Professional Documents
Culture Documents
¬ Derivatives – an overview
¬ Futures contract
¬ Hedging in futures
¬ Speculating in futures
¬ Arbitrage in futures
¬ Options
¬ Options strategies
¬ Derivatives products
¬ Open interest
¬ Futures price = spot price + cost of carry
DERIVATIVES
The word “DERIVATIVES” is derived from the word itself derived of a
underlying asset. It is a future image or copy of a underlying asset
which may be shares, stocks, commodities, stock indices, etc.
Derivatives is a financial product (shares, bonds) any act which is
concerned with lending and borrowing (bank) does not have its value
borrow the value from underlying asset/ basic variables.
Derivatives is derived from the following products:
A. Shares
B. Debuntures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
Derivatives is a type of market where two parties are entered into a
contract one is bullish and other is bearish in the market having
opposite views regarding the market. There cannot be a derivatives
having same views about the market. In short it is like a INSURANCE
market where investors cover their risk for a particular position.
Derivatives are financial contracts of pre-determined fixed duration,
whose values are derived from the value of an underlying primary
financial instrument, commodity or index, such as: interest rates,
exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to
reduce exposure to changes in foreign exchange rates, interest rates,
or stock indexes or commonly known as risk hedging. Hedging is the
most important aspect of derivatives and also its basic economic
purpose. There has to be counter party to hedgers and they are
speculators. Speculators don’t look at derivatives as means of reducing
risk but it’s a business for them. Rather he accepts risks from the
hedgers in pursuit of profits. Thus for a sound derivatives market, both
hedgers and speculators are essential.
The first product which was launched by BSE and NSE in the
derivatives market was index futures
BACKGROUND
Consider a hypothetical situation in which ABC trading company has to
import a raw material for manufacturing goods. But this raw material
is required only after 3 months. However in 3 months the prices of raw
material may go up or go down due to foreign exchange fluctuations
and at this point of time it can not be predicted whether the prices
would go up or come down. Thus he is exposed to risks with
fluctuations in forex rates. If he buys the goods in advance then he will
incur heavy interest and storage charges. However, the availability of
derivatives solves the problem of importer. He can buy currency
derivatives. Now any loss due to rise in raw material prices would be
offset by profits on the futures contract and vice versa. Hence the
company can hedge its risk through the use of derivatives
DEFINATIONS
PURPOSE
The primary purpose of futures market is to provide an efficient and
effective mechanism for management of inherent risks, without
counter-party risk.
It is a derivative instrument and a type of forward contract The future
contracts are affected mainly by the prices of the underlying asset. As
it is a future contract the buyer and seller has to pay the margin to
trade in the futures market
It is essential that both the parties compulsorily discharge their
respective obligations on the settlement day only, even though the
payoffs are on a daily marking to market basis to avoid default risk.
Hence, the gains or losses are netted off on a daily basis and each
morning starts with a fresh opening value. Here both the parties face
an equal amount of risk and are also required to pay upfront margins
to the exchange irrespective of whether they are buyers or sellers.
Index based financial futures are settled in cash unlike futures on
individual stocks which are very rare and yet to be launched even in
the US. Most of the financial futures worldwide are index based and
hence the buyer never comes to know who the seller is, both due to
the presence of the clearing corporation of the stock exchange in
between and also due to secrecy reasons
EXAMPLE
The current market price of INFOSYS COMPANY is Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is
bullish and kishore is bearish in the market. The initial margin is 10%.
paid by the both parties. Here the Hitesh has purchased the one
month contract of INFOSYS futures with the price of Rs.1650.The lot
size of infosys is 300 shares.
Suppose the stock rises to 2200.
Profit
20
2200
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-
1650*3oo)] and notional profit for the buyer is 500.
Unlimited loss for the buyer because the buyer is bearish in the market
Suppose the stock falls to Rs.1400
Profit
20
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
MARGIN
Margin is money deposited by the buyer and the seller to ensure the
integrity of the contract. Normally the margin requirement has been
designed on the concept of VAR at 99% levels. Based on the value at
risk of the stock/index margins are calculated. In general margin
ranges between 10-50% of the contract value.
PURPOSE
TYPES OF MARGIN
INITIAL MARGIN:
OBJECTIVE
The basic aim of Initial margin is to cover the largest potential loss in
one day. Both buyer and seller have to deposit margins. The initial
margin is deposited before the opening of the position in the Futures
transaction.
MAINTENANCE MARGIN:
ILLUSTRATION
On MAY 15th two traders, one buyer and seller take a position on June
NSE S and P CNX nifty futures at 1300 by depositing the initial margin
of Rs.50,000with a maintenance margin of 12%. The lot size of nifty
futures =200.suppose on MAY 16th
The price of futures settled at Rs.1950. As the buyer is bullish and the
seller is bearish in the market. The profit for the buyer will be 10,000
[(1350-1300)*200]
Loss for the seller will be 10,000[(1300-1350)]
As the sellers balance dropped below the maintenance margin i.e. 12%
of 1400*200=33600 While the initial margin was 50,000.Thus the
seller must deposit Rs.20,000 as a margin call.
Now the nifty futures settled at Rs.1390.
Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the
buyer)
Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for
the seller)
ADDITIONAL MARGIN:
CROSS MARGINING:
This is a method of calculating margin after taking into account
combined positions in Futures, options, cash market etc. Hence, the
total margin requirement reduces due to cross-Hedges.
MARK-TO-MARKET MARGIN:
HEDGERS :
Hedgers are the traders who wish to eliminate the risk of price change
to which trhey are already exposed.It is a mechanism by which the
participants in the physical/ cash markets can cover their price risk.
Hedgers are those persons who don’t want to take the risk therefore
they hedge their risk while taking position in the contract. In short it is
a way of reducing risks when the investor has the underlying security.
PURPOSE:
“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE
RISK”
Figure 1.1
Hedgers
STRATEGY:
The basic hedging strategy is to take an equal and opposite position in
the futures market to the spot market. If the investor buys the scrip in
the spot market but suddenly the market drops then the investor
hedge their risk by taking the short position in the Index futures
Hedging is one of the principal ways to manage risk, the other being
diversification. Diversification and hedging do not have have cost in
cash but have opportunity cost. Hedging is implemented by adding a
negatively and perfectly correlated asset to an existing asset. Hedging
eliminates both sides of risk: the potential profit and the potential loss.
Diversification minimizes risk for a given amount of return (or,
alternatively, maximizes return for a given amount of risk).
Diversification is affected by choosing a group of assets instead of a
single asset (technically, by adding positively and imperfectly
correlated assets).
ILLUSTRATION
Ram enters into a contract with Shyam that he sells 50 pens to Shyam
for Rs.1000. The cost of manufacturing the pen for Ram is only Rs.
400 and he will make a profit of Rs 600 if the sale is completed.
COST SELLING PRICE PROFIT
400 1000 600
However, Ram fears that Shyam may not honour his contract. So he
inserts a new clause in the contract that if Shyam fails to honour the
contract he will have to pay a penalty of Rs.400. And if Shyam honours
the contract Ram will offer a discount of Rs 100 as incentive.
Shyam defaults Shyam honors
400 (Initial Investment) 600 (Initial profit)
400 (penalty from Shyam (-100) discount given to Shyam
- (No gain/loss) 500 (Net gain)
Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will
recover his initial investment. If Shyam honors the bill the ram will get
a profit of 600 deducting the discount of Rs.100 and net profit for ram
is Rs.500. Thus Ram has hedged his risk against default and protected
his initial investment.
Now let’s see how investor hedge their risk in the market
Example:
Say you have bought 1000 shares of XYZ Company but in the short
term you expect that the market would go down due to some news.
Then, to minimize your downside risk you could hedge your position by
buying a Put Option. This will hedge your downside risk in the market
and your loss of value in XYZ will be set off by the purchase of the Put
Option.
Therefore hedging does not remove losses .The best that can be
achieved using hedging is the removal of unwanted exposure,
i.e.unnessary risk. The hedging position will make less profits than the
un-hedged position, half the time. One should not enter into a hedging
strategy hoping to make excess profits for sure; all that can come out
of hedging is reduce risk.
ILLUSTRATION:
With a market price of ACC Rs.600 the investor buys the 50 shares of
ACC.Now the investor excepts that price will fall by 100.So he decided
to buy the put Option b y paying the premium of Rs.25. Thus the
investor has hedge their risk by purchasing the put Option. Finally
stock falls by 100 the loss of investor is restricted t the premium paid
of Rs.2500 as investor recovered Rs.75 a share by buying ACC put.
HEDGING STRATEGIES:
Under this investor takes a long position on the security and sell some
amount of
Nifty Futures. This offsets the hidden Nifty exposure that is inside
every long- security position. Thus the position LONG SECURITY, SELL
NIFTY is a pure play on the performance of the security, without any
extra risk from fluctuations of the market index. Finally the investor
has “HEDGED AWAY” his index exposure.
EXAMPLE:
As the fall in the price of the security will result in a fall in the price of
Futures. Now the Futures will trade at a price lower then the price at
which the hedger entered into a short position.
Finally the loss of Rs.40 incurred on the security hedger holds, will be
made up the profits made on his short futures position.
This is one of the simplest ways to take on hedge. Here the investor
buys 100 shares of HLL.The spot price of HLL is 232 suddenly the
investor worries about the fall of price. Therefore the solution is buy
put options on HLL.
The investor buys put option with a strike of Rs.240. The premium
charged is Rs.10.Here the investor has two possible scenarios three
months later.
1) IF PRICE RISES
Thus loss he suffers on the stock will be offset by the profit the
investor earns on the put option bought.
2) IF PRICE RISES:
Here the investor are holding the portfolio of stocks and selling nifty
futures. In the case of portfolios, most of the portfolio risk is
accounted for by index fluctuations. Hence a position LONG
PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as
the LONG PORTFOLIO position.
SPECULATORS:
If hedgers are the people who wish to avoid price risk, speculators are
those who are willing to take such risk. speculators are those who do
not have any position and simply play with the others money. They
only have a particular view on the market, stock, commodity etc. In
short, speculators put their money at risk in the hope of profiting from
an anticipated price change. Here if speculators view is correct he
earns profit. In the event of speculator not being covered, he will loose
the position. They consider various factors such as demand supply,
market positions, open interests, economic fundamentals and other
data to take their positions.
SPECULATION IN THE FUTURES MARKET
• Speculation is all about taking position in the futures market without
having the underlying. Speculators operate in the market with motive
to make money. They take:
• Naked positions - Position in any future contract.
• Spread positions - Opposite positions in two future contracts. This is
a conservative speculative strategy.
Speculators bring liquidity to the system, provide insurance to the
hedgers and facilitate the price discovery in the market.
Figure 1.2
Speculators
ILLUSTRATION:
Here the Speculator believes that stock market will going to
appreciate.
Current market price of PATNI COMPUTERS = 1500
Strategy: Buy February PATNI futures contract at 1500
Lot size = 100 shares
Contract value = 1,50,000 (1500*100)
Margin = 15000 (10% of 150000)
Market action = rise to 1550
Future Gain:Rs. 5000 [(1550-1500)*100]
Market action = fall to 1400
Future loss: Rs.-10000 [(1400-1500)*100]
Thus the Speculator has a view on the market and accept the risk in
anticipating of profiting from the view. He study the market and play
the game with the stock market
TYPES:
♣ POSITION TRADERS:
These traders have a view on the market an hold positions over a
period of as days until their target is met.
♣ DAY TRADERS:
. Day traders square off the position during the curse of the trading
day and book the profits.
♣ SCALPERS:
Scalpers in anticipation of making small profits trade a number of
times throughout the day.
This shows that investor can earn more in the call option because it
gives 25% returns over a investment of 2months as compared to
6.6% returns over a investment in stocks
Finally on the day of expiration the spot and future price converges the
investor makes a profit because the speculator is bearish in the market
and all the future stocks need to sell in the market.
ARBITRAGEURS:
Arbitrage is the concept of simultaneous buying of securities in one
market where the price is low and selling in another market where the
price is higher.
Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent
and knowledgeable person and ready to take the risk He is basically
risk averse. He enters into those contracts were he can earn risk less
profits. When markets are imperfect, buying in one market and
simultaneously selling in other market gives risk less profit.
Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage
opportunities by buying from lower priced market and selling at the
higher priced market.
JM Morgan introduced EQUITY DERIVATIVES FUND called as
ARBITRAGE FUND where the investor buys the shares in the cash
market and sell the shares in the future market.
ARBITRAGEURS IN FUTURES MARKET
Arbitrageurs facilitate the alignment of prices among different markets
through operating in them simultaneously.
Figure 1.3
Arbitrageurs
Example:
Current market price of ONGC in BSE= 500
Current market price of ONGC in NSE= 510
Lot size = 100 shares
Thus the Arbitrageur earns the profit of Rs.1000(10*100)
STRATEGIES:
θ BUY SPOT, SELL FUTURES:
In this the investor observing that futures have been overpriced, how
can the investor cash in this opportunity to earn risk less profits. Say
for instance ACC = 1000 and One month ACC futures = 1025.
This shows that futures have been overpriced and therefore as an
Arbitrageur, investor can make risk less profits entering into the
following set f transactions.
• On day one, borrow funds, buy security on the spot market at 1000
• Simultansely, sell the futures on the security at1025
• Take delivery of the security purchased and hold the security for a
month
• on the futures expiration date, the spot and futures converge . Now
unwind the position
• Sa y the security closes at Rs.1015. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.15 on the spot position and Rs.10
on the futures position
• Return the Borrow funds.
Finally if the cost of borrowing funds to buy the security is less than
the arbitrage profit possible, it makes sense for the investor to enter
into the arbitrage. This is termed as cash – and- carry arbitrage.
CASE-1
Spot Price of INFOSEYS = 1650
Future Price Of INFOSEYS = 1675
In this case the arbitrageur will buy INFOSEYS in the cash market at
Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free
profit Of Rs.25.
CASE-2
Future Price Of ACC = 675
Spot Price of ACC = 700
In this case the arbitrageur will buy ACC in the Future market at
Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of
Rs.25.
INTRODUCTION TO OPTIONS
MONTHLY OPTIONS :
The exchange trade option with one month maturity and the contract
usually expires on last Thursday of every month.
WEEKLY OPTIONS:
The exchange trade option with one or weak maturity and the contract
expires on last Friday of every weak
ADVANTAGES
TYPES OF OPTION:
ϖ CALL OPTION
A call option gives the holder (buyer/ one who is long call), the right to
buy specified quantity of the underlying asset at the strike price on or
before expiration date. The seller (one who is short call) however, has
the obligation to sell the underlying asset if the buyer of the call option
decides to exercise his option to buy. To acquire this right the buyer
pays a premium to the writer (seller) of the contract.
ILLUSTRATION
Suppose in this option there are two parties one is Mahesh (call buyer)
who is bullish in the market and other is Rakesh (call seller) who is
bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and
premium is Rs.25
1. CALL BUYER
Here the Mahesh has purchase the call option with a strike price of
Rs.600.The option will be excerised once the price went above 600.
The premium paid by the buyer is Rs.25.The buyer will earn profit
once the share price crossed to Rs.625(strike price + premium).
Suppose the stock has crossed Rs.660 the option will be exercised the
buyer will purchase the RELIANCE scrip from the seller at Rs.600 and
sell in the market at Rs.660.
Profit
30
20
10
0
590 600 610 620 630 640
-10
-20
-30
Loss
2. CALL SELLER:
In another scenario, if at the tie of expiry stock price falls below Rs.
600 say suppose the stock price fall to Rs.550 the buyer will choose
not to exercise the option.
Profit
30
20
10
0
590 600 610 620 630 640
-10
-20
-30
Loss
Finally the stock price goes to Rs.610 the buyer will not exercise the
option because he has the lost the premium of Rs.25.So he will buy
the share from the seller at Rs.610.
Thus from the above example it shows that option contracts are
formed so to avoid the unlimited losses and have limited losses to the
certain extent
ϖ PUT OPTION
A Put option gives the holder (buyer/ one who is long Put), the right to
sell specified quantity of the underlying asset at the strike price on or
before a expiry date. The seller of the put option (one who is short
Put) however, has the obligation to buy the underlying asset at the
strike price if the buyer decides to exercise his option to sell.
ILLUSTRATION
Suppose in this option there are two parties one is Dinesh (put buyer)
who is bearish in the market and other is Amit(put seller) who is
bullish in the market.
Here the Dinesh has purchase the put option with a strike price of
Rs.800.The option will be excerised once the price went below 800.
The premium paid by the buyer is Rs.20.The buyer’s breakeven point
is Rs.780(Strike price – Premium paid). The buyer will earn profit once
the share price crossed below to Rs.780. Suppose the stock has
crossed Rs.700 the option will be exercised the buyer will purchase the
RELIANCE scrip from the market at Rs.700and sell to the seller at
Rs.800
Profit
20
10
0
600 700 800 900 1000 1100
-10
-20
Loss
Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) –
premium}
Loss limited for the buyer up to the premium paid = 20
20
10
0
600 700 800 900 1000 1100
-10
-20
Loss
Unlimited loses for the seller if stock price below 780 say 750 then
unlimited losses for the seller because the seller is bullish in the
market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20
♣ LONG POSITION
If the investor expects price to fall i.e. bearish in the market he takes
a long position by buying Put option.
♣ SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he takes a
short position by selling Put option
For instance, as the price of the underlying asset rises, the premium of
a call will increase and the premium of a put will decrease. A decrease
in the price of the underlying asset’s value will generally have the
opposite effect
θ Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an
option’s underlying. Higher volatility estimates reflect greater expected
fluctuations (in either direction) in underlying price levels. This
expectation generally results in higher option premiums for puts and
calls alike, and is most noticeable with at- the- money options.
ϖ RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of
the underlying assets at a price agreed upon by the buyer & seller, on
or before a specified time. Both the buyer and seller are obligated to
buy/sell the underlying asset.
In case of options the buyer enjoys the right & not the obligation, to
buy or sell the underlying asset.
ϖ RISK
Futures Contracts have symmetric risk profile for both the buyer as
well as the seller.
ϖ PRICES:
The Futures contracts prices are affected mainly by the prices of the
underlying asset.
While the prices of options are however, affected by prices of the
underlying asset, time remaining for expiry of the contract & volatility
of the underlying asset.
ϖ COST:
ϖ STRIKE PRICE:
In the Futures contract the strike price moves while in the option
contract the strike price remains constant .
ϖ Liquidity:
ϖ Price behaviour:
ϖ PAY OFF:
OPTION STRATAGIES:
Profit
20
10
0
1490 1500 1510 1520 1530 1540
-10
-20
Loss
2. BEAR PUT SPREAD:
It is implemented in the bearish market with a limited downside. The
Bear put Spread consists of the purchase a higher strike price put and
sale of a lower strike price put, of the same month. It provides high
leverage over a limited range of stock prices. However, the total
investment is usually far less than that required to buy the stock
shares.
Current price of INFOSYS TECHNOLOGIES is Rs. 4500
Here the investor buys one month put of 5510(higher price) at 55 ticks
per contract and sell one month put of 4490 (lower price) and receive
45 ticks per contract.
Premium = 10 ticks per contract(55 paid- 45 received)
Lot size = 200 shares
BREAK- EVEN- POINT= 5510-10 = 5500.
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 5500 then the
option will close at Breakeven. The put purchase of 5510 is 10 result in
no-profit no loss situation to the premium paid while the 4490 put
option sold will expire worthless and also reduce the premium
received.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :
If the index is between 5510 an 5500 then the 5510 put option will
have an intrinsic value of 5 which is less than premium paid result in
loss of 5.While 4490 call option sold will not expire which will reduce
the loss of Rs.10 through receiving the net premium.
If the index is between 5500 and 4490 then the 5510 put option will
have an intrinsic value of 15 i.e. deep in the money While 4490 put
option sold will have no intrinsic value the premium receive will
generate profit .
iii. AT STRIKE:
If the index is at 5510, the 5510 put option will have an intrinsic value
of 0 and expire worthless. While 4490 will also have no intrinsic value
an put sold result in reducing the loss as the premium received
If the index is at 4490 the 5510 put option will have maximum profit
deep in the money. While 4490 put sold will have no intrinsic value
and expire worthless and profit is the premium received between the
strike price an premium paid.
iv. ABOVE STRIKE PRICE:
IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option
will have no intrinsic value. while the 4490 put option sold result in
maximum loss to the premium received.
If the underlying stock is above 4490 but below 5510, the 4490 put
option will have no intrinsic value. while the 5510 put option sold
result in the maximum profit strike price - premium
v. BELOW STRIKE PRICE:
IF the underlying stock is below 5510, the 5510 option purchase while
be in the money and 4490 option sold will be assigned (strike price –
premium paid) = profit .
20
10
0
3000 3500 4000 4500 5000 5500 6000 6500 7000
-10
-20
Loss
OPTION PAYOFF
Profit
Loss
OPTION PAYOFF
Profit
Loss
5). STRADDLE:
In this strategy the investor purchase and sell the call as well as the
put option of the same strike price, the same expiration date, and the
same underlying. In this strategy the investor is neutral in the market.
This strategy is often used by the SPECULATORS who believe that
asset prices will move in one direction or other significantly or will
remain fairly constant.
TYPES:
LONG STRADDLE:
Here the investor takes a long position(buy) on the call and put with
the same strike price and same expiration date. In this the investor is
beneficial if the price of the underlying stock move substantially in
either direction. If prices fall the put option will be profitable an if the
prices rises the call option will give gains. Profit potential in this
strategy is unlimited ,While the loss is limited up to the premium paid.
This will occur if the spot price at expiration is same as the strike price
of the options.
SHORT STRADDLE:
This strategy is reverse of long straddle. Here the investor write(sell)
the call as well as the put in equal number for the same strike price an
same expiration. This strategy is normally used when the prices of the
underlying stock is stable but the investor start suffering losses if the
market substantially moves in either direction .
Detailed example of a long straddle
Current market price of BAJAJ AUTO is Rs.600
Here the investor buys one month call of strike price 600 at 20 ticks
per contract and two month put of strike price 600 for 15 ticks per
contract.
Premium Paid = 35 ticks
Lot size = 400 shares
Lower Break- Even- Point = 600 – 35 = 565
Higher Break- Even- Point = 600 + 35 = 635
i. AT BREAK- EVEN- POINT:
If the stock is at 565 or at 635, this option strategy will be at Break-
Even- Point. At 565 the 600 call will have no intrinsic value an expire
worthless but the 600 put will have an intrinsic value of 35.
At 635 the 600 call will have an intrinsic value of 35, while the put 600
will expire worthless.
ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:
If the stock price goes to 550 then the 600 call will have no intrinsic
value and expire worthless while 600 put will have an intrinsic value of
50.
iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:
If the stock price touches 650 the 600 call will have an intrinsic value
of 50, while 600 put will have no intrinsic value an will expire
worthless.
iv. BETWEEN LOWER BEP AND HIGHER BEP:
If the stock prices goes to 6oo then the both call and put option will
expire worthless which results in the loss of 35(premium).
40
30
20
10
550 560 570 580 590 600 610 620 630 640 650
-10
-20
-30
-40
Loss
6. STRANGLE:
In this strategy the investor is neutral in the market which involves the
purchase of a higher call and a lower put that are slightly out of the
money with different strike price and with the different expiration date.
The premiums are lower as compared to straddle also the risk is more
involved as compare to straddle which not leads to the profit.
TYPES
1) LONG STRANGLE:
Here the investor purchases a higher call and a lower put with different
strike price and with the different expiration date. A long strangle
strategy is used to profit from a volatile price an loss from stable
prices.
2) SHORT STRANGLE:
In this the investor sells a higher call and a lower put with different
strike price and with the different expiration date. A short strangle
strategy is used to profit from a stable prices an loss starts when price
is volatile.
Profit
20
10
0
3900 3925 3950 3975 4000 4025 4050 4075 4100
-10
-20
Loss
7) COVERED CALL:
Under this strategy investors buys the shares which shows that they
are bullish in the market but suddenly they are scared about the
market falls thus they sells the call option. Here the seller is usually
negative or neutral on the direction of the underlying security. This
strategy is best implemented in a bullish to neutral market where a
slow rise in the market price of the underlying stock is anticipated.
Thus if price rises he will not participate in the rally. However he has
now reduced loss by the amount of premium received, if prices
falls.Finally if prices remains unchanged obtains the maximum profit
potential.
EXAMPLE:
If the stock closes at 300, the 300 call option will not exercised and
seller will receive the premium.
If the stock ends at 275, the 300 call option expires worthless equilant
to the premium received results into no profit no loss.
If the stock ends above 300, the 300 call option is exercised and call
writer receives the premium results into the maximum profit potential.
The payoff diagram of a covered call with long stock + short call =
short put
Profit
:
50
25
0
250 275 300 325 350
-25
-50
Loss
8) COVERED PUT:
Here the writer sell stock as well as put because he overall moderate
bearish on the market and profit potential is limited to the premium
received plus the difference between the original share price of the
short position and strike price of the put. The potential loss on this
position, however is substantial if price increases above the original
share price of the short position. In this case the short stock will suffer
losses which will be offset by the premium received.
Profit
:
Premium Received
Lower
Loss
9) UNCOVERED CALL:
This shows that the seller has one sided position in the contract for
this the seller must deposit and maintain sufficient margin with the
broker to assure that the stock can be purchased for delivery if option
is exercised.
• If the market price of the stock rises sharply the calls could be
exercised, while as far as the obligation is concerned the seller must
buy the stock more than the option strike price, which results in a
substantial loss.
ILLUSTRATION:
Net premium: 6
Therefore the option will not be assigned because the seller has no
stock position and price decline has no effect on the profit of the
premium received.
Suppose the price settled at Rs.75 the option assigned and the seller
has to cover the position at a net loss of Rs.400 [1000 (loss on
covering call)- 600(premium income)]
Finally the loss is unlimited to the increase in the stock price and profit
is limited to the declining stable stock price.
Under this strategy the investor purchases the stock along with the put
option because the investor is bearish in the market. This strategy
enables the holder of the stock to gain protection from a surprise
decline in the price as well as protect unrealized profits. Till the option
expires, no matter what the price of underlying is, the option buyer
will be able to sell the stock at strike price of put option.
SCENARIO
Here the investor pays an additional margin of Rs.10 along with the
price of Rs.210 combining a share with a put option is referred as a
Protective Put.
• AT BREAK-EVEN-POINT:
Previously if the price rises to 200 the investor will gain but now the
investor pays an margin of Rs.10. If price rises to Rs.210 then only the
investor will gain.
profit
:
20
10
0
180 190 200 210 220
-10
-20
Loss
PRICING OF AN OPTION
θ DELTA
A measure of change in the premium of an option corresponding to a
change in the price of the underlying asset.
Change in option premium
Delta = --------------------------------
Change in underlying price
ILUSTRATION
The investor has buys the call option in the future contract for the
strike price of Rs.19. The premium charged for the strike price of 19 at
0.80 The delta for this option is 0.5.Here if the price of the option rises
to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50.
The new option premium will be 0.80 + 0.50 = Rs 1.30.
Here in the money call option will increase the delta by 1.which will
make the value more and expensive while at the money option have
the delta to 0.5 and finally out the money call option will have the
delta very close to 0 as the change in underlying price is not likely to
make them valuable or cheap and reverse for the put option
Delta is positive for a bullish position (long call and short put) as the
value of the position increases with rise in the price of the underlying.
Delta is negative for a bearish position (short call and long put) as the
value of the position decreases with rise in the price of the underlying.
Delta varies from 0 to 1 for call options and from –1 to 0 for put
options. Some people refer to delta as 0 to 100 numbers.
ADVANTAGE
The delta is advantageous for the option buyer because it can tell him
much of an option and accordingly buyer can expect his short term
movements by the underlying stock. This can help the option of an
buyer which call/put option should be bought.
θ GAMMA
A measure of change in the delta that may occur corresponding to the
rise or fall in the price of the underlying asset.
Gamma = change in option delta
__________________
change in underlying price
The gamma of an option tells you how much the delta of an option
would increase or decrease for a unit change in the price of the
underlying. For example, assume the gamma of an option is 0.04 and
its delta is 0.5. For a unit change in the price of the underlying, the
delta of the option would change to 0.5 + 0.04 = 0.54. The new delta
of the option at changed underlying price is 0.54; so the rate of
change in the premium has increased. suppose the delta changed to
0.5-0.04 = 0.46 thus the rate of premium will decreased .
Gamma is positive for long positions (long call and long put) and
negative for short positions (short call and short put). Gamma does
not matter much for options with long maturity. However for options
with short maturity, gamma is high and the value of the options
changes very fast with swings in the underlying prices
θ THETA:
ADVANTAGE
Theta is always positive for the seller of an option, as the value of the
position of the seller increases as the value of the option goes down
with time.
DISADVANTAGE
Theta is always negative for the buyer of an option, as the value of the
option goes
down each day if his view is not realized.
In simple words theta tells how much value the option would lose after
one day, with all the other parameters remaining the same.
θ VEGA
The extent of extent of change that may occur in the option premium,
given a change in the volatility of the underlying instrument.
Change in an option premium
Vega = -----------------------------------------
Change in volatility
ILLUSTRATION
Suppose the Vega of an option is 0.6 and its premium is Rs15 when
volatility of the
underlying is 35%. As the volatility increases to 36%, the premium of
the option
would change upward to Rs15.6.
Vega is positive for a long position (long call and long put) and
negative for a short position (short call and short put).
ADVANTAGE
DISADVANTAGE
θ SENSEX OPTIONS:
θ STOCK FUTURES:
θ STOCK OPTIONS:
θ INDEX OPTIONS
An index option provides the buyer of the option, the right but not the
obligation to buy or sell the underlying index, at a pre-determined
strike price on or before the date of expiration, depending on the type
of option.
CONTRACT SPECIFICATIONS
Expiry Date The last Thursday of the expiry month or the Previous
trading day if the last Thursday of the month is a trading holiday
The last Thursday of the expiry month or the Previous trading day if
the last Thursday of the month is a trading holiday
Settlement Price S&P CNX Nifty Futures / Daily settlement price will be
the closing value of the underlying index
Index Options The settlement price shall be closing value of underlying
index
Assuming that the market consists of three traders only following table
indicates how Open Interest changes on different day’s trades in PATNI
COMPUTERS with a call American option at a strike price of Rs. 180
OPEN INTEREST(FUTURES)
The total number of net outstanding futures contracts is called as open
interest i.e. long minus short contracts. A decline in open interest of
the near term futures indicates a short-term weakness whereas an
increase in the open interest in the long term futures indicate that the
markets may bounce back after some time provided this trend persists
for a long time
θ If both open interest and prices are increasing, this shows that the
buyers have entered in the market unfolding. Expect the uptrend to
continue.
θ In the event of open interest declining while prices are also slipping,
liquidation by long positions is the implication, therefore suggesting a
technically strong market overall. In other words, the market is strong
as open interest declining suggests no new aggressive shorts, as this
would entail an increase in open interest.
θ When open interest is declining and prices are increasing, short
covering is the most likely cause suggesting that overall the market is
weak - i.e. attracting new buyers would be required for a technically
strong market and consequently open interest would rise.
ILLUSTRATION
Suppose there are only two brokers Mr. A and Mr. B in the market. A
buys and B sells contracts on Index futures on a specific day. At the
end of the day , we may say that open interest in the market is 10
contracts and volume for the day is 10 contracts.
Now, if next day a new trader Mr. C comes from Mr. A, open interest
at the endo f the 2 day of trading remains same 10 contracts and
volume for the day is again 10 contracts. Understand that on the
second day, Mr. C assumes Mr. A’s position on first day of trading. But
for the market as a whole, at the end of the 2nd day all only 10
contracts remain open.
COST OF CARRY
The relationship between futures and spot prices can be summarized
in terms of what is know as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the
income earned on the asset.
Cost of carry gives us an idea about the demand-supply forces in the
futures market. It basically indicates the annualized interest cost which
players are willing to pay (receive) for buying (selling) a futures
contract.
In the Indian markets the cost of carry marketing varies between a
negative 35% per annum to a positive 35 % per annum. It can even
be higher or lower than the 35% figure but that would be an
extraordinary event. We all know that at expiry the futures price closes
at the cash price of the security or an index.
The cost-of-carry model in financial futures, thus, is
Futures price = Spot price + Carrying cost — Returns (dividends, etc.)
VOLATILITY
Higher the price volatility of the underlying stock of the put option,
higher would be the premium.
Lower the price volatility of the underlying stock of the call option,
lower would be the premium.
TYPES OF VOLATILITY
θ HISTORICAL VOLATILITY:
θ IMPLIED VOLATILITY:
It is the option market predication of volatility of the underlying
instrument over the life of the option. It helps in determining what
strategies are to be used.When implied volatility is high, the market
price of the option will be greater than their theoretical price.
Example
Stock Price: Rs 280
Strike Price: Rs 260
Annual volatility: 50%
Days to expiry 20 days
Interest rate 12% annual
The price of the Option applying Black-Scholes Model comes to Rs
26.28. But the actual price of that Option in the market might be (say)
Rs 29.50. This means that the market is imputing another volatility to
that option going forward. Now instead of providing the volatility figure
yourself, you can provide the Option price instead. Now if the investor
work backwards and find out what is the volatility that would support
the price of Rs 29.50, that volatility comes to 65 per cent.
While the value of a call option is an increasing function of the value of
its underlying, it is also an increasing function of the volatility of its
underlying. That is, the more uncertain the underlying, the more the
option is worth.
From the above scenario it is possible that the players are expecting
the scrip to increase another possibility is that the market is mis-
pricing the option and could fall. It could also be possible that the
market is anticipating some development, which could push the stock
higher. If you believe that volatility would rise and the underlying then
you may go in for a bull strategy or if you are an aggressive player
you could sell the option with a belief to buy them at a later date.
Most traders, however, use a general rule of thumb: Buy options in
low volatility and sell options during periods of high volatility.
If you see low implied volatilities, you should buy the At the Money
(ATM) option and sell an Out of the Money (OTM) option. You can also
create a similar position using puts. In this case, you should buy ATM
and sell In the Money (ITM) put options. If you see high implied
volatilities, you should buy an In the Money (ITM) Call and sell an ATM
call. You will find that both the calls are expensive, but the ATM will be
in most circumstances more expensive than the others. Thus, by
selling the ATM call, you can realize a good price.
Finally implied volatility can increase or decrease even without price
changes ion the underlying security. This is because implied volatility
is the level of expected volatility i.e. it is also based not on actual
prices of the security, but expected price trends. Implied voltility also
declines, as the option gets closer to expiration, as changes in
volatility become less significant with fewer trading days
ILLUSTRATION
Let's choose the strike price 165 in Satyam for the June contracts.
Satyam is one of the most actively traded contracts in the NSE F&O
segment.
The IV for the call is 97.66 per cent and that of put is 99.40 per cent
on April 25, 2005 Since the IV is high, it is a premium-selling time. (a
good time to sell calls and puts)
# On May 25, the investor `short straddle' the Satyam by selling the
165 call and put for Rs 27.
# The inflow in this strategy is Rs 54 (2X27).
# The underlying spot has been trading within a range of 157-177.
# However, the call IV has ranged from 99.40 - 63.36 and that of put
has ranged from 97.66-46.01
# On May 29, 2003 the IV of call and put are low, hence the investor
can square off positions.
# The respective IV was 63.36 for call and 46.01 for put. The
underlying Satyam was Rs 169.50.
# The call closed at Rs 11.45 and the put closed at Rs 9.50.
# Square-off position by buying call and put of the same strike. Your
outflow would be 20.95 (11.45+9.50). Hence, your net profits would
be Rs 33.05 (54-20.95).
Here the strategy has “limited profit and unlimited losses”. Here the
Profit is limited to the premiums received. Losses would be unlimited if
you are wrong on the stock outlook and the volatility outlook.