Derivative Handouts

8/8/2019 Derivative Handouts

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FINANCIAL MARKETS

SPOT/ CASH MARKET DERIVATIVES

FUTURES OPTIONS

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The most commonl used derivative roducts are

Forwards, Futures and Options.

orwar s -Is a customized contract between two parties to buy or sellan asset on a specified date in the future for a specifiedprice.They are traded outside the exchangesAre ex osed to counter art risk.

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Futures

These are agreements between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are standardized and exchange traded. This makes them

. Supply and demand on the secondary market determines the futures

price. Index futures are all futures contracts where the underl in is the stock

index (Nifty or Sensex) and helps a trader to take a view on the market as awhole.

In India we have index futures contracts based on S&P CNX Nifty and the

times. Each contract expires on the last Thursday of the expiry month and

simultaneously a new contract is introduced for trading after expiry of a

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.


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Bu 1 contract of Nift Futures 5400

Total contract value is 5400 x 50 lot size = Rs.2,70,000. arg n s approx ma e y Means that trader pays only Rs.40,500 to control Rs.2,70,000.


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ty moves to .

Profit is 5700-5400 = 300

Total profit is 300 x lot size of 50 = 15000

(15000/40500) x 100 = 37% return

y move on y . . o


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In terms of underlying asset Index Fut Stock Fut

In terms of expiry

Near Month Far Month


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Basis Futures rice minus s ot rice. In a normal market

basis is positive as futures prices normally exceed spot prices. Cost of carry Relationship between futures prices and spotrices. It measures the stora e cost lus the interest aid to

finance the asset less the income earned on the asset.

Initial margin Amount deposited in the margin a/c at the timea futures contract is first entered into. Marking-to-market At the end of each day, margin a/c is

adjusted to reflect the investors gain or loss. .

that balance in margin a/c never becomes negative. If balancein a/c falls below maintenance margin, investor receives amar in call.


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Open interest indicates the total gross outstanding open positions inthe market for that particular series.

The most useful measure of market activit is O en interest whichis also published by exchanges and used for technical analysis.Open interest indicates the liquidity of a market and is the totalnumber of contracts, which are still outstanding in a futures marketfor a specified futures contract.

O en interest is therefore a measure of contracts that have not beenmatched and closed out. The number of open long contracts mustequal exactly the number of open short contracts.


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Action Resulting open interest

a new contract.

Existing buyer sells and existing seller buys The oldcontract is closed.

Fall

New buyer buys from existing buyer. The Existingbuyer closes his position by selling to new buyer.

No change there is no increase in longcontracts being held

Existing seller buys from new seller. The Existingseller closes his osition b bu in from new seller.

No change there is no increase in shortcontracts bein held

Price Open interest Market Strong

Warning signalWeak

Warning signal


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Daily margining is of two types:

1. Initial margins : The initial margin amount is large enough to cover a one-day loss that can beencountered on 99% of the days.

2. Mark-to-market rofit/loss : The dail settlement rocess called "mark-to-market" rovides forcollection of losses that have already occurred (historic losses) whereas initial margin seeks tosafeguard against potential losses on outstanding positions. The mark-to-market settlement is donein cash.

demonstrate the margins payments that would occur.

A client purchases 4 contract of FUTIDX NIFTY 29JUN2001 at Rs 1500. (Lot size 50) The initial margin payable as calculated by VaR is 15%.

= * *, ,Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look asfollows:


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-Position on Day 1

Close Price Loss Margin released Net cash outflow

1400*50*4=2,80,000

20,000 (3,00,000-2,80,000) 3,000 (45,000-42,000) 17,000(20,000-3000)

New position on Day 2

made

,

Value of new position = 1,400*50*4= 2,80,000 Margin = 42,000

Close Price Gain Addn Margin Net cash inflow

1510*50*4=3,02,000

22,000 (3,02,000-2,80,000)

3,300 (45,300-42,000) 18,700 (22,000-3300)

Payment to be 18,700rec


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Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000Margin = Rs 45,300

Close Price Gain Net cash inflow

1600*50*4 =3,20,000 18,000 (3,20,000-3,02,000) 18,000 + 45,300* = 63,300

Payment to be recd 63,300


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Margin account*

= ,

Margin released (Day 1) = (-) Rs 3,000Position on Day 2 Rs 42,000

= +Total margin in a/c Rs 45,300*

Net gain/lossDay 1 (loss) = (Rs 17,000)Day 2 Gain = Rs 18,700Day 3 Gain = Rs 18,000

Total Gain = Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total


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-

Gives the holder the right to do something, but not the.

Purchaser of option has to pay something for this right in theform of a remium.

One can also sell/write options and receive an option premiumfrom the buyer. A seller is obliged to sell/buy an asset if thebuyer exercises it on him.

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.

Stock Options Options which have stocks as theunderlying asset.

Call Option Gives the holder the right but not the

obligation to buy an asset by a certain date for a. Put Option Gives the holder the right but not the

obligation to sell an asset by a certain date for a

certain price.


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Bu 1 Tata Motors 900 Au Call Rs.25

As Lot size is 500, total premium paid is Rs.25 x 500 = Rs.12500. CMP in cash mkt is Rs.900

Now if Tata Motors moves to Rs.1000 optionpremium would roughly increase to Rs.125.


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i n T rmin l Option price Price which option buyer pays to option seller.

so nown as prem um

Expiration date The date specified in the options contract isknown as the expiration date, the exercise date, the strike dateor t e matur ty.

Strike Price Price specified in the options contract. Also

called exercise price. American Options Options that can be exercised at any time

upto the expiration date. Most exchange traded options areAmerican.

European Options Options that can be exercised only on theexpiration date itself.


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In-the-money option An option that brings a positive cash

ow to t e o er exerc se mme ate y. ca opt on s n-

the-money if CMP of underlying asset is higher than strike price.

At-the-money option An option that brings zero cash flow ifexercised immediately. A call option is at-the-money if CMP of

underlying asset is equal to strike price.

Out-of-the-money option An option that brings negative cashflow if exercised immediately. A call option is out-of-the-money if

CMP of underlying asset is less than strike price.


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Option Premium is made up of two components

Intrinsic Value & Time Value

option is OTM or ATM, its intrinsic value is zero.

.OTM and ATM options have only time value. Max time valueexist when option is ATM. Longer the time to expiration, greateris an o tions time value. At ex iration an o tion should have no time value.


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Factors affecting option price

Stock Price Call options become more valuable as stockprice go up.

Strike Price - Call options become more valuable as strikepr ce goes own.

Time to expiration More the time more the value of the

option Risk free interest rate Prices of call options increase as

risk free interest rate increases.

positive effect on put options as dividends have the effect ofreducing the stock price on ex-dividend date.


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Difference between Futures andOptions

Futures have unlimited profit and loss potential.

Options have limited risk and unlimited profit

potential.


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ayo or u ures

Profit

2500

Nifty

Loss


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Profit

NiftyPremium

Loss


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Profit

Nifty

Premium

Loss


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or pecu at on1. Bullish outlook Long Nifty Futures

. -Get the advantage of leverage


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or e g ng1. Long Security, Short Nifty Futures

. ,3. Have portfolio, Short Nifty Futures4. Have funds Lon Nift Futures


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Hed in B bu in uts

Speculation u s uy y a s or e y u s Bearish Sell Nifty Calls or Buy Nifty Puts

Anticipate Volatility Buy a call and put at same strike Bull Spreads Buy a call and sell another Bear Spreads Sell a call and buy another


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Usin Index O tions

Hedging By buying puts

When index falls your portfolio will lose value and the puto tions bou ht b ou will ain.

Level of protection depends on strike price of options chosen..

If Nifty spot is 2500 and you buy puts with a strike of 2400, it will

nsure your port o o aga nst an n ex a ower t an .

Upside remains potentially unlimited.


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S eculation Bullish outlook

Buy Nifty Call Options or Sell Put Option Buying Call Options Limited risk, Unlimited gain Strike Price is chosen depending on the view of the market.

A Trader is bullish on the index. Spot Nifty is at 1200. He buys athree month Nifty Call Option contract with a strike price of 1260at a premium of Rs.15 per call. Three months later, the index

c oses at . s tota pro t s

(1295-1260 15) * 200 = 20 * 200 = Rs.4,000.


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pecu at on nt c pate vo at ty

If you think that market is going to witness volatile swings buthave no opinion on the direction of the swing, you canmp ement a er vat ve strategy ca e a stra e.

Can be used around budget time or during times of political

uncertainty. Involves buying a call and a put with the same strike price and

maturity. Maximum loss is the premium paid for the two options.

Gains are made only if the underlying asset moves significantly.


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Summary

CALL OPTION BUYER CALL OPTION WRITER (Seller)

Pays premium

Profits from rising pricesLimited losses, Potentially unlimitedgain

Obligation to sell shares if exercisedProfits from falling prices or remaining neutralPotentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium

Profits from falling pricesLimited losses, Potentially unlimitedgain

Obligation to buy shares if exercisedProfits from rising prices or remaining neutralPotentially unlimited losses, limited gain


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The Strike Price denotes the price at which the buyer of the option has a right topurchase or sell the underlying.

Five different strike prices will be available at any point of time.

The strike rice interval will be of 20. If the index is currentl at 1,410, the strike ricesavailable will be 1,370, 1,390, 1,410, 1,430, 1,450.

The strike price is also called Exercise Price. This price is fixed by the exchange for

entire duration of the option depending on the movement of the underlying stock orindex in the cash market.


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In-the-money

A Call Option is said to be "In-the-Money" if the strike price is less than the marketprice of the underlying stock.

A Put Option is In-The-Money when the strike price is greater than the market price ofthe underlying stock.

eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10

In the above example, the option is "in-the-money", till the market price of SATCOM isruling above the strike price of Rs 190, which is the price at which Raj would like to buy

.

Similary, if Raj had purchased a Put at the same strike price, the option would havebeen "in-the- mone " if the market rice of SATCOM was lower than Rs 190 er share.


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Out-of-the-Money

A Call Option is said to be "Out-of-the-Money" if the strike price is greater than themarket price of the stock.A Put o tion is Out-Of-Mone if the strike rice is less than the market rice.

eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150

" ", - - - ,is

ruling below the strike price of Rs 3500, which is the price at which SAM would like tobuy 100 shares anytime before the end of August.

Similary, if Sam had purchased a Put at the same strike price, the option would havebeen "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.


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- At-the-Money

The option with strike price equal to that of the market price of the stock is considered asbeing "At-the-Money" or Near-the-Money.

eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10

In the above case, if the market price of ACC is ruling at Rs 150, which is equal to thestrike price, then the option is said to be "at-the-money".

If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410,, , , .

or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering thatthe underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390,which are lower than the underl in of 1 410.


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For Call options the right to buy the underlying at a fixed strike :

Price as the underlying price rises so does its premium. As the underlyingpr ce a s so oes e cos o e op on prem um.

For Put options the right to sell the underlying at a fixed strike :

Price as the underlying price rises, the premium falls; as the underlyingprice falls the premium cost rises.


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The Time Value of an Option

Generally, the longer the time remaining until an options expiration, the higher itspremium will be. This is because the longer an options lifetime, greater is theposs ythat the underlying share price might move so as to make the option in-the-money.

All other factors affectin an o tions rice remainin the same the time value portion of an options premium will decrease (or decay) with the passage of time.

Option Time to expiry Premium cost

Put


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Volatility

Volatility is the tendency of the underlying securitys market price to fluctuate either up ordown. It reflects a price changes magnitude; it does not imply a bias toward pricemovement in one direction or the other.

Thus, it is a major factor in determining an options premium. The higher the volatility ofthe underlying stock, the higher the premium because there is a greater possibility that

the option will move in-the-money.

Generally, as the volatility of an under-lying stock increases, the premiums of both callsand puts overlying that stock increase, and vice versa.

O p t i o n Vo l a t i l i t y P r e m iu m c o s t C a l l

P u t


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Thank you

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