Intro..Derivatives

8/8/2019 Intro..Derivatives

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Dalal & Broacha Stock Broking Private Limited Derivatives

A NEW ‘OPTION’ IN THE STOCK MARKET

You buy or trade stocks, bonds and mutual funds. Did you know you might be using a form of options as part of

your everyday life? Do you pay a premium every quarter for house, auto and medical insurance? You have

purchased insurance as a option (safeguard) against a fire in your home, a damage to your car, or large medical

bills. Investors can also use options on stocks or indexes to protect and insure the value of their portfolios. A

major advantage of options is their versatility. They can be as conservative or as speculative as your investing

strategy dictates. Options enable you to tailor your position to your own set of circumstances. Consider the

Following benefits of Options:

• You can protect stock holdings from a decline in market price.

• You can increase income against current stock holding.

• You can prepare to buy a stock at a lower price.

• You can position yourself for a big market move even when you don’t know which way prices will move.

• You can benefit from a stock price rise without incurring the cost of buying the stock outright.

What are options?

An option is a deferred delivery contract, which gives the buyer (holder) the right, but not the obligation, to buy

or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expira-

tion date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instru-

ments like equity stocks/ stock index/ bonds etc.

Let us understand the various terms involv ed wit h the help of an example:

Supposing the current market price of Reliance Industries is Rs. 400 and right now it is the month of June. Now

there are the following Call and Put Options available in the market:

Sr. No. Particulars Type of Option Exercise Price Exercise Date Premium

1 RILCJUL380 Call 380 July 40



4 RILCAUG400 Call 400 August 25

5 RILCSEP400 Call 400 September 30

6 RILPJUL420 Put 420 July 40



9 RILPAUG400 Put 400 August 25

10 RILPSEP400 Put 400 September 30

Now let us understand each of the terms with the help of this example.

Important Terminology involved

• Underlying - The specific security / asset on which an options contract is based. In the above example, the

underlying is the stock of Reli ance Industires.

• Option Buyer /Holder - The person who buys an option, which can be a call option or a put option. He

enjoys the right to buy or sell the underlying asset at a specified price on or before specified time, but he does

not have the obligation to do so. The option buyer has to pay a premium to the option writer in order to

purchase this right. His upside potential is unlimited while losses are limited to the Premium paid by him

to the option writer. Any one can be an option buyer, provided he pays the premium.

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• Option S eller /Writer – The person who writes the option, which can be a call option or a put option. He has

the obligation to buy (in case of Put option) or to sell (in case of call option) the underlying asset, in case the

buyer of the option decides to exercise his option. The option writer collects the premium from the option

buyer. His profits are limited to the premium received from the buyer while his downside is unlimi ted.

There are some requirements for a person to become an option writer, one of them being that the minimumnetworth requirement is Rs. 3 crores. Moreover, Mutual Funds are not allowed to act as Option Writers.

• Call Option - A call option gives the buyer/holder the right to buy specified quantity of the underlying asset

at the strike price on or before expiration date. The seller of the call option on the other hand has the

obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. For

example, in the above case, the first option, which is a call option, gives the buyer the right to buy shares of

Reliance at the exercise price of R s. 380 on or before the expiration date of July by paying a premium of Rs.

40.

• Put Option - A Put option gives the buyer/holder the right to sell specified quantity of the underlying asset

at the strike price on or before expiration date. The seller of the put option on the other hand has the obligation

to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. For example,in the above case, the sixth option, which is a put option, gives the buyer the right to sell shares of Reliance

at the exercise price of Rs. 420 on or before the expiration date of July by paying a premium of Rs. 40.

• Option Premium – Option Premium is the price paid by the buyer to the option seller to acquire the right to

buy or sell the underlying. In the above case, supposing a person buys the first option i.e. the July – 380 Call

Option, he has to pay a premium of Rs. 40, while the writer receives the same for writing the option. The

premium has to be paid up front and the writer receives the premium irrespective of whether the option is

exercised or not. Calculation of the option premium depends on a lot of factors, which will be covered later.

• Strik e Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price

of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/

sell on or before the expiration day. For example, Option no. 1 will have an exercise price of Rs. 380, i.e. thecall buyer can buy the stock of Reliance at Rs. 380, while Option no. 6 will have an exercise price of Rs. 420

i.e. the put buyer can sell the stock of Reliance at Rs. 420.

• Expiration date -The date on which the option expires is known as Expiration Date. On Expiration date,

either the option is exercised or it expires worthless. For example, if it is an August option (Option no. 4/9),

then the expiration date would be the last Thursday of the month, beyond which the option cannot be

exercised.

• Exercise Date – The date on which the option is actually exercised by the buyer. In case of European Options,

the exercise date is same as the expiration date while in case of American Options, the exercise date may be

the same or it may be earlier than the expiration date. Exercise date cannot be beyond the expiration date.

• European & American Style of options - An American style option is the one which can be exercised by the

buyer any time on or before the expiration date, i.e. anytime between the day of purchase of the option and the

day of its expiry. For example, if a person has purchased option no. 5 i.e. the September Call Option, he can

exercise the option any time till the end of September.

The European style of option is the one which can be exercised by the buyer on the expiration day only & not

anytime before that. For example, if a person has purchased option no. 5 i.e. the September Call Option, he

can exercise the option only on the end September date.

• Option Class – It refers to all listed options of a particular type (i.e., call or put) on a particular underlying

instrument. For example, in the above example, all Call Options of Reliance or all Put Options of Reliance are

referred to as an Option Class.

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• Option Series - An option series consists of all the options of a given class with the same expiration date and

strike price. For example, RILCJUL400 is an options series, which includes all Reliance Call options that are

traded with Strike Price of 400 & Expiry in July.

• Open Interest - The total number of options contracts outstanding in the market at any given point of time.


POSITONS THAT CAN BE TAKEN

Long Call

A long call, the purchase of a call, is an option to buy an asset at the Strike price. It is a strategy to take advantage

of any increase in the price of the underlying asset.

E.g. Strike Price = Rs.100 Current Market Price = Rs.100

Option Premium/Price = Rs.5

Now let us consider the Pay-off table

Mkt .Pr ices Exerc ise (Y/N) Profi t/ (Loss)

98 No (5)

101 Yes (4)

103 Yes (2)

105 Yes 0

108 Yes 3

Short Call

A short call, the writing of a call, is the obligation to sell an asset at the strike price if the long call chooses to

exercise the option. Here the strategy is designed to profit from falls in the price of the underlying asset.

Erg. Considering the above values, the Pay-off table would be as follows;

M kt .P ri ce s P ro fi t/ Lo ss

98 5

101 4

103 2

105 0

108 (3)

Long Put

A long put, the purchaser of the put, is an option to sell an asset at the Strike price. It is a strategy designed to take

advantage of a fall in the spot price of the underlying.

E.g. Considering the same values, the Pay-off table would be as follows:

M k t.Prices Exercise (Y/N) Prof it/(Loss)

94 Yes 195 Yes 099 Yes (4)

102 No (5)

Short Put

A short put, the writer of the put, has the obligation to buy an asset at the strike price if the long put chooses to

exercise.

E.g. Considering the same values, the Pay-off table would be as follows;

Mkt.Prices Prof it/Loss

94 595 497 299 0

102 (1)

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PERCEPTIONS & STRATEGIES

! BULLISH

Strategy View : The market will move upwards.

Strategy Implementation : Buy a Call Option (preferably Out-of-the-money)

Upside Potential : Unlimited

Downside risk : Limited to the amount of the premium paid.

BEP : Strike Price + Premium

Margin : Not Required

! BEARISH

Strategy View : The market will move downwards.

Strategy Implementation : Buy a Put Option

Upside Potential : Unlimited

Downside risk : Limited to the extent of the Premium paid.

BEP : Strike Price + Premium

Margin : Not Required

! CERTAIN THAT MARKET WILL NOT RIS E

Strategy View : The market will not rise/could be in a trading zone.

Strategy Implementation : Sell a Call Option (preferably at-the-money option)

Upside Potential : Limited to the extent of the Premium Received.

Downside risk : Unlimited upon exercise of the option by the holder.

BEP : Strike Price - Premium

Margin : Required

! CERTAIN THAT THE MARKET WILL NOT FALL

Strategy View : The market will not fall/could be in a trading zone.

Strategy Implementation : Sell a Put Option (preferably at-the-money option)

Upside Potential : Limited to the extent of the Premium Received.

Downside risk : Unlimited upon exercise of the option by the holder.

BEP : Strike Price - Premium

Margin : Required

! MODERATELY BULLISH

Strategy View : The participant is moderately bullish as he feels that the

Market will not fall considerably.

Strategy Implementation : (i) Buy a lower Strike Call option and Sell a higher Strike Call option

(ii) Buy a lower Strike Put option and Sell a higher Strike Put option

Upside Potential : Limited in both the cases as follows:

(i) Calls: Diff. Between Strikes minus Initial Debit

(ii) Puts: Net Initial Credit

Downside risk : Limited in both the cases as follows:

(i) Calls: Net Initial debit(ii) Puts: Diff.between Strikes minus Initial Credit

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A NOTE ON INDEX FUTURES

BEP : (i) Calls: Lower Strike + Net Premium paid

(ii) Puts: Higher Strikes – Net Premium Received

Margin : Set-off of margins possible

Analysis : This is a very conservative strategy as the Profit potentials and the risk factors

are limited. If the closing is above the higher strike it gives you the maximum

profit and if the closing happens to be below the lower strike, it gives you

maximum loss.

! MODERATELY BEARIS H

Strategy View : The participant is moderately bearish as he feels that the Market will not rise

considerably.

Strategy Implementation : (i) Buy a higher Strike Call option and Sell a lower Strike Call option

(ii) Buy a higher Strike Put option and Sell a lower Strike Put Option

Upside Potential : Limited in both the cases as follows:

(i) Calls: Net Initial Credit

(ii) Puts: Diff.between Strikes minus premium paid.

Downside risk : Limited in both the cases as follows:

(i) Calls: Diff in Strikes minus net premium received.

(ii) Puts: Net Initial debit

BEP : (i) Calls: Lower Strike + Net Premium Received

(ii) Puts: Higher Strike – Net Premium paid

Margin : Set-off of margins possible

Analysis : This is also very conservative strategy. The maximum occurs when the closing

is below the lower strike and the maximum loss if the closing is above the

higher strike.

The world financial markets have undergone qualitative changes in the last two-three decades due to phenomenal

growth of derivatives. Amongst the financial futures, the first to emerge were the currency futures in 1972 in US

followed by Interest Rate futures. Index Futures and Options first emerged in 1982.Since then, the financial

futures have quickly spread to an increasing number of developed and developing countries. Countries having

securities market much smaller than that of India have successfully implemented derivatives segment. With the

world embracing the derivatives market on a large scale, the India market obviously cannot remain aloof and nor

do our investors.

Futures

Futures are exchange traded contracts to sell or buy financial instruments at an agreed price. There is an agreement

to buy or sell a specified quantity of the financial instruments at a price agreed upon. Futures are recognized as

the best and most efficient way of meeting the need for risk hedging.

Stock Index Futures

Stock Index represents the change in the value of the set of the underlying stocks, which constitute the index. Any

index is an average of its constituents. The BSE Sensex is the weighted average of the prices of the 30 selected

stocks & S&P CNX Nifty of 50 selected stocks, where the weight is the market capitalization of the constituent

stocks. Thus Index Futures are future contracts where the underlying asset is the Stock Index ie.the BSE Sensex

in BSE & CNX Nifty in the NSE.

The Bombay Stock Exchange and the National Stock Exchange launched Index based Futures inJune2000.

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A BIR D’S EYE-VIEW OF THE INDEX FUTURES M ECHAN ISM

The Multiplier Effect

The multiplier for the Index futures is 50 & 200 in BSE and NSE respectively. To explain, if you buy or sell an

index in BSE at 4000 then your Contract Value would be Rs.200000 (i.e. 1*50*4000).

Margins

The exchange at present charges two margins viz. Initial Margin & Mark -to-Market margin

Based on the volatility of the market indices, the initial margin is expected to be between 8-18%.

Mark-to-Market margin is the daily settlement of profits or losses at the day’s closing rate of the particular Index

Series.

Opening Dly.Setl.Rt Calculation Daily MTM

Pstn op.@ 4280 - - -

Day 1 4300 4300-4280 +1000

Day 2 4300 4250 4250-4300 -2500

Day 3 4250 4305 4305-4205 +2750

Day 4 4305 4295 4295-4305 -500

Day 5 4295 4310 4310-4295 +750

Pstn cls @ 4345 4310 4345-4310 +1750

+3250

Thus, you have a final profit of Rs.3250 [(4345-4280)*50*1]

Tenure of the Contract

At any point of time, next three months contracts are available.

(In March one can take positions in March, April and May Series)

All the open positions will be settled out on the last Thursday of the Contract month.

(March expires on- 29/03/2001, April on 26/04/2001& May on 31/05/2001)New contracts will be open for trading on the next day of the expiry day.

Settlement Price for the S eries

The Final Settlement Price for a particular series would converge with the closing index of the Equity segment of

that particular day.

STRATAGIES

Speculation

Speculators are those traders who take an open view on the market. A speculator may take a long position on the

futures when he expects the market to go up. He intends to make money by reversing his position at a higher

price. Similarly, he would take a short position when he is bearish on the market to make profits by reversing hisposition at a lower price. Thus, a speculator accepts open risk in pursuit of profit. This is a highly specialized

strategy as the speculators success is dependent on their ability to forecast the Future prices.

Hedging

Hedging is a strategy to reduce the price inherent in the open positions. Hedging using derivatives has become

a central part of the risk management in the modern economies. Hedging does not mean maximisation of returns;

it only means reduction in variation of returns. The basic logic behind hedging is “IF LONG IN CASH - GO

SHORT IN FUTURES & IF SHORT IN CASH - GO LONG IN FUTURES.”

It may thus be observed that any gains in the futures market offset losses in the cash market and any losses in the

futures market are offset by gains in the cash market.

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Arbitrage

Arbitrage is a simultaneous purchase and sale of the same underlying in two markets in an attempt to make

profits without risk. The complexity of the arbitrage activity is such that it is reserved particularly to well

informed and professional traders, equipped with powerful calculative and analytical ability.

Arbitrage opportunities can be explained as follows:

• Cash & Carry arbitrage: It refers to a long position in the Cash segment and a short position in the Futures

market.

• Reverse Cash & Carry Arbitrage: It refers to a short position in the Cash segment and a long position in the

Futures market.

• Inter-Market arbitrage: It refers to taking opposite position on Sensex and Nifty.

How are options different f rom futures?

The significant differences in Futures and Options are as follows:

•

Futures are contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by thebuyer & seller, on or before a specified time. Both the parties are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right but not the obligation, to buy or sell the underlying asset.

• Futures Contracts have symmetric risk profile for both the buyer and the seller, whereas options have

asymmetric risk profile. In case of an option buyer, the downside is limited to the premium paid while the

profits may be unlimited, while for the writer of an option, the downside is unlimited while profits are

limited to the premium received from the buyer.

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

•

Futures contract does not involve any cost for entering into the contract, whereas there is a cost (in the formof Premium) of entering into an options contract. However, in case of Futures, one is required to pay margins

(up-front as well as mark to market), while Options does not involve any such margins.

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