Mastering Derivatives: Trading advantages of Nifty options

Previously in this column, we discussed the advantages of trading index options. To recap, in a volatile market, betting on the directional movement of an individual stock is riskier than betting on an index, as it contains a basket of stocks. This week, continuing with this discussion, we look at the trading advantages of initiating index option positions. Specifically, Nifty Index options allow you to avoid margin requirements relating to delivery. Also, you can play the position till expiry.

Trading advantages of Nifty Index options arises from the fact that such options are cash-settled. This is because when an index call option expires in-the-money (ITM), delivering all the constituents of the Nifty Index can be cumbersome. Note that it is mandatory to take delivery of shares when equity call options expire ITM. To reduce default during delivery on the expiry of an ITM equity call option, brokers collect delivery margins from the longs. Typically, margins start four days before expiry, progressively increasing from 10 per cent of the delivery margins to 100 per cent on the day of expiry. This significantly increases your capital requirement on long ITM equity call positions as the option approaches expiry. This also leads to a secondary effect. To reduce such margin requirements, you may be tempted to close your position before expiry. That means you may not be allowing your position play for the target price on the underlying. The trade-off is simple: You can moderate your delivery margin requirements at the expense of giving up potential gains. 

What if you trade Nifty Index options instead? As index options are cash-settled, you can avoid delivery margins. That releases your trading capital to either increase your index option position or to allocate the capital to set up newer positions. Also, cash-settlement allows you to play index option positions till expiry. This is especially important when your option position becomes ITM just before expiry and you continue to have a bullish outlook on the underlying. You can let the option become deep ITM (typically more than three strikes lower than the current underlying price), without worrying about delivery risk or liquidity risk. You run delivery risk when the option you hold turns ITM and you are forced to take delivery. Liquidity risk is the risk that you will be unable to close (sell) your long call position at a reasonable price because it is deep ITM. Note that options lose liquidity as they move from out-of-the-money (OTM) to deep ITM.

Once you are comfortable trading index options and confident of managing delivery risk and liquidity risk, you can consider betting on equity options. The fact is that index options are more liquid than equity options. Note that the cash-settled system works in favour of index options not just for plain-vanilla strategies such as long calls and long puts but also for spread strategies such as bull and bear spreads and ratio spreads.

The author offers training programmes for individuals to manage their personal investments