The term derivatives is used to refer to financial instruments which derive their value from some underlying assets.

Derivatives derive their names from their respective underlying asset. The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of risk to those who are willing to take it.

Forwards Futures Options Swaps

A forward contract is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract.

Long Position Short Position Forward Price Expiry Date

Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis.

A drawback of forward contracts is that they are subject to default risk. Regardless of whether the contract is for physical or cash settlement, there exists a potential for one party to default, i.e. not honor the contract. It could be either the buyer or the seller. This results in the other party suffering a loss. This risk of making losses due to any of the two parties defaulting is known as counter party risk.

a futures contract is not a private transaction but gets traded on a recognized stock exchange. Also, both buyer and seller of the futures contracts are protected against the counter party risk by an entity called the Clearing Corporation.

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. The option to buy an asset is called the CALL OPTION, an option to sell as asset is called the PUT OPTION. MAIN Style 1. European - exercised only on maturity date 2. American exercised any time before maturity Three possibilities where options are used 1. In-the-money 2. Out-of-the-money 3. At-the-money

is a derivative in which counterparties exchange cash flows of one partys financial instrument for those of the other partys financial instrument.

Types 1. Interest rate swap 2. Currency swap 3. Commodity swaps 4. Credit default swap

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate; rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators.

Fut ure s

In futures, both the buyer and seller are obliged to buy/sell the underlying asset. In futures, there is unlimited upside & downside for both buyer and seller.

Futures contract prices are affected mainly by prices of the underlying asset.

In options, the buyer enjoys the right and not the obligation, to buy or sell the underlying asset. Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller, profits are limited whereas losses can be unlimited. Prices of options are affected by (a) prices of the underlying asset, (b) time remaining for expiry of the contract.

Op tio ns

Basis is defined as the difference between cash and futures prices: Basis = Cash prices - Future prices Basis can be either positive or negative. Basis may change its sign several times during the life of the contract. Basis turns to zero at maturity of the futures contract i.e. both cash and future prices converge at maturity.

The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position. As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market.

Price Discovery: Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Risk Reduction: Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell.

Margin: Margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any dayto-day losses. Initial Margin: When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract.

Maintenance Margin: It is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount. Leverage The Double-Edged Sword: In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay. In futures market, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.

Going Long: When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. Example: Let's say that, with an initial margin of Rs2000 in June, Varun buys one September contract of wheat at Rs50 per Kg, for a total of 1,000 Kgs or Rs50,000. By buying in June, Varun is going long, with the expectation that the price of wheat will rise by the time the contract expires in September. By August, the price of wheat increases by Rs2 to Rs52 per Kg and Varun decides to sell the contract in order to realize a profit. The 1,000 Kg contract would now be worth Rs52,000 and the profit would be Rs2,000. Thus by going long, Varun has made a profit of 100%. The opposite would be true if the price of wheat had fallen by Rs2. In that case, Varun would have realized a 100% loss.

Going Short: A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.

Example: Let's say that Sandy did some research and came to the conclusion that the price of HUL was going to decline over the next six months. He could sell a contract today, in April, at the current higher price, and buy it back within the next six months after the price has declined. With an initial margin deposit of Rs10000, Sandy sold one October HUL contract for a total value of Rs100000. By August, the price of HUL declined and Sandy bought back the contract which was valued at Rs90000 now. By going short, Sandy made a profit of Rs10000.

Spreads: A futures spread is simply the simultaneous trading of one contract against another. Spreads involve taking advantage of the price difference between two different contracts of the same commodity. In many cases, spreads can offer trades that have less volatility and reduced margins, while still having excellent profit potential. Sometimes the return on margin for a futures spread can be much better than an outright futures trade. Spreads can also reduce the risk of a larger-thanexpected loss. While the outright futures trader has to be right about market direction to profit, a futures spread can still make gains even if the underlying markets move contrary to expectations.

Calendar/Intra-Market Spread: This involves the simultaneous purchase and sale of two futures of the same type or commodity, having the same price, but different delivery dates. Inter-Commodity Spread: Here the investor, with contracts of the same month, goes long in one market and short in another market in the same exchange. A typical inter-market spread in the grains might be trading Corn versus Wheat. This spread has seasonal characteristics in both directions, due to the different production and usage characteristics between these two commodities. Inter-Exchange Spread: This is any type of spread in which each position is created in different futures exchanges.

 Long position in shares

Buying a put option with exercise price equal to the current market price of the share

Value of share and put option

HDFC BANK: Protective put strategy

Max Profit : unlimited Max loss: 8.5

A naked option is a position where the option writer does not hold a share in her portfolio that has a counterbalancing effect.

The investor can protect herself by taking a covered position. A covered call position is an investment in a share plus the sale of a call on that share.

Long position in share + Selling a at-the-money call (short position)

Perception Bullish on the Stock in the long term but expecting little variation during the lifetime of Call Contract

Income received from the premium on Call Profits are limited . Losses can be unlimited

SUZLON ENERGY: Covered call strategy

NET OUTFLOW: 25.85

 Price spread/ vertical spread: involves buying and selling of options for the same share and expiration date but different strike prices. Horizontal spread/calendar spread: involves buying and selling of options for the same share and strike price, but different expiration date.

For Investors who are bullish, but at the same time conservative BUY A CALL CLOSER TO SPOT PRICE & WRITE A CALL WITH A HIGHER PRICE

TATA STEEL: Bullish call spread strategy

Spot price : 470.50 Long call: Strike price: 460 Premium: 25.45

Short call: Strike price: 480 Premium:14.7 NET OUTFLOW: 10.75

Max Gain: 9.25 Max Loss:10.75

 Low Risk Low Reward Strategy

Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike Price

HDFC BANK: Bearish call spread strategy

Spot price : 529.0 Long call: Strike price: 520 Premium: 20.35

Short call: Strike price: 500 Premium:33.75 Immediate gain of Rs.13.4

Max Gain: 13.4 Max Loss:6.6

The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread.
A limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

LONG BUTTERFLY OPTION The long Butterfly Spread is a debit spread volatile option strategy where the investor gains by buying more and selling less Sentiment of the investor is low price volatility. METHOD Buy one call/put with low exercise price Buy a second call/put with a high exercise price Sell two calls/puts with an exercise price in between the two.

MAXIMUM PROFIT Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid

Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

SHORT BUTTERFLY
The Short Butterfly Spread is a credit spread volatile option strategy where the investor gets to keep the net credit if the underlying stock rallies or ditches. Investor sells a butterfly spread to someone who is speculating on the same underlying stock being stagnant.

METHOD

Sell one call/ put with a low exercise price Sell a second call/put with a high exercise price Buy two calls/ put with an exercise price in between the two.

MAXIMUM PROFIT Maximum Profit = Net Credit

Maximum Loss = (Difference between consecutive strike prices - credit) * 100

1. Type

of option- Long Call Butterfly option 2. Target Company- SBI 3. Index- NSE 4. Trade date- 31 March 2012, Price on trade- 2135
Name Expiry Strike Type Position Premimu m 78.8 Net Valu e -78.8

OPTSTK_2 7

26 April 2012

2150

Call

Long

OPTSTK_2 9
OPTSTK_2 9 OPTSTK_3 1

26 April 2012
26 April 2012 26 April 2012

2200
2200 2250

Call
Call Call

Short
Short Long

56.75
56.75 39.5

56.75
56.75 -39.5

Case 1- If stock price remains below 2150

Option Call 1 Call 2 Call 3 Call 4 Strike price 2150 2200 2200 2250 Exercise d or not No No No No Pay off -78.8 56.75 56.75 -39.5 Net Pay off -4.8

Case 2- If stock price reaches 2200

Option Stricke price Exercise d or not Pay off Net Pay off

Call 1
Call 2 Call 3 Call 4

2150
2200 2200 2250

Yes
Indiffere nt Indiffere nt No

-28.8
56.75 56.75 -39.5

45.2

Case 3- If stock price reaches 2250

Option Call 1 Call 2 Call 3 Call 4

Strike Price 2150 2200 2200 2250

Exercise d or not Yes Yes Yes Indiffere nt

Pay off 21.2 6.75 6.75 -39.5

Net Pay off -4.8

Advantages Of Butterfly Spread: :: Large profit percentage due to low cost involve in executing the position. :: Limited risk should the underlying asset rally or ditch unexpectedly. (unlike the Short Straddle) :: Maximum loss and profits are predictable. Disadvantages Of Butterfly Spread:

:: Larger commissions involved than simpler strategies with lesser trades.

:: Not a strategy that traders with low trading levels can execute.