Derivatives April

Derivatives (Futures & Options)

April , 2014

Derivatives• “Derivatives” is used to refer to financial

instruments which derive their value from some underlying assets

• Assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index

• Derivatives can be traded either on a regulated exchange, such as the NSE or off the exchanges, i.e., directly between the different parties, which is called “over-the-counter” (OTC) trading.

Derivatives• 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. In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices.– For example, on November 1, 2013 a rice farmer may wish to

sell his harvest at a future date (say January 1, 2014) for a pre-determined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the "underlying".

Derivatives• The earliest evidence of these types of instruments can be traced back to ancient

Greece• Derivatives contracts initially developed in commodities. The first “futures”

contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers.

• These were evidently standardized contracts, much like today’s futures contracts.• In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of

forward contracts on various commodities.• Derivatives markets have been functioning since the nineteenth century, with

organized trading in cotton through the establishment of the Cotton Trade Association in 1875.

• Derivatives, as exchange traded financial instruments were introduced in India in June 2000.

• The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract.

Derivatives• Spot Market : In the context of securities, the spot market or

cash market is a securities market in which securities are sold for cash and delivered immediately. – The delivery happens after the settlement period. – Eg: The NSE’s cash market segment is known as the Capital Market

(CM) Segment. In this market, shares of SBI, Reliance, Infosys, ICICI Bank, and other public listed companies are traded.

– The settlement period in this market is on a T+2 basis i.e., the buyer of the shares receives the shares two working days after trade date and the seller of the shares receives the money two working days after the trade date.

• Three basic types of derivative instruments are : – Forwards– Futures– Options

Derivatives• Forwards :

– A forward contract or simply a forward 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.

– The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price.

– Forwards are private contracts and their terms are determined by the parties involved.– It is a commitment by both the parties to engage in a transaction at a later date with the

price set in advance. – This is different from a spot market contract, which involves immediate payment and

immediate transfer of asset.– The party that agrees to buy the asset on a future date is referred to as a long investor and

is said to have a long position.– Party that agrees to sell the asset in a future date is referred to as a short investor and is

said to have a short position. – The price agreed upon is called the delivery price or the Forward Price.– 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.

Examples of a forward• Pizza forward contract.

Order pizza by phone. Specify topping (type), size, delivery time and location and price - fixed when contract is established. Pay on delivery.

• Energy forward– You buy 50,000 cubic feet (50 Mcf) of heating gas in

summer from your heating company for $10 per thousand cubic feet (Mcf), deliverable from Jan. – March.

– Long in forward: You– Short: Heating Co.

Derivatives

• Settlement of forward contracts– Physical settlement – Cash settlement

• Physical Settlement– Physical delivery of the underlying asset by a short

investor (i.e. the seller) to the long investor (i.e. the buyer)

– Payment of the agreed forward price by the buyer to the seller on the agreed settlement date

Derivatives• Illustration : Consider two parties (A and B) enter into a forward contract on

1 August, 2009 where, A agrees to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per share, on 29 th August, 2009 (the expiry date). In this contract, A, who has committed to sell 1000 stocks of Unitech at Rs.100 per share on 29th August, 2009 has a short position and B, who has committed to buy 1000 stocks at Rs. 100 per share is said to have a long position.

• In case of physical settlement, on 29th August, 2009 (expiry date), A has to actually deliver 1000 Unitech shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A.

• In case A does not have 1000 shares to deliver on 29th August, 2009, he has to purchase it from the spot market and then deliver the stocks to B .

• On the expiry date the profit/loss for each party depends on the settlement price, that is, the closing price in the spot market on 29th August, 2009. Depending on the closing price, three different scenarios of profit/loss are possible for each party.

Derivatives• Scenario I. Closing spot price on 29 August, 2009 (S T) is

greater than the Forward price (FT)– Assume that the closing price of Unitech on the settlement

date 29 August, 2009 is Rs. 105.– Since the short investor has sold Unitech at Rs. 100 in the

Forward market on 1 August, 2009, he can buy 1000 Unitech shares at Rs. 105 from the market and deliver them to the long investor.

– The person who has a short position makes a loss of (100 – 105) X 1000 = Rs. 5000.

– If the long investor sells the shares in the spot market immediately after receiving them, he would make an equivalent profit of (105 – 100) X 1000 = Rs. 5000.

Derivatives• Scenario II. Closing Spot price on 29 August (S T), 2009 is the same as the

Forward price (F T)– The short seller will buy the stock from the market at Rs. 100 and give it to the long

investor.– As the settlement price is same as the Forward price, neither party will gain or lose

anything.

• Scenario III. Closing Spot price (S T) on 29 August is less than the futures price (F T)– Assume that the closing price of Unitech on 29 August, 2009 is Rs. 95. The short investor,

who has sold Unitech at Rs. 100 in the Forward market on 1 August, 2009, will buy the stock from the market at Rs. 95 and deliver it to the long investor. Therefore the person who has a short position would make a profit of (100 – 95) X 1000 = Rs. 5000

– The person who has long position in the contract will lose an equivalent amount (Rs. 5000), if he sells the shares in the spot market immediately after receiving them.

• Disadvantage of physical settlement: – Transaction costs in terms of actual purchase of securities by the party holding a short

position (in this case A) and transfer of the security to the party in the long position (in this case B).

– If the party in the long position is actually not interested in holding the security, then she will have to incur further transaction cost in disposing off the security.

Payoffs From Forward Contracts• Let ST denote the spot price of the asset at the delivery date T

and let Ft be the delivery price (price set at t payable at T)• The payoffs on the delivery date are:

long position payoff: ST − Ft

short position payoff: Ft − ST

Derivatives• Cash Settlement

– Cash settlement does not involve actual delivery or receipt of the security. – Each party either pays (receives) cash equal to the net loss (profit) arising out of

their respective position in the contract. – In case of Scenario I, where the spot price at the expiry date (ST) was greater

than the forward price, A will simply pay Rs. 5000 to B on the expiry date. – The opposite is the case in Scenario (III), when ST < FT. The long party will be at a

loss and have to pay an amount equivalent to the net loss to the short party. In our example, B will have to pay Rs. 5000 to A on the expiry date.

– In case of Scenario (II) where ST = FT, there is no need for any party to pay anything to the other party.

– Profit and loss position in case of physical settlement and cash settlement is the same except for the transaction costs which is involved in the physical settlement.

• Default risk in forward contracts– Whether the contract is for physical or cash settlement, there exists a

potential for one party to default. This risk of making losses due to any of the two parties defaulting is known as counter party risk.

Derivatives• Futures

– An agreement between two parties in which the buyer agrees to buy/sell an underlying asset from the seller, at a future date at a price that is agreed upon today

– A futures contract is not a private transaction but gets traded on a recognized stock exchange

– A futures contract is standardized by the exchange– All the terms, other than the price, are set by the stock exchange (rather

than by individual parties as in the case of a forward contract).– Both buyer and seller of the futures contracts are protected against the

counter party risk by an entity called the Clearing Corporation– The Clearing Corporation holds an amount as a security from both the

parties. This amount is called the Margin money and can be in the form of cash or other financial assets.

– Since the futures contracts are traded on the stock exchanges, the parties have the flexibility of closing out the contract prior to the maturity by squaring off the transactions in the market.

Forwards Futures

Privately negotiated contracts Traded on an exchange

Not standardized Standardized contracts

Settlement dates can be set by the parties

Fixed settlement dates as declared by theexchange

High counter party risk Almost no counter party risk

Derivatives

• An option is a derivative contract between a buyer and a seller, where one party gives to the other the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price.

• In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the “premium” or price of the option.

• The right to buy or sell is held by the “option buyer” (also called the option holder); the party granting the right is the “option seller” or “option writer”.

• Options require a cash payment (called the premium) upfront from the option buyer to the option seller.

• Options can be traded either on the stock exchange or in over the counter (OTC) markets.

Derivatives

• Call option– A call option is an option granting the right to the buyer of the

option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so.

– The person who has the right to buy the underlying asset is known as the “buyer of the call option”.

– The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract (strike price of the contract - call option strike price in this case).

– The buyer will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract.

– The buyer of the call option does not have an obligation to buy if he does not want to

Derivatives

• Put option– A put option is a contract granting the right to the buyer of the

option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so.

– It is the seller who grants this right to the buyer of the option. – The person who has the right to sell the underlying asset is known

as the “buyer of the put option”. – The price at which the buyer has the right to sell the asset is

agreed upon at the time of entering the contract. This price is known as the strike price of the contract (put option strike price in this case).

– The buyer of the put will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry .

– The buyer of the put option does not have the obligation to sell if he does not want to.

Derivatives

• Illustration• Suppose A has “bought a call option” of 2000 shares of Hindustan

Unilever Limited (HLL) at a strike price of Rs 260 per share at a premium of Rs 10.– This option gives A, the buyer of the option, the right to buy 2000 shares of

HLL from the seller of the option, on or before August 27, 2009 (expiry date of the option).

– The seller of the option has the obligation to sell 2000 shares of HLL at Rs 260 per share on or before August 27, 2009 (i.e. whenever asked by the buyer of the option).

• Suppose instead of buying a call, A has “sold a put option” on 100 Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium of Rs 8.– This option is an obligation to A to buy 100 shares of Reliance Industries (RIL)

at a price of Rs 2000 per share on or before August 27 (expiry date of the option) i.e., as and when asked by the buyer of the put option.

– It depends on the option buyer as to when he exercises the option.– The buyer does not have the obligation to exercise the option.

Derivatives

Futures Options

Both the buyer and the seller areunder an obligation to fulfill thecontract.

The buyer of the option has the right and not an obligation whereas the seller is under obligation to fulfill the contract if and when the buyer exercises his right.

The buyer and the seller aresubject to unlimited risk of loss.

The seller is subjected to unlimited risk of losing whereas the buyer has limited potential to lose (which is the option premium).

The buyer and the seller havepotential to make unlimited gain orloss.

The buyer has potential to make unlimited gain .On the other hand the buyer has a limited loss potential and the seller has an unlimited loss potential.

Derivatives

Key Terminologies• Spot price (ST) : Spot price of an underlying asset is the

price that is quoted for immediate delivery of the asset. For example, at the NSE, the spot price of Reliance Ltd. at any given time is the price at which Reliance Ltd. shares are being traded at that time in the Cash Market Segment of the NSE.

• Forward price or futures price (F) : Forward price or futures price is the price that is agreed upon at the date of the contract for the delivery of an asset at a specific future date. These prices are dependent on the spot price, the prevailing interest rate and the expiry date of the contract.

Derivatives

Key Terminologies• Strike price (K) : The price at which the buyer of an

option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. Strike price is used in the case of options only; it is not used for futures or forwards.

• Expiration date (T) : In the case of Futures, Forwards, Index and Stock Options, Expiration Date is the date on which settlement takes place. It is also called the final settlement date.

Derivatives

Key Terminologies• Types of options : Options can be divided into two different categories depending

upon the primary exercise styles associated with options: – European Options: European options are options that can be exercised only on the

expiration date.– American options: American options are options that can be exercised on any day

on or before the expiry date. • Contract size : As futures and options are standardized contracts traded on an

exchange, they have a fixed contract size. – One contract of a derivatives instrument represents a certain number of shares of

the underlying asset. For example, if one contract of BHEL consists of 300 shares of BHEL, then if one buys one futures contract of BHEL, then for every Re 1 increase in BHEL’s futures price, the buyer will make a profit of 300 X 1 = Rs 300 and for every Re 1 fall in BHEL’s futures price, he will lose Rs 300.

• Contract Value : Contract value is notional value of the transaction in case one contract is bought or sold. It is the contract size multiplied but the price of the futures. Contract value is used to calculate margins etc. for contracts. In the example above if BHEL futures are trading at Rs. 2000 the contract value would be Rs. 2000 x 300 = Rs. 6 lacs.

Derivatives

Key Terminologies• Margins : In the spot market, the buyer of a stock has to pay the entire transaction

amount (for purchasing the stock) to the seller. – For example, if Infosys is trading at Rs. 2000 a share and an investor wants to buy 100 Infosys

shares, then he has to pay Rs. 2000 X 100 = Rs. 2,00,000 to the seller. The settlement will take place on T+2 basis; that is, two days after t he transaction date.

• In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement happens on a future date. Because of this, there is a high possibility of default by any of the parties.

• In order to prevent any of the parties from defaulting on his trade commitment, the clearing corporation levies a margin on the buyer as well as seller of the futures and option contracts. This margin is a percentage (approximately 20%) of the total contract value.

• For the aforementioned example, if a person wants to buy 100 Infosys futures, then he will have to pay 20% of the contract value of Rs 2,00,000 = Rs 40,000 as a margin to the clearing corporation. This margin is applicable to both, the buyer and the seller of a futures contract.

• A maintenance margin is set lower than initial margin. When balance falls below maintenance margin the investor receives margin call and has to topup the account to initial margin level.

Derivatives

Derivatives

• Margins : Investor contacts his broker to buy 2 Gold futures contracts (one contract is of 100 ounces). The current future price is $600 per ounce. The initial margin requirement is $2000 per contract. The maintenance margin is $1500 per contract. Calculate margin requirements for below futures price movements.

Day Futures price Daily Gain/Loss Cumulative gain/loss

Margin account balance

Margin call

600 40001 597 (600) (600) 34002345678910

Derivatives

• Margins : Investor contacts his broker to buy 2 Gold futures contracts (one contract is of 100 ounces). The current future price is $600 per ounce. The initial margin requirement is $2000 per contract. The maintenance margin is $1500 per contract. Calculate margin requirements for below futures price movements.

Day Futures price Daily Gain/Loss Cumulative gain/loss

Margin account balance

Margin call

600 40001 597 (600) (600) 34002 596.1 (180) (780) 32203 598.2 420 (360) 36404 597.1 (220) (580) 34205 596.7 (80) (660) 33406 595.4 (260) (920) 30807 593.3 (420) (1340) 2660 13408 593.6 60 (1280) 40609 591.8 (360) (1640) 370010 592.7 180 (1460) 3880

Derivatives• Moneyness of an Option: “Moneyness” of an

option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not.– “Moneyness” of an option at any given time depends

on where the spot price of the underlying is at that point of time relative to the strike price.

– The premium paid is not taken into consideration while calculating moneyness of an Option, since the premium once paid is a sunk cost and the profitability from exercising the option does not depend on the size of the premium.

Derivatives• Moneyness of an Option:

– In-the-money option : An option is said to be in-the-money if on exercising the option, it would produce a cash inflow for the buyer.

– Call Options are in-the-money when the value of spot price of the underlying exceeds the strike price.

– Put Options are in-the- money when the spot price of the underlying is lower than the strike price.

– Moneyness of an option should not be confused with the profit and loss arising from holding an option contract.

– While moneyness of an option does not depend on the premium paid, profit/loss depend on premium paid. Thus a holder of an in-the-money option need not always make profit as the profitability also depends on the premium paid.

Derivatives• Moneyness of an Option:• Out-of-the-money option : An out-of-the-money option is an

opposite of an in-the-money option. – An option-holder will not exercise the option when it is out-of-

the-money. – A Call option is out-of-the-money when its strike price is greater

than the spot price of the underlying – A Put option is out-of-the money when the spot price of the

underlying is greater than the option’s strike price.• At-the-money option

– An at-the-money-option is one in which the spot price of the underlying is equal to the strike price.

Moneyness of an OptionCall Option, K=75 Put Option, K=55

Underlying Price

Option Payoff

0

75

In the money

Out of the money

At the money

Underlying Price

Option Payoff

0

55

Out of the moneyIn the

money

At the money

• Illustration :– Consider some Call and Put options on stock XYZ. As on 13 August, 2009, XYZ is trading

at Rs 116.25. The table below gives the information on closing prices of four options, expiring in September and December, and with strike prices of Rs. 115 and Rs. 117.50.

• Suppose the spot price of the underlying (closing share price) as at end of September is Rs. 116 and at end of December is Rs. 118. On the basis of the rules stated above, which options are in-the-money and which ones are out-of-the-money?

Derivatives

Strike Price September Calloption

December Calloption

SeptemberPut option

December Putoption

Rs 115.00 Rs. 8.35 Rs. 12.30 Rs. 4.00 Rs. 8.00

Rs 117.50 Rs. 4.00 Rs. 8.15 Rs. 8.00 Rs. 12.00

In-the-money Options Out-of-money Options

Option Justification Option Justification

Derivatives

In-the-money Options Out-of-money Options

Option Justification Option Justification

September 115Call

Rs. 115 < Rs. 116 September 115Put

Rs. 115 < Rs. 116

September 117.50Put

Rs. 117.50 > Rs. 116 September 117.50Call

Rs. 117.50 > Rs. 116

December 115Call

Rs 115 < Rs 118 December 115Put

Rs 115 < Rs 118

December 117.50Call

Rs 117.50 < Rs 118 December 117.50Put

Rs 115 < Rs 118

Derivatives

• Investors can be broadly classified into three groups:

• Hedgers• Speculators• Arbitrageurs

Derivatives

• Hedgers : These investors have a position (i.e., have bought stocks) in the underlying market but are worried about a potential loss arising out of a change in the asset price in the future. – Want to lock the prices at which they will be able

to transact in the future. – A hedger normally takes an opposite position in

the derivatives market to what he has in the underlying market.

– Hedging in futures market can be done through two positions, viz. short hedge and long hedge.

Derivatives

• Short hedge• A short hedge involves taking a short position in the futures market. • Short hedge position is taken by someone who already owns the underlying

asset or is expecting a future receipt of the underlying asset• An investor holding Reliance shares may be worried about adverse future price

movements and may want to hedge the price risk. He can do so by holding a short position in the derivatives market. – The investor can go short in Reliance futures at the NSE. This protects him from price

movements in Reliance stock. – In case the price of Reliance shares falls, the investor will lose money in the shares

but will make up for this loss by the gain made in Reliance Futures. • A short position holder in a futures contract makes a profit if the price of the

underlying asset falls in the future. In this way, futures contract allows an investor to manage his price risk.

• Similarly, a sugar manufacturing company could hedge against any probable loss in the future due to a fall in the prices of sugar by holding a short position in the futures/ forwards market.– If the prices of sugar fall, the company may lose on the sugar sale but the loss will be

offset by profit made in the futures contract.

Derivatives

• Long Hedge : A long hedge involves holding a long position in the futures market.• A Long position holder agrees to buy the underlying asset at the expiry date by

paying the agreed futures/ forward price. – This strategy is used by those who will need to acquire the underlying asset

in the future.– For example, a chocolate manufacturer who needs to acquire sugar in the

future will be worried about any loss that may arise if the price of sugar increases in the future.

– To hedge against this risk, the chocolate manufacturer can hold a long position in the sugar futures.

– If the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal market, but he will be compensated against this loss through a profit that will arise in the futures market.

– A long position holder in a futures contract makes a profit if the price of the underlying asset increases in the future.

– Long hedge strategy can also be used by those investors who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to lock the prevailing price in the market. This may be because he thinks that the prevailing price is very low.

Derivatives

• Illustration:– For example, suppose the current spot price of

Wipro Ltd. is Rs. 250 per stock. An investor is expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is at a very attractive level and he may miss the opportunity to buy the stock if he waits till the end of the month. In such a case, he can buy Wipro Ltd. in the futures market. By doing so, he can lock in the price of the stock. Assuming that he buys Wipro Ltd. in the futures market at Rs.250 (this becomes his locked-in price), there can be three probable scenarios:

Derivatives

• Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300.– As futures price is equal to the spot price on the expiry day, the

futures price of Wipro would be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the futures market at Rs. 300.

– Profit : 300 – 250 = Rs. 50 in the futures trade. – Investor can now buy Wipro Ltd in the spot market at Rs. 300.

Therefore, his total investment cost for buying one share of Wipro Ltd equals Rs.300 (price in spot market) – 50 (profit in futures market) = Rs.250.

– This is the amount of money he was expecting to have at the end of the month.

– If the investor had not bought Wipro Ltd futures, he would have had only Rs. 250 and would have been unable to buy Wipro Ltd shares in the cash market. The futures contract helped him to lock in a price for the shares at Rs. 250.

Derivatives

• Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250.– As futures price tracks spot price, futures price

would also be at Rs. 250 on expiry day. – The investor will sell Wipro Ltd in the futures market

at Rs. 250. By doing this, he has made Rs. 0 in the futures trade.

– He can buy Wipro Ltd in the spot market at Rs. 250.– His total investment cost for buying one share of

Wipro will be = Rs. 250 (price in spot market) + 0 (loss in futures market) = Rs. 250.

Derivatives

• Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200.– As futures price tracks spot price, futures price

would also be at Rs. 200 on expiry day. – The investor will sell Wipro Ltd in the futures market

at Rs. 200. By doing this, he has made a loss of 200 – 250 = Rs. 50 in the futures trade.

– He can buy Wipro in the spot market at Rs. 200.– Therefore, his total investment cost for buying one

share of Wipro Ltd will be = 200 (price in spot market) + 50 (loss in futures market) = Rs. 250.

Derivatives

• Speculators– A Speculator is one who bets on the derivatives market based

on his views on the potential movement of the underlying stock price.

– Speculators take large, calculated risks as they trade based on anticipated future price movements.

– They hope to make quick, large gains; but may not always be successful. – They normally have shorter holding time for their positions as

compared to hedgers. – If the price of the underlying moves as per their expectation

they can make large profits. – If the price moves in the opposite direction of their assessment,

the losses can also be enormous.

Derivatives

• Illustration– Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and also

at Rs.500 in the futures market. A speculator feels that post the RBI’s policy announcement, the share price of ICICI will go up. The speculator can buy the stock in the spot market or in the derivatives market. If the derivatives contract size of ICICI is 1000 and if the speculator buys one futures contract of ICICI, he is buying ICICI futures worth Rs 500 X 1000 = Rs. 5,00,000.

– He will have to pay a margin of say 20% of the contract value to the exchange. The margin that the speculator needs to pay to the exchange is 20% of Rs. 5,00,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for the futures contract.

– If the speculator would have invested Rs. 1,00,000 in the spot market, he could purchase only 1,00,000 / 500 = 200 shares.

– Let us assume that post RBI announcement price of ICICI share moves to Rs. 520. With one lakh investment each in the futures and the cash market, the profits would be:

• (520 – 500) X 1,000 = Rs. 20,000 in case of futures market and• (520 – 500) X 200 = Rs. 4000 in the case of cash market.

– The opposite price movement will result in case of adverse movement in stock prices, wherein the speculator will be losing more in the futures market than in the spot market.

Derivatives

• Arbitrageurs : Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous trades that offset each other and capture a risk-free profit.

• An arbitrageur may also seek to make profit in case there is price discrepancy between the stock price in the cash and the derivatives markets.

• On 1st August, 2009 the SBI share is trading at Rs. 1780 in the cash market and the futures contract of SBI is trading at Rs. 1790, the arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the spot market and sell the same number of SBI futures contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will close at the price at which SBI closes in the spot market. Calculate payoffs if SBI closes at 2000, 1780 & 1500 in the spot market and overall profit to the arbitrageur.

• Possible price scenarios at which SBI can close on expiry day

Derivatives

• Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot market on expiry day (24 August 2009)

• SBI futures will close at the same price as SBI in spot market on the expiry day i.e., SBI futures will also close at Rs. 2000.

• The arbitrageur reverses his previous transaction entered into on 1 August 2009.

• Profit/ Loss (– ) in spot market = 2000 – 1780 = Rs. 220• Profit/ Loss (– ) in futures market = 1 790 – 2000

= Rs. ( –) 210• Net profit/ Loss (– ) on both transactions combined = 220

– 210 = Rs. 10 profit.

Derivatives

• Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009)

• SBI futures will close at the same price as SBI in spot mar ket on expiry day i.e., SBI futures will also close at Rs 1780.

• The arbitrageur reverses his previous transaction entered into on 1 August 2009.

• Profit/ Loss (– ) in spot market = 1780 – 1780 = Rs 0• Profit/ Loss (– ) in futures market = 1790 – 1780 = Rs.

10• Net profit/ Loss (– ) on both transactions combined =

0 + 10 = Rs. 10 profit.

Derivatives

• Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009)

• SBI futures will close at Rs. 1500. • The arbitrageur reverses his previous transaction

entered into on 1 August 2009.• Profit/ Loss (– ) in spot market = 1500 – 1780 = Rs.

(–) 280• Profit/ Loss (– ) in futures market = 1790 – 1500 =

Rs. 290• Net profit/ Loss (– ) on both transactions

combined = (–) 280 + 290 = Rs. 10 profit.

Derivatives

Trading Derivatives

• Trading Futures• The Pay-off of a futures contract on maturity depends on the spot price of the underlying

asset at the time of maturity and the price at which the contract was initially traded. • There are two positions that could be taken in a futures contract:

– Long position: one who buys the asset at the futures price (F) takes the long position– Short position: one who sells the asset at the futures price (F) takes the short position

• Pay-off for a long position in a futures contract on one unit of an asset is:– Long Pay-off = S T – F (F is the traded futures price and ST is the spot price of the asset

at expiry of the contract)– The long investor makes profits if the spot price (ST) at expiry exceeds the futures

contract price F, and makes losses if the opposite happens.• Pay-off from a short position in a futures contract on one unit of asset is:

– Short Pay-off = F – ST– Investor makes profits if the spot price (ST) at expiry is below the futures contract

price F, and makes losses if the opposite happens.

• A theoretical model for Future pricing (cost of carry model)– Futures prices in reality are determined by demand and supply, one can

obtain a theoretical futures price, using the following model:

– Where:– F = Futures price– S = Spot price of the underlying asset– r = Cost of financing (using continuously compounded interest rate)– T = Time till expiration in years– e = 2.71828

• Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% per annum. Calculate the fair value of a one-month futures contract

Trading Derivatives

• Trading Options:• Option Payoffs

– Non-linear payoff for options• losses for the buyer of an option are limited, however

the profits are potentially unlimited. • For a writer (seller), the payoff is exactly the opposite.

His profits are limited to the option premium, however his losses are potentially unlimited.

Trading Derivatives

• LONG CALL STRATEGY : Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option with a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty goes above 4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless) with a maximum loss of the premium

Trading Derivatives

Current Nifty index

4191.10

Call Option Strike Price (Rs.)

4600

Mr. XYZ Pays Premium (Rs.)

36.35

Break Even Point(Rs.) (Strike Price+ Premium)

4636.35

On expiry Niftycloses at

Net Payoff from CallOption (Rs.)

4100.00

4300.00

4500.00

4636.35

4700.00

4900.00

5100.00

5300.00

• LONG CALL STRATEGY : Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option with a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty goes above 4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless) with a maximum loss of the premium

Trading Derivatives

Current Nifty index

4191.10


4600


36.35


4636.35



4100.00 -36.35

4300.00 -36.35

4500.00 -36.354636.35 0

4700.00 63.65

4900.00 263.65

5100.00 463.65

5300.00 663.65

53

Long Call Profit from buying one European call option: option price

= $5, strike price = $100, option life = 2 months

30

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

• SHORT CALL STRATEGY : Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Calloption will not be exercised by the buyer of the Call and Mr. XYZ can retain the entire premium of Rs. 154.

Trading Derivatives

Current Nifty index

2694


2600

Mr. XYZ receives

Premium (Rs.)

154


2754



2400

2500

2600

2700

2754

2800

2900

3000

• SHORT CALL STRATEGY : Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Calloption will not be exercised by the buyer of the Call and Mr. XYZ can retain the entire premium of Rs. 154.

Trading Derivatives

Current Nifty index

2694


2600

Mr. XYZ receives

Premium (Rs.)

154


2754



2400 154

2500 154

2600 1542700 54

2754 0

2800 -46

2900 -146

3000 -246

56

Short Call Profit from writing one European call option: option price

= $5, strike price = $100

-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)


• SYNTHETIC LONG CALL - BUY STOCK, BUY PUT : Purchase a stock since with bullish expectations. To protect against price fall buy a Put on the stock, which gives the right to sell the stock at the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price).

• In case the price of the stock rises you get the full benefit of the price rise.

• In case the price of the stock falls, exercise the Put Option (remember Put is a right to sell)

Trading Derivatives

• SYNTHETIC LONG CALL - BUY STOCK, BUY PUT : Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs. 4000 on 4th July. To protect against fall in the price of ABC Ltd. (his risk), he buys an ABC Ltd. Put option with a strike price Rs. 3900 (OTM) at a premium of Rs. 143.80 expiring on 31st July..

Trading Derivatives

Buy Stock(Mr. XYZ pays)

Current Market Price of ABC Ltd.

2694

Strike Price (Rs.) 3900

Buy Put(Mr. XYZ pays)

Premium (Rs.) 143.80

Break Even Point (Rs.)(Put Strike Price + PutPremium + Stock Price –Put Strike Price)*

4143.80

• SYNTHETIC LONG CALL - BUY STOCK, BUY PUT :

Trading Derivatives

ABC Ltd. closes at(Rs.) on expiry

Payoff from theStock (Rs.)

Net Payoff from the Put Option (Rs.)

Net Payoff(Rs.)

3400.00

3600.00

3800.00

4000.00

4143.80

4200.00

4400.00

4600.00

4800.00

• SYNTHETIC LONG CALL - BUY STOCK, BUY PUT :

Trading Derivatives

ABC Ltd. closes at(Rs.) on expiry

Payoff from theStock (Rs.)

Net Payoff from the Put Option (Rs.)

Net Payoff(Rs.)

3400.00 -600.00 356.20 -243.80

3600.00 -400.00 156.20 -243.80

3800.00 -200.00 -43.80 -243.80

4000.00 0 -143.80 -143.80

4143.80 143.80 -143.80 0

4200.00 200.00 -143.80 56.20

4400.00 400.00 -143.80 256.20

4600.00 600.00 -143.80 456.20

4800.00 800.00 -143.80 656.20

• LONG PUT : Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 2694. He buys a Put option with a strike price Rs. 2600 at a premium of Rs. 52, expiring on 31st July. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Trading Derivatives

Current Nifty index

2694

Put Option Strike Price (Rs.)

2600


52

Break Even Point (Rs.)(Strike Price - Premium)

2548


Net Payoff fromPut Option (Rs.)

2300

2400

2500

2548

2600

2700

2800

2900

Limits risk to the amount of premium paid but profit potential remains unlimited

• LONG PUT : Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 2694. He buys a Put option with a strike price Rs. 2600 at a premium of Rs. 52, expiring on 31st July. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Trading Derivatives

Current Nifty index

2694

Put Option Strike Price (Rs.)

2600


52

Break Even Point (Rs.)(Strike Price - Premium)

2548



2300 248

2400 1482500 48

2548 0

2600 -52

2700 -52

2800 -52

2900 -52

Limits risk to the amount of premium paid but profit potential remains unlimited

63

Long Put Profit from buying a European put option: option price =

$7, strike price = $70

30

20

10

0

-770605040 80 90 100

Profit ($)


• SHORT PUT :Mr. XYZ is bullish on Nifty when it is at 4191.10. He sells a Put option with a strike price of Rs. 4100 at a premium of Rs. 170.50 expiring on 31st July. If the Nifty index stays above 4100, he will gain the amount of premium as the Put buyer won’t exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and the Mr. XYZ will start losing money. If the Nifty falls below 3929.50, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty.

Trading Derivatives

Current Nifty index

4191.10

Put Option Strike Price (Rs.) 4100

Mr. XYZ receives

Premium (Rs.) 170.5

Break Even Point for option buyer (Rs.)(Strike Price - Premium)

3929.5



3400.00

3500.00

3700.00

3900.00

3929.50

4100.00

4200.00

4500.00

Selling Puts can lead to regular income in a rising or range bound markets.

• SHORT PUT :Mr. XYZ is bullish on Nifty when it is at 4191.10. He sells a Put option with a strike price of Rs. 4100 at a premium of Rs. 170.50 expiring on 31st July. If the Nifty index stays above 4100, he will gain the amount of premium as the Put buyer won’t exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and the Mr. XYZ will start losing money. If the Nifty falls below 3929.50, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty.

Trading Derivatives

Current Nifty index

4191.10

Put Option Strike Price (Rs.) 4100

Mr. XYZ receives

Premium (Rs.) 170.5

Break Even Point for option buyer (Rs.)(Strike Price - Premium)

3929.5



3400.00 -529.50

3500.00 -429.50

3700.00 -229.50

3900.00 -29.50

3929.50 0

4100.00 170.50

4200.00 170.50

4500.00 170.50

Selling Puts can lead to regular income in a rising or range bound markets.

66

Short Put

Profit from writing a European put option: option price = $7, strike price = $70

-30

-20

-10

70

70

605040

80 90 100

Profit ($)Terminal

stock price ($)

• Covered call :– Investor Sells a Call option on a stock he owns (netting him a premium). – The Call Option which is sold in usually an OTM Call. – The Call would not get exercised unless the stock price increases above the strike

price. Till then the investor in the stock (Call seller) can retain the Premium as income. – Usually adopted by a stock owner who is Neutral to moderately Bullish about the

stock.– If the stock price stays at or below the strike price, the Call Buyer will not exercise

the Call. The Premium is retained by the investor. – In case the stock price goes above the strike price, the Call buyer who has the right to

buy the stock at the strike price will exercise the Call option. – The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the

stock at the strike price. – This was the price which the Call seller (the investor) was anyway interested in exiting

the stock and now exits at that price. – Besides the strike price which was the target price for selling the stock, the Call

seller (investor) also earns the Premium which becomes an additional gain– The income increases as the stock rises, but gets capped after the stock reaches the

strike price.

Trading Derivatives

• Covered call : Mr. A bought XYZ ltd for 3850 and simultaneously sells a call option at 4000 (indicating Mr. A’s belief that stock price will not go above 4000). If price increases beyond 4000, call option will be exercised by the call buyer and A can exit his position. If stock price does not go beyond 4000 option will not be exercised and A can retain the premium (80) .

Trading Derivatives

Mr. A buys stock of XYZ

Stock price 3850

Call Option Strike Price (Rs.) 4000

Mr. A receives

Premium (Rs.) 80

Break Even Point(Rs.) (Stock Pricepaid - PremiumReceived)

3770

XYZ Ltd. price closes at (Rs.)

Net Payoff (Rs.)

3600

3700

3740

3770

3800

3900

4000

4200

• Covered call : Mr. A bought XYZ ltd for 3850 and simultaneously sells a call option at 4000 (indicating Mr. A’s belief that stock price will not go above 4000). If price increases beyond 4000, call option will be exercised by the call buyer and A can exit his position. If stock price does not go beyond 4000 option will not be exercised and A can retain the premium (80) .

Trading Derivatives

Mr. A buys stock of XYZ

Stock price 3850

Call Option Strike Price (Rs.) 4000

Mr. A receives

Premium (Rs.) 80

Break Even Point(Rs.) (Stock Pricepaid - PremiumReceived)

3770

XYZ Ltd. price closes at (Rs.)

Net Payoff (Rs.)

3600 -170

3700 -70

3740 -30

3770 0

3800 30

3900 130

4000 230

4200 230

Trading Derivatives

• LONG COMBO : SELL A PUT, BUY A CALL :• If an investor is bullish he can sell an OTM (lower strike) Put and buy an OTM (higher

strike) Call. • This strategy simulates the action of buying a stock (or a futures) but at a fraction of the

stock price.• It is an inexpensive trade, similar in pay-off to Long Stock, except there is a gap between

the strikes.• This strategy is often referred to as “synthetic long stock” because the risk / reward

profile is nearly identical to long stock.• If you remain in this position until expiration, you will probably wind up buying the stock

at strike one way or the other - If the stock is above strike A at expiration, it would make sense to exercise the call and buy the stock. If the stock is below strike A at expiration, you’ll most likely be assigned on the put and be required to buy the stock.

• A stock ABC Ltd. is trading at Rs. 450. Mr. XYZ is bullish on the stock. But does not want to invest Rs. 450. He does a Long Combo. He sells a Put option with a strike price Rs. 400 at a premium of Rs. 1.00 and buys a Call Option with a strike price of Rs. 500 at a premium of Rs. 2. The net cost of the strategy (net debit) is Rs. 1.

Trading Derivatives

• LONG COMBO : SELL A PUT, BUY A CALL :

Trading DerivativesABC Ltd. Current Market

Price (Rs.)450

Call Option

Current Market Price (Rs.)

500

Sells Put Strike Price (Rs.)

400

Mr. XYZ receives

Premium (Rs.) 1

Buys Call Strike Price (Rs.) 500

Mr. XYZ pays

Premium (Rs.) 2

Break Even Point (Rs.)(Higher Strike + Net Debit)

501

ABC Ltd. price closes at (Rs.)

Net Payoff fromthe Put Sold(Rs.)

Net Payoff from theCall purchased(Rs.)

Net Payoff(Rs.)

700650600550501500450

400

350

300250

• LONG COMBO : SELL A PUT, BUY A CALL :

Trading DerivativesABC Ltd. Current Market

Price (Rs.)450

Call Option

Current Market Price (Rs.)

500


400

Mr. XYZ receives

Premium (Rs.) 1

Buys Call Strike Price (Rs.) 500

Mr. XYZ pays

Premium (Rs.) 2

Break Even Point (Rs.)(Higher Strike + Net Debit)

501


Net Payoff fromthe Put Sold(Rs.)

Net Payoff from theCall purchased(Rs.)

Net Payoff(Rs.)

700 1 198 199650 1 148 149600 1 98 99550 1 48 49501 1 -1 0500 1 -2 -1450 1 -2 -1

400 1 -2 -1

350 -49 -2 -51

300 -99 -2 -101250 -149 -2 -151

Trading Derivatives

• COVERED PUT : Covered Put is a neutral to Bearish strategy. • Investor expectation : Price of a stock / index is going to remain range bound

or move down. • Involves a short in a stock / index along with a short Put on the options on

the stock / index.• The investor shorts a stock because he is bearish about it, but does not mind

buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price).

• Selling a Put means, buying the stock at the strike price if exercised • If the stock falls below the Put strike, the investor will will have to buy the

stock at the strike price (which is anyway his target price to repurchase the stock).

• Investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place.

• Suppose ABC Ltd. is trading at Rs 4500 in June. An investor, Mr. A, shorts Rs 4300 Put by selling a July Put for Rs. 24 while shorting an ABC Ltd. stock. The net credit received by Mr. A is Rs. 4500 + Rs. 24 = Rs. 4524.

Trading Derivatives

• COVERED PUT :

Trading DerivativesSells Stock(Mr. Areceives)

Current MarketPrice (Rs.)

4500


4300

Mr. A receives

Premium (Rs.) 24

Break Even Point(Rs.) (Sale price ofStock + PutPremium)

4524


Net Payoff fromthe Stock(Rs.)

Net Payoff from thePut option(Rs.)

Net Payoff(Rs.)

400041004200430044004450

4500

452445504600

46354650

• COVERED PUT :

Trading DerivativesSells Stock(Mr. Areceives)

Current MarketPrice (Rs.)

4500


4300

Mr. A receives

Premium (Rs.) 24

Break Even Point(Rs.) (Sale price ofStock + PutPremium)

4524


Net Payoff fromthe Stock(Rs.)

Net Payoff from thePut option(Rs.)

Net Payoff(Rs.)

4000 500 -276 2244100 400 -176 2244200 300 -76 2244300 200 24 2244400 100 24 1244450 50 24 74

4500 0 24 24

4524 -24 24 0

4550 -50 24 -264600 -100 24 -76

4635 -135 24 -1114650 -150 24 -136

Trading DerivativesCOVERED PUT :

• LONG STRADDLE : A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements.

• This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index.

• If the price of the stock / index increases, the call is exercised while the put expires worthless

• If the price of the stock / index decreases, the put is exercised, the call expires worthless.

• Either way if the stock / index shows volatility to cover the cost of the trade, profits are to be made.

• With Straddles, the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction.

• Suppose Nifty is at 4450 on 27th April. An investor, Mr. A enters a long straddle by buying a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss.

Trading Derivatives

• LONG STRADDLE :

Trading DerivativesNifty index

Current Value

4450

Call and Put

Strike Price (Rs.)

4500

Mr. A pays

Total Premium(Call + Put) (Rs.)

207

Break Even Point(Rs.)

4707(U)

4293(L)

On expiryNifty closes at

Net Payoff from Putpurchased (Rs.)

Net Payoff from Callpurchased (Rs.)

Net Payoff(Rs.)

38003900400041004200

42344293

430044004500

46004700

• LONG STRADDLE :


Current Value

4450

Call and Put

Strike Price (Rs.)

4500

Mr. A pays


207


4707(U)

4293(L)




Net Payoff(Rs.)

3800 615 -122 4933900 515 -122 3934000 415 -122 2934100 315 -122 1934200 215 -122 934234 181 -122 59

4293 122 -122 0

4300 115 -122 -7

4400 15 -122 -1074500 -85 -122 -207

4600 -85 -22 -1074700 -85 78 -7

• LONG STRADDLE :

Trading Derivatives




Net Payoff(Rs.)

4707 -85 85 04766 -85 144 594800 -85 178 934900 -85 278 1935000 -85 378 2935100 -85 478 3935200 -85 578 4935300 -85 678 593

• Short Straddle : • It is a strategy to be adopted when the investor feels the market will not show

much movement. • Sells a Call and a Put on the same stock / index for the same maturity and strike

price. • It creates a net income for the investor. If the stock / index does not move much

in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised.

• However, incase the stock / index moves in either direction, up or down significantly, the investor’s losses can be significant.

• This is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited.

• If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.

• Suppose Nifty is at 4450 on 27th April. An investor, Mr. A, enters into a short straddle by selling a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net credit received is Rs. 207, which is also his maximum possible profit.

Trading Derivatives

• SHORT STRADDLE :


Current Value

4450

Call and Put

Strike Price (Rs.)

4500

Mr. A pays


207


4707(U)

4293(L)




Net Payoff(Rs.)

38003900400041004200

42344293

430044004500

46004700

• Short Straddle :


Current Value

4450

Call and Put

Strike Price (Rs.)

4500

Mr. A receives


207

Break Even Point(Rs.)*

4707(U)

*From buyer’s point of view

4293(L)


Net Payoff from PutSOLD (Rs.)

Net Payoff from CallSOLD (Rs.)

Net Payoff(Rs.)

3800 -615 122 -4933900 -515 122 -3934000 -415 122 -2934100 -315 122 -1934200 -215 122 -934234 -181 122 -59

4293 -122 122 0

4300 -115 122 7

4400 -15 122 1074500 85 122 207

4600 85 22 1074700 85 -78 7

• SHORT STRADDLE :

Trading Derivatives



Net Payoff from CallSOLD(Rs.)

Net Payoff(Rs.)

4707 85 -85 04766 85 -144 -594800 85 -178 -934900 85 -278 -1935000 85 -378 -293

Profit

STK

Trading Derivatives

Trading Derivatives

Trading Derivatives

• LONG STRANGLE: • A Strangle is a slight modification to the Straddle to make it cheaper to execute.• This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM)

put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date.

• Investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased.

• Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher.

• However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle.

• The strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential.

• Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Long Strangle by buying a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs 4700 Nifty Call for Rs 43. The net debit taken to enter the trade is Rs. 66, which is also his maximum possible loss.

Trading Derivatives

• LONG STRANGLE: • :


Current Value

4500

Buy Call Option

Strike Price (Rs.)

4700

Mr. A pays

Premium 43

Break Even Point (Rs.)

4766

Buy Put Option

Strike Price (Rs.)

4300

Mr. A pays

Premium 23


4234


Net Payoff from PutPurchased (Rs.)

Net Payoff from CallPurchased (Rs.)

Net Payoff(Rs.)

38003900400041004200

4234430044004500

46004700

• LONG STRANGLE: • :


Current Value

4500

Buy Call Option

Strike Price (Rs.)

4700

Mr. A pays

Premium 43


4766

Buy Put Option

Strike Price (Rs.)

4300

Mr. A pays

Premium 23


4234




Net Payoff(Rs.)

3800 477 -43 4343900 377 -43 3344000 277 -43 2344100 177 -43 1344200 77 -43 344234 43 -43 0

4300 -23 -43 -664400 -23 -43 -664500 -23 -43 -664600 -23 -43 -664700 -23 -43 -66

• LONG STRANGLE:

Trading Derivatives




Net Payoff(Rs.)

4766 -23 23 04800 -23 57 344900 -23 157 1345000 -23 257 2345100 -23 357 3345200 -23 457 4345300 -23 557 534

• SHORT STRANGLE: • A Short Strangle is a slight modification to the Short Straddle. • It tries to improve the profitability of the trade for the Seller of the options by

widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising.

• This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date.

• This typically means that since OTM call and put are sold, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened.

• The underlying stock has to move significantly for the Call and the Put to be worth exercising. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium.

• Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs.4700 Nifty Call for Rs 43. The net credit is Rs. 66, which is also his maximum possible gain.

Trading Derivatives

• SHORT STRANGLE: • : • :


Current Value

4500

Sell Call Option

Strike Price (Rs.)

4700

Mr. A receives

Premium 43


4766

Sell Put Option

Strike Price (Rs.)

4300

Mr. A pays

Premium 23


4234


Net Payoff from PutSold (Rs.)

Net Payoff from CallSold (Rs.)

Net Payoff(Rs.)

3800 -477 43 -4343900 -377 43 -3344000 -277 43 -2344100 -177 43 -1344200 -77 43 -344234 -43 43 0

4300 23 43 664400 23 43 664500 23 43 664600 23 43 664700 23 43 66

• SHORT STRANGLE:

Trading Derivatives



Net Payoff from CallSOLD(Rs.)

Net Payoff(Rs.)

4766 23 -23 04800 23 -57 -344900 23 -157 -1345000 23 -257 -2345100 23 -357 -3345200 23 -457 -4345300 23 -557 -534

A Strangle Combination

K1 K2

Profit

ST

Trading Derivatives

Trading Derivatives

• BULL CALL SPREAD : • Buying an in-the-money (ITM) call option, and selling another out-of-the-money

(OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money.

• Both calls must have the same underlying security and expiration month.• The net effect of the strategy is to bring down the cost and breakeven on a Buy

Call (Long Call) Strategy. • This strategy is exercised when investor is moderately bullish to bullish, because

the investor will make a profit only when the stock price / index rises.• If the stock price falls to the lower (bought) strike, the investor makes the

maximum loss (cost of the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit.

• Mr. XYZ buys a Nifty Call with a Strike price Rs. 4100 at a premium of Rs. 170.45 and he sells a Nifty Call option with a strike price Rs. 4400 at a premium of Rs. 35.40. The net debit here is Rs. 135.05 which is also his maximum loss.

Trading Derivatives

• BULL CALL SPREAD : • : • :


Current Value

4191.10

Buy ITM CallOption

Strike Price (Rs.)

4100

Mr. XYZ Pays

Premium 170.45

Sell OTM CallOption

Strike Price (Rs.)

4400

Mr. XYZReceives

Premium (Rs.)

35.40

Net Premium Paid(Rs.)

135.05


4235.05


Net Payoff from CallBuy (Rs.)

Net Payoff fromCall Sold (Rs.)

Net Payoff(Rs.)

350036003700380039004000

4100

4200

4235.05

4300

4400

4500

4600

• BULL CALL SPREAD : • : • :


Current Value

4191.10

Buy ITM CallOption

Strike Price (Rs.)

4100

Mr. XYZ Pays

Premium 170.45

Sell OTM CallOption

Strike Price (Rs.)

4400

Mr. XYZReceives

Premium (Rs.)

35.40

Net Premium Paid(Rs.)

135.05


4235.05




Net Payoff(Rs.)

3500 -170.45 35.40 -135.053600 -170.45 35.40 -135.053700 -170.45 35.40 -135.053800 -170.45 35.40 -135.053900 -170.45 35.40 -135.054000 -170.45 35.40 -135.05

4100 -170.45 35.40 -135.05

4200 -70.45 35.40 -35.05

4235.05 -35.40 35.40 0

4300 29.55 35.40 64.95

4400 129.55 35.40 164.95

4500 229.55 -64.60 164.95

4600 329.55 -164.60 164.95

• BULL CALL SPREAD :

Trading Derivatives




Net Payoff(Rs.)

4700 429.55 -264.60 164.954800 529.55 -364.60 164.954900 629.55 -464.60 164.955000 729.55 -564.60 164.955100 829.55 -664.60 164.955200 929.55 -764.60 164.95

Bull Spread Using Calls

K1 K2

Profit

ST

• BULL PUT SPREAD : • A bull put spread can be profitable when the stock / index is either range bound or rising.• The concept is to protect the downside of a Put sold by buying a lower strike Put, which

acts as an insurance for the Put sold.• The lower strike Put purchased is further OTM than the higher strike Put sold ensuring

that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold.

• This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income.

• If the stock / index rises, both Puts expire worthless and the investor can retain the Premium. If the stock / index falls, then the investor’s breakeven is the higher strike less the net credit received. Provided the stock remains above that level, the investor makes a profit. Otherwise he could make a loss.

• The maximum loss is the difference in strikes less the net credit received. This strategy should be adopted when the stock / index trend is upward or range bound.

• Mr. XYZ sells a Nifty Put option with a strike price of Rs. 4000 at a premium of Rs. 21.45 and buys a further OTM Nifty Put option with a strike price Rs. 3800 at a premium of Rs. 3.00 when the current Nifty is at 4191.10, with both options expiring on 31st July..

Trading Derivatives

• BULL PUT SPREAD : • : • :


Current Value

4191.10

Sell Put Option

Strike Price (Rs.)

4000

Mr. XYZ Receives

Premium 21.45

Buy Put Option

Strike Price (Rs.)

3800

Mr. XYZ Pays

Premium (Rs.)

3

Net PremiumReceived (Rs.)

18.45


3981.55


Net Payoff fromPut Buy (Rs.)

Net Payoff fromPut Sold (Rs.)

Net Payoff(Rs.)

3500 297.00 -478.55 -181.55

3600 197 -378.55 -181.55

3700 97 -278.55 -181.55

3800 -3.00 -178.55 -181.55

3900 -3.00 -78.55 -81.55

3981 -3.00 3 0

4000 -3.00 21.45 18.45

4100 -3.00 21.45 18.45

4200 -3.00 21.45 18.45

4300 -3.00 21.45 18.45

4400 -3.00 21.45 18.45

4500 -3.00 21.45 18.454600 -3.00 21.45 18.45

4700 -3.00 21.45 18.45

4800 -3.00 21.45 18.45

Bull Spread Using Puts

K1 K2

Profit

ST

• BEAR CALL SPREAD : • The Bear Call Spread strategy can be adopted when the investor feels that the stock / index

is either range bound or falling.• The concept is to protect the downside of a Call Sold by buying a Call of a higher strike price

to insure the Call sold. • The investor receives a net credit because the Call he buys is of a higher strike price than the

Call sold.• The strategy requires the investor to buy out-of-the-money (OTM) call options while

simultaneously selling in-the-money (ITM) call options on the same underlying stock index.• This strategy can also be done with both OTM calls with the Call purchased being higher

OTM strike than the Call sold.• If the stock / index falls both Calls will expire worthless and the investor can retain the net

credit. If the stock / index rises then the breakeven is the lower strike plus the net credit.• Provided the stock remains below that level, the investor makes a profit. Otherwise he could

make a loss. The maximum loss is the difference in strikes less the net credit received.. • Mr. XYZ is bearish on Nifty. He sells an ITM call option with strike price of

Rs. 2600 at a premium of Rs. 154 and buys an OTM call option with strike price Rs. 2800 at a premium of Rs. 49.

Trading Derivatives

• BEAR CALL SPREAD : • : • :


Current Value

2694

Sell ITM CallOption

Strike Price (Rs.)

2600

Mr. XYZ Receives

Premium 154

Buy OTM CallOption

Strike Price (Rs.)

2800

Mr. XYZ Pays

Premium (Rs.)

49

Net PremiumReceived (Rs.)

105


2705


Net Payoff from CallSold (Rs.)

Net Payoff from Callbought (Rs.)

Net Payoff(Rs.)

2100 154 -49 105

2200 154 -49 105

2300 154 -49 105

2400 154 -49 105

2500 154 -49 105

2600 154 -49 105

2700 54 -49 5

2705 49 -49 0

2800 -46 -49 -95

2900 -146 51 -95

3000 -246 151 -95

3100 -346 251 -95

3200 -446 351 -95

3300 -546 451 -95

Bear Spread Using Calls

K1 K2

Profit

ST

• BEAR PUT SPREAD : • Investor to buy an in-the-money (higher) put option and sell an out-of-the-money

(lower) put option on the same stock with the same expiration date. • This strategy creates a net debit for the investor. The net effect of the strategy is to

bring down the cost and raise the breakeven on buying a Put (Long Put).• The strategy needs a Bearish outlook since the investor will make money only when

the stock price / index falls.• The bought Puts will have the effect of capping the investor’s downside. While the

Puts sold will reduce the investors costs, risk and raise breakeven point (from Put exercise point of view).

• If the stock price closes below the out-of-the-money (lower) put option strike price on the expiration date, then the investor reaches maximum profits.

• If the stock price increases above the in-the-money (higher) put option strike price at the expiration date, then the investor has a maximum loss potential of the net debit.

• Nifty is presently at 2694. Mr. XYZ expects Nifty to fall. He buys one Nifty ITM Put with a strike price Rs. 2800 at a premium of Rs. 132 and sells one Nifty OTM Put with strike price Rs. 2600 at a premium Rs. 52.

Trading Derivatives

• BEAR PUT SPREAD : • : • : • :


Current Value

2694

Buy ITM Put Option

Strike Price (Rs.)

2800

Mr. XYZ pays

Premium 132

Sell OTM Put Option

Strike Price (Rs.)

2600

Mr. XYZ receives

Premium (Rs.)

52

Net PremiumPaid(Rs.)

80


2720


Net Payoff fromPut Buy (Rs.)

Net Payoff fromPut Sold (Rs.)

Net Payoff(Rs.)

2200 468 -348 120

2300 368 -248 120

2400 268 -148 120

2500 168 -48 120

2600 68 52 120

2720 -52 52 0

2700 -32 52 20

2800 -132 52 -80

2900 -132 52 -80

3000 -132 52 -80

3100 -132 52 -80

Bear Spread Using Puts

K1 K2

Profit

ST

Documents

Derivatives April