the Futures markets. To add to our market width and keep up with the rapidly developing stock markets in other parts of the world, its time that we start working on introducing the Options at the KSE. It takes time for the Options market to develop; therefore, the sooner, the better.