Getting your timing right

As stated in the previous article, offeringbidding price techniques and price chasing are very important for markets with low trading liquidity, such as the options market. For highliquidity markets, technical analysis based on charts to decide at which price to buy or sell - or socalled market timing - is the common technique in this market.

However, the markettiming concept for options trading is a little bit different.

Options have a maturity while a stock does not. The remaining maturity is a component in deciding an option's price.

Time value is the premium paid on top of the intrinsic value when investors want to buy options whose prices are relatively high and sometimes higher than the intrinsic value.

For instance, atthemoney options (ATMs), which expire in three months, have a time value of around 30 points (derived from SET50 = 600 points and volatility = 30 per cent) while the intrinsic value stands at zero.

If the SET50 Index remains unchanged, an option's value will gradually decline in tandem with its approaching maturity.

Typically, the value decreases gradually in the initial stage and 50 per cent of the value is gone in the last two weeks until it is zero at the maturity date.

Due to the low trading liquidity in the options market, setting bid and offer quotes might result in a loss even though investors predict and use a strategy correctly.

If we are buyers, we should go long on options with a long remaining maturity and unwind our position before the last month to maturity. We should also go long on options while their prices are increasing to face a minimum loss in time value. On the other hand, we should short options with the nearest approaching maturity to gain a timevalue profit.

In case investors have limited funds and are longing for handsome profits, going long on options, particularly outofthemoney options (OTMs), will provide high returns compared with the amount invested (high leverage).

For example, if investors go long on S50M08C710 (based on twomonth maturity, SET50 at 600 points and volatility at 30 per cent), they will make 4.52 times or 452 per cent in profit if the SET50 goes up to 700 points in one month.

Besides using options for speculation, investors can use them as a hedging tool.

For example, if we have a stock portfolio, we can sell stocks in the portfolio and buy them back when their prices are weaker. This method is complicated compared with going long on put options.

If the SET50 drops, we make a profit from going long on put options and that can compensate for the decline in the value of the stock portfolio. If the SET50 rises, we lose the premium paid for going long on put options but we earn a profit from the increased value of the stock portfolio.

The prices of inthemoney options (ITMs) change more than OTMs. For instance, if the SET50 slumps 30 points to 570, the premium for S50M08P700 will rise by 27 points while the premium for S50M08P500 might rise by only three points (based on volatility at 30 per cent and two months of remaining maturity).

Therefore, investors should go long on put options with a high strike price if they want to do so with the aim of hedging their stock portfolio. Keep in mind that high strike prices always command high premiums.

Options investment can also follow a mixed strategy by going long and short on put options at the same time.

With a mixed strategy, investors can make profits during every state of the stock market.

Lastly, options are the most beneficial instrument as they can be adapted to all stockmarket environments. Or at least options are another investment alternative and they have gained tremendous popularity in other stock markets around the world.

This article was contributed by Trinity Group.