INDIAN STOCK MARKET

DERIVATIVES

INTRODUCTION TO DERIVATIVES

The main instruments under the derivatives are:

1. Forward contract

2. Future contract

3. Options

4. Swaps

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

Business growth of futures and options market: NSE Turnover (Rs.cr)

MonthIndex futures

Stock futures

Index options

Stock options Total

Jun-00 35 - - - 35

Sep-00 119 - - - 119

Dec-00 237 - - - 237

01-Mar 381 - - - 381

01-Jun 590 - 196 - 785

01-Sep 2857 - 559 2012 5281

01-Dec 2339 7515 405 2660 12919

02-Mar 2185 13989 360 3957 20490

2001-02 21482 51516 3766 25163 101925

Instruments available in India

Products Index Futures Index OptionsFutures on Individual Securities

Options on Individual Securities

Underlying Instrument

S&P CNX Nifty S&P CNX Nifty31 securities

stipulated by SEBI

31 securities stipulated by

SEBI

Type European American

Trading Cycle

maximum of 3-month trading cycle. At any

point in time, there will be 3 contracts available :

1) near month,2) mid month &

3) far month duration

Same as index futures

Same as index futures

Same as index futures

Expiry DayLast Thursday of the

expiry monthSame as index

futuresSame as index

futuresSame as index

futures

Contract SizePermitted lot size is 200

& multiples thereofSame as index

futures

As stipulated by NSE (not less than

Rs.2 lacs)

As stipulated by NSE (not

less than Rs.2 lacs)

OPTIONS

• The Parties to an Option• The options are of two styles.

1) European option and 2) American option• The options are of two types. 1) Call option and

2) Put option.

In-the-Money, At-the-Money, Out-the-Money

CALL OPTION PUT OPTION

In-the-money Strike price < Spot price Strike price > Spot price

At-the-money Strike price = Spot price Strike price = Spot price

Out-the-money Strike price > Spot price Strike price < Spot price

Option value

• Intrinsic value and

• Time value.

Factors affecting the value of an option

Factor Option Type Impact on Option ValueComponent of Option Value

Share price moves up Call Option Option Value will also move up Intrinsic Value

Share price moves down Call Option Option Value will move down Intrinsic Value

Share price moves up Put Option Option Value will move down Intrinsic Value

Share prices moves down Put Option Option Value will move up Intrinsic Value

Time to expire is high Call Option Option Value will be high Time Value

Time to expire is low Call Option Option Value will be low Time Value

Time to expire is high Put Option Option Value will be high Time Value

Time to expire is low Put Option Option Value will be low Time Value

Volatility is high Call Option Option Value will be high Time Value

Volatility is low Call Option Option Value will be low Time Value

Volatility is high Put Option Option Value will be high Time Value

Volatility is low Put Option Option Value will be low Time Value

OPTIONS ON NIFTY & INDIVIDUAL

SECURITIES

• Trading cycle

• Expiry day

• Strike Price Intervals

• Contract size

DERIVATIVES TRADING STRATEGIES USING OPTIONS

• Classification Of Strategies According To Market View

• When market to be bullish: • Buy index/ stock futures

• Buy call option

• Sell put option

• Bull call spread

• Bull put spread

• Bullish calendar spread

• When market to be bearish: • Sell index/ stock futures

• Sell call option

• Buy put option

• Bear call spread

• Bear put spread

• Bearish calendar spread

• When market to be uncertain but expects to move in either direction sharply:

• Long straddle

• Long strangle

• Covered call

• Strips

• Straps

• When market to remain stable:• Short straddle

• Short strangle

• Butterfly spreads

• Neutral calendar spread

BULL CALL SPREAD: buy a call and sell a call with different strike price and same expiry date with sell call strike price higher than the buy call strike price.

140

BEP= 142

Profit

Loss

8

4

-2

-6

Profit/loss of Long call

Profit/loss of Short call

150

146

Example:Assumptions: Spot price of ACC - Rs 142, Mutiplier : 1500Buy ACC April 140 call @ Rs 6 & Sell ACC April 150 call @ Rs 4Break-even point: Rs 142There are four scenarios at the expiry date:ACC <= 140. Loss = Rs 3000 (limited to the extent of premium paid - premium received)ACC > 140 and <=142. Loss= (142–closing spot price at expiry)*1500ACC>142 and <=150. Profit= (closing spot price at expiry–142)*1500ACC > 150. Profit = (150 – 142) * 1500Limited risk: since the loss can be maximum to the extent of net premium paid.Limited Profit: maximum being the difference between higher strike price option and lower strike price option after deducting the net premium paid.

Profit

Loss

2

-4

-8

6Profit/loss of Long call

150

142140

Profit/loss of short call

BEAR CALL SPREAD:Buy a call and sell a call with different strike price and same expiry date with sell call strike price lower than the buy call strike price.

Example: Assumptions: Spot price of ACC - Rs 142Sell ACC April 140 call @ Rs 6 & Buy ACC April 150 call @ Rs 4Mutiplier : 1500Break-even point: Rs 142There are four scenarios at the expiry date:ACC <= 140. Profit = Rs 3000 (limited to the extent of premium received - premium paid)ACC>140 and <=142. Profit=(142–closing spot price at expiry) * 1500ACC>142 and <=150. Loss=(closing spot price at expiry–142) * 1500ACC > 150. Loss = (150 – 142) * 1500Limited risk: since the loss can be maximum of Rs 12000.Limited Profit: maximum being the difference between premium received and premium paid.

Profit

Loss

-3

-5

-2

135

138 140 150 153

155

Long CallLong Put

LONG STRANGLE:Buy a call and buy a put with same expiry date but different strike price, with the put strike price lower than the call strike price and when one is uncertain about the market but expects it to move in either direction sharply.

Example:Assumptions : Spot price of the ACC – Rs 145 , Multiplier : 1500Buy ACC Sep. 140 put @ 2 & Buy ACC Sep. 150 call @ 3Break-even point : Rs 155 for call option/ Rs 135 for put optionThere are five scenarios at the expiry date.ACC <= 135 profit = (135- closing price at expiry)*1500ACC > 135 & <= 140. Loss = (colsing price at expiry -135)*1500ACC >140 & <=150 Loss = maximum to the extent of premium paid = Rs 7500ACC>150 & <155. Loss= (155- closing spot price at expiry)*1500ACC>= 155. Profit = (closing price at expiry –155)*1500Limited risk: since loss can be limited to the extent of premium paid.Returns : unlimited as the maximum gain could be greater if sharp movement occur.

SHORT STRADDLE:Sell a call and sell a put with the same strike price and same expiry date when prices are expected to be stable.

Profit

Loss

9

17

8

132

140

149

123 157

Sell CallSell Put

Example Assumptions:Multiplier: 1600Sell Tata Sept. 140 call @ 9 & Sell Tata Sept. 140 put @ 8Break-even point : 157 for call option/ 123 for put optionTata <=123 loss = (123- closing at expiry)*1600 Tata> 123 & <=140 . profit = ( closing at expiry - 123)*1600Tata > 140 & <= 157. Profit = ( 157 – closing spot price at expiry)*1600Tata >157. Loss = (closing spot price at expiry - 157)*1600Risk: the maximum risk could be greater if sharp movements occur.Limited profit: since profit can be limited to the extent of premium received. Max. profit is Rs. 27200(17*1600) at a price of 140

Put/Call Ratio

Uncertain Greater than 0.35 and less than 0.75

Extremely bearishGreater than 0.75

Extremely bullishLess than 0.35

IndicationP/C ratio

OPEN INTEREST (An indicator)

• Some interpretations using Open Interest:

• Rising open interest in an uptrend is bullish

• Declining open interest in an uptrend is bearish.

• Rising open interest in a downtrend is bearish.

• Declining open interest in a downtrend is bullish.

• Within an uptrend, a sudden leveling off or decline in open interest often warns a change in trend.

• Very high open interest at market tops is dangerous and can intensify downside pressure.

FUTURES

Only the sellers have to put in margins.

Both the parties have to put in margins.

Impose obligations on the sellers only.

Impose obligations on both the parties

The buyers have to pay a premium to the sellers.

There is no premium

Risk exposure and profit potential are limited for the seller.

Risk exposure and profit potential are unlimited for both the parties.

OptionsFutures

DIFFERENCE BETWEEN FUTURES AND OPTIONS

• Types of Futures

• Agricultural

• Metallurgical

• Interest Bearing Assets

• Indexes

• Foreign Currencies

Margin Money

• Different Types of Margins:• Initial Margin

• Mark-to-Market Margin

• Maintenance Margin

• Additional Margin

• Cross Margining

THE BLACK -SCHOLES MODEL

(An option pricing model)

FINDINGSGrowth:• Cash market- turnover-3692 cr. (BSE & NSE)• Derivatives market- traded value - 2417 cr.

Factors that hinder the growth of DerivativesMarket in India:

• Market is dominated by few large players.• Very high minimum contract size.• Initial investment.• Number of scrips available for trading is 31.• Cash settlement only.

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