DERIVATIVES IN TREASURY MANAGEMENTPARIKSHIT JAIN 08 EM-028SUSHAN RUNGTA 08EM-048NILESH BAID 08EM-024

1.1

THE NATURE OF DERIVATIVES

A derivative is an instrument whose value depends on the values of other more basic underlying variables

1.2

EXAMPLES OF DERIVATIVES

Swaps Options Forward Contracts Futures Contracts

1.3

DERIVATIVES MARKETS Exchange Traded

standard products trading floor or computer trading virtually no credit risk

Over-the-Counter non-standard products telephone market some credit risk

1.4

WAYS DERIVATIVES ARE USED

To hedge risksTo reflect a view on the future

direction of the marketTo lock in an arbitrage profitTo change the nature of a liabilityTo change the nature of an

investment without incurring the costs of selling one portfolio and buying another

1.5

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price)

It can be contrasted with a spot contract which is an agreement to buy or sell immediately

1.6

HOW A FORWARD CONTRACT WORKS The contract is an over-the-counter (OTC)

agreement between 2 companies The delivery price is usually chosen so that the

initial value of the contract is zero No money changes hands when contract is first

negotiated and it is settled at maturity

1.7

THE FORWARD PRICE The forward price for a contract is the

delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)

The forward price may be different for contracts of different maturities

1.8

TERMINOLOGY

The party that has agreed to buy has what is termed a long position

The party that has agreed to sell has what is termed a short position

1.9

EXAMPLE

On January 20, 1998 a trader enters into an agreement to buy £1 million in three months at an exchange rate of 1.6196

This obligates the trader to pay $1,619,600 for £1 million on April 20, 1998

What are the possible outcomes?

1.10

PROFIT FROM ALONG FORWARD POSITION

1.11

Profit

Price of Underlying at Maturity, STK

PROFIT FROM A SHORT FORWARD POSITION

1.12

Profit

Price of Underlying at Maturity, STK

FUTURES CONTRACTS

Agreement to buy or sell an asset for a certain price at a certain time

Similar to forward contract Whereas a forward contract is traded OTC a

futures contract is traded on an exchange

1.13

1. GOLD: AN ARBITRAGE OPPORTUNITY? Suppose that:

- The spot price of gold is US$300

- The 1-year forward price of gold is US$340

- The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

1.14

2. GOLD: ANOTHER ARBITRAGE OPPORTUNITY?

Suppose that:

- The spot price of gold is US$300

- The 1-year forward price of gold is US$300

- The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity? 1.15

THE FORWARD PRICE OF GOLD If the spot price of gold is S & the forward

price for a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of interest.In our examples, S=300, T=1, and r=0.05 so that

F = 300(1+0.05) = 315 1.16

1. OIL: AN ARBITRAGE OPPORTUNITY?

Suppose that:- The spot price of oil is US$19- The quoted 1-year futures price of oil is

US$25- The 1-year US$ interest rate is 5% per

annum- The storage costs of oil are 2% per

annum

Is there an arbitrage opportunity?

1.17

2. OIL: ANOTHER ARBITRAGE OPPORTUNITY?

Suppose that:- The spot price of oil is US$19- The quoted 1-year futures price of oil is

US$16- The 1-year US$ interest rate is 5% per

annum- The storage costs of oil are 2% per

annum

Is there an arbitrage opportunity?

1.18

EXCHANGES TRADING FUTURES

Chicago Board of Trade Chicago Mercantile Exchange BM&F (Sao Paulo, Brazil) LIFFE (London) TIFFE (Tokyo) and many more (see list at end of book)

1.19

OPTIONS

1.20

A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)

A put is an option to sell a certain asset by a certain date for a certain price (the strike price)

LONG CALL ON IBM

Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months

1.21

30

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

SHORT CALL ON IBM

Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months

1.22-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

LONG PUT ON EXXON

Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths

1.23

30

20

10

0

-770605040 80 90 100

Profit ($)

Terminalstock price ($)

SHORT PUT ON EXXON Profit from writing an Exxon European put option:

option price = $7, strike price = $70, option life = 3 mths

1.24-30

-20

-10

7

070

605040

80 90 100

Profit ($)Terminal

stock price ($)

PAYOFFS FROM OPTIONSWHAT IS THE OPTION POSITION IN EACH CASE? X = Strike price, ST = Price of asset at

maturity

1.25

Payoff Payoff

ST STX

X

Payoff Payoff

ST STX

X

TYPES OF TRADERS

1.26

• Hedgers

• Speculators

• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

HEDGING EXAMPLES A US company will pay £1 million for imports

from Britain in 6 months and decides to hedge using a long position in a forward contract

An investor owns 500 IBM shares currently worth $102 per share. A two- month put with a strike price of $100 costs $4. The investor decides to hedge by buying 5 contracts

1.27

SPECULATION EXAMPLE

An investor with $7,800 to invest feels that Exxon’s stock price will increase over the next 3 months. The current stock price is $78 and the price of a 3-month call option with a strike of 80 is $3

What are the alternative strategies?

1.28

ARBITRAGE EXAMPLE

A stock price is quoted as £100 in London and $172 in New York

The current exchange rate is 1.7500 What is the arbitrage opportunity?

1.29

EXCHANGES TRADING OPTIONS

Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Stock Exchange European Options Exchange Australian Options Market and many more (see list at end of book)

1.30

2.31

FUTURES MARKETS AND THE USE OF FUTURESFOR HEDGING

2.32

FUTURES CONTRACTS

Available on a wide range of underlyings Exchange traded Specifications need to be defined:

What can be delivered, Where it can be delivered, & When it can be delivered

Settled daily

2.33

MARGINS

A margin is cash or marketable securities deposited by an investor with his or her broker

The balance in the margin account is adjusted to reflect daily settlement

Margins minimize the possibility of a loss through a default on a contract

2.34

EXAMPLE OF A FUTURES TRADE

An investor takes a long position in 2 December gold futures contracts on June 3contract size is 100 oz.futures price is US$400margin requirement is US$2,000/contract

(US$4,000 in total)maintenance margin is US$1,500/contract

(US$3,000 in total)

2.35

A POSSIBLE OUTCOME

Daily Cumulative Margin

Futures Gain Gain Account Margin

Price (Loss) (Loss) Balance Call

Day (US$) (US$) (US$) (US$) (US$)

400.00 4,000

3-Jun 397.00 (600) (600) 3,400 0. . . . . .. . . . . .. . . . . .

11-Jun 393.30 (420) (1,340) 2,660 1,340 . . . . . .. . . . .. . . . . .

17-Jun 387.00 (1,140) (2,600) 2,740 1,260 . . . . . .. . . . . .. . . . . .

24-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000

<

2.36

OTHER KEY POINTS ABOUT FUTURES

They are settled daily Closing out a futures position

involves entering into an offsetting trade

Most contracts are closed out before maturity

2.37

DELIVERY

If a contract is not closed out before maturity, it usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses.

A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

2.38

SOME TERMINOLOGY

Open interest: the total number of contracts outstanding equal to number of long positions or number of

short positions

Settlement price: the price just before the final bell each day used for the daily settlement process

Volume of trading: the number of trades in 1 day

2.39

CONVERGENCE OF FUTURES TO SPOT

Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price

2.40

QUESTIONS

When a new trade is completed what are the possible effects on the open interest?

Can the volume of trading in a day be greater than the open interest?

2.41

REGULATION OF FUTURES

Regulation is designed to protect the public interest

Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

2.42

ACCOUNTING & TAX If a contract is used for

Hedging: it is logical to recognize profits (losses) at the same time as on the item being hedged

Speculation: it is logical to recognize profits (losses) on a mark to market basis

Roughly speaking, this is what the treatment of futures in the U.S.and many other countries attempts to achieve

2.43

LONG & SHORT HEDGES

A long futures hedge is appropriate when you know you will purchase an asset in the future & want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

2.44

BASIS RISK

Basis is the difference between spot & futures

Basis risk arises because of the uncertainty about the basis when the hedge is closed out

2.45

LONG HEDGE

Suppose that

F1 : Initial Futures Price

F2 : Final Futures Price

S2 : Final Asset Price You hedge the future purchase of an asset by

entering into a long futures contract Cost of Asset=S2 -F2+F1 = F1 + Basis

2.46

SHORT HEDGE

Suppose that

F1 : Initial Futures Price

F2 : Final Futures Price

S2 : Final Asset Price You hedge the future sale of an asset by

entering into a short futures contract Price Realized=S2 -F2+F1 = F1 + Basis

2.47

CHOICE OF CONTRACT

Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge

When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis

2.48

OPTIMAL HEDGE RATIO

Proportion of the exposure that should optimally be hedged is

where S : spot price,

F : futures price, sS : standard deviation of DS ,

sF : standard deviation of DF & : r coefficient of correlation between DS & DF

h S

F

2.49

ROLLING THE HEDGE FORWARD

We can use a series of futures contracts to increase the life of a hedge

Each time we switch from 1 futures contract to another we incur a type of basis risk

2.50

FORWARD CONTRACTS VS FUTURES CONTRACTS

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cashsettlement usually occurs

Contract usually closed outprior to maturity

FORWARDS FUTURES

5.51

SWAPS

5.52

NATURE OF SWAPS

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

5.53

AN EXAMPLE OF A “PLAIN VANILLA” INTEREST RATE SWAP

An agreement by “Company B” to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million

Next slide illustrates cash flows

5.54

---------Millions of Dollars---------

LIBOR FLOATING FIXED Net

Date Rate Cash Flow Cash Flow Cash Flow

Mar.1, 1998 4.2%

Sept. 1, 1998 4.8% +2.10 –2.50 –0.40

Mar.1, 1999 5.3% +2.40 –2.50 –0.10

Sept. 1, 1999 5.5% +2.65 –2.50 +0.15

Mar.1, 2000 5.6% +2.75 –2.50 +0.25

Sept. 1, 2000 5.9% +2.80 –2.50 +0.30

Mar.1, 2001 6.4% +2.95 –2.50 +0.45

CASH FLOWS TO COMPANY B

5.55

TYPICAL USES OF ANINTEREST RATE SWAP

Converting a liability fromfixed rate to

floating rate floating rate

to fixed rate

Converting an investment from fixed rate to

floating ratefloating rate to

fixed rate

5.56A AND B TRANSFORM A LIABILITY

A B

LIBOR

5%

LIBOR+0.8%

5.2%

5.57

FINANCIAL INSTITUTION IS INVOLVED

A F.I. B

LIBOR LIBORLIBOR+0.8%

4.985% 5.015%

5.2%

5.58

A AND B TRANSFORM AN ASSET

A B

LIBOR

5%

LIBOR-0.25%

4.7%

5.59

FINANCIAL INSTITUTION IS INVOLVED

A F.I. B

LIBOR LIBOR

4.7%

5.015%4.985%

LIBOR-0.25%

5.60THE COMPARATIVE ADVANTAGE ARGUMENT

Company A wants to borrow floating Company B wants to borrow fixed

Fixed Floating

Company A 10.00% 6-month LIBOR + 0.30%

Company B 11.20% 6-month LIBOR + 1.00%

5.61

THE SWAP

A B

LIBOR

LIBOR+1%

9.95%

10%

5.62

THE SWAP WHEN A FINANCIAL INSTITUTION IS INVOLVED

A F.I. B

10%

LIBOR LIBOR

LIBOR+1%

9.93% 9.97%

5.63

CRITICISM OF THE COMPARATIVE ADVANTAGE ARGUMENT

The 10.0% and 11.2% rates available to A and B in fixed rate markets are 5-year rates

The LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are six-month rates

B’s fixed rate depends on the spread above LIBOR it borrows at in the future

5.64

VALUATION OF AN INTEREST RATE SWAP

Interest rate swaps can be valued as the difference between the value of a fixed-rate bond & the value of a floating-rate bond

Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

5.65

VALUATION IN TERMS OF BONDS

The fixed rate bond is valued in the usual way

The floating rate bond is valued by noting that it is worth par immediately after the next payment date

5.66

VALUATION IN TERMS OF FRAS

Each exchange of payments in an interest rate swap is an FRA

The FRAs can be valued on the assumption that today’s forward rates are realized

5.67

AN EXAMPLE OF A CURRENCY SWAP

An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years

5.68

EXCHANGE OF PRINCIPAL

In an interest rate swap the principal is not exchanged

In a currency swap the principal is exchanged at the beginning &the end of the swap

5.69

THE CASH FLOWS

Years

Dollars Pounds$

------millions------

0 –15.00 +10.001 +1.20 –1.102 +1.20 –1.10

3 +1.20 –1.104 +1.20 –1.10

5 +16.20 -11.10

£

5.70

TYPICAL USES OF A CURRENCY SWAP

Conversion from a liability in one currency to a liability in another currency

Conversion from an investment in one currency to an investment in another currency

5.71

COMPARATIVE ADVANTAGE ARGUMENTS FOR CURRENCY SWAPS

Company A wants to borrow AUDCompany B wants to borrow USD

USD AUD

Company A 5.0% 12.6%

Company B 7.0% 13.0%

5.72

VALUATION OF CURRENCY SWAPS

Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts

5.73

SWAPS & FORWARDS A swap can be regarded as a convenient way

of packaging forward contracts The “plain vanilla” interest rate swap in our

example consisted of 6 FRAs The “fixed for fixed” currency swap in our

example consisted of a cash transaction & 5 forward contracts

5.74

SWAPS & FORWARDS(CONTINUED)

The value of the swap is the sum of the values of the forward contracts underlying the swap

Swaps are normally “at the money” initiallyThis means that it costs

NOTHING to enter into a swap It does NOT mean that each

forward contract underlying a swap is “at the money” initially

5.75

CREDIT RISK

A swap is worth zero to a company initially At a future time its value is liable to be

either positive or negative The company has credit risk exposure only

when its value is positive

5.76

EXAMPLES OF OTHER TYPES OF SWAPS

Amortizing & step-up swaps Extendible & puttable swaps Index amortizing swaps Equity swaps Commodity swaps Differential swaps

6.77

OPTIONS MARKETS

6.78ASSETS UNDERLYINGEXCHANGE-TRADED OPTIONS

Stocks Foreign Currency Stock Indices Futures

6.79

SPECIFICATION OFEXCHANGE-TRADED OPTIONS

Expiration date Strike price European or American Call or Put (option class)

6.80

TERMINOLOGY

Moneyness :At-the-money optionIn-the-money optionOut-of-the-money option

6.81

TERMINOLOGY(CONTINUED)

Option class Option series Intrinsic value Time value

6.82

DIVIDENDS & STOCK SPLITS Suppose you own N options with a

strike price of X : No adjustments are made to the option terms for

cash dividends When there is an n-for-m stock split,

the strike price is reduced to mX/n the no. of options is increased to nN/m

Stock dividends are handled in a manner similar to stock splits

6.83

DIVIDENDS & STOCK SPLITS(CONTINUED)

Consider a call option to buy 100 shares for $20/share

How should terms be adjusted:

for a 2-for-1 stock split?for a 5% stock dividend?

6.84

ORGANIZATION OF TRADING

Types of traders:Market

makersFloor

brokers

Alternative systems for limit ordersOrder book officialsSpecialists

6.85

MARGINS Margins are required when options are sold When a naked option is written the margin is

the greater of:1 A total of 100% of the proceeds of the sale

plus 20% of the underlying share price less the amount (if any) by which the option is out of the money

2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price

For other trading strategies there are special rules

6.86

WARRANTS

Warrants are options that are issued (or written) by a corporation or a financial institution

The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire

6.87

WARRANTS(CONTINUED)

Warrants are traded in the same way as stocks The issuer settles up with the holder when a

warrant is exercised When call warrants are issued by a corporation

on its own stock, exercise will lead to new treasury stock being issued

6.88

EXECUTIVE STOCK OPTIONS

Option issued by a company to executives When the option is exercised the company

issues more stock Usually at-the-money when issued

6.89

EXECUTIVE STOCK OPTIONS CONTINUED

They become vested after a period ot time They cannot be sold They often last for as long as 10 or 15 years

6.90

CONVERTIBLE BONDS

Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

6.91

CONVERTIBLE BONDS(CONTINUED)

Very often a convertible is callable The call provision is a way in which the

issuer can force conversion at a time earlier than the holder might otherwise choose

 Forwards

A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. Futures  An agreement between two parties to buy or sell an asset at a certain time in the future at a certain price . Futures contacts are special types of forward contracts in the contracts in the sense that the former are standardized exchange-traded contracts.  Options

Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

TYPES OF DERIVATIVES

 

FUTURES OPTIONS

Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset.

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

Unlimited upside & downside for both buyer and seller.  

Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited.  

Futures contracts prices are affected mainly by the prices of the underlying asset

Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.

DIFFERENCE BETWEEN FUTURES & OPTIONS

 OPTION TERMINOLOGY (For The Equity Markets)

OptionsOptions are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

• Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

• Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.

• Call Option - Option to buy.

• Put Option - Option to sell.

• American Option - An option which can be exercised anytime on or before the expiry

date. • Strike Price/ Exercise Price - Price at which the option is to be exercised.

• Expiration Date - Date on which the option expires.

• European Option - An option which can be exercised only on expiry date.

• Exercise Date - Date on which the option gets exercised by the option holder/buyer.

• Option Premium - The price paid by the option buyer to the option seller for granting the

option.

 

  Call Option Put Option

Option Buyer

Buys the right to buy the underlying asset at the Strike Price

Buys the right to sell the underlying asset at the Strike Price

Option Seller

Has the obligation to sell the underlying asset to the option holder at the Strike Price

Has the obligation to buy the underlying asset from the option holder at the Strike Price

An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

Illustration on Call Option

An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.

Illustration on Put Options

STRATEGIES OF TRADING IN FUTURE AND OPTIONS

USING STOCK OPTIONS

Hedging:Have stock, buy puts

Speculation: bullish stock, buy calls or sell puts

Speculation : bearish Stock, buy put or sell calls

BULLISH STRATEGIES

LONG CALL 

Market Opinion - Bullish Most popular strategy with investors. Used by investors because of better leveraging compared to buying the underlying stock – insurance against decline in the value of the underlying

Profit +

0

DR

Loss -

Underlying Asset Price

Stock Price

Lower Higher

BEP

S

RISK REWARD SCENARIOMAXIMUM LOSS = LIMITED (PREMIUM PAID)MAXIMUM PROFIT = UNLIMITEDPROFIT AT EXPIRATION = STOCK PRICE AT EXPIRATION – STRIKE PRICE – PREMIUM PAIDBREAK EVEN POINT AT EXPIRATION = STRIKE PRICE + PREMIUM PAID

SHORT PUT

Market Opinion - Bullish

Risk Reward ScenarioMaximum Loss – Unlimited

Maximum Profit – Limited (to the extent of option premium)

Makes profit if the Stock price at expiration > Strike price - premium

Profit +

CR

0

Loss -

Underlying Asset Price

Stock Price

Lower Higher

BEP

S

BULL CALL SPREAD For Investors who are bullish but at the same time conservative BUY A CALL CLOSER TO SPOT PRICE & WRITE A CALL WITH A HIGHER PRICE In a market that has bottomed out, when stocks rise, they rise in small steps for a short duration. Bull Call Spread can be Used where gains & losses are limited. CESE Spot Price = Rs.250 Premium of 260 CA= Rs.10 Premium of 270 CA = Rs. 6 Strategy – Buy 260 CA @ Rs.10 & Sell 270 CA @ Rs.6 Net Outflow = Rs.4  

Stock Price at Expiration

Net Profit/ Loss

250 -4

260 -4

264 0

266 2

270 6

280 6

Risk is Low & confined to Spread. Return is also limited.  While Trading try to minimize the Spread.

BULL PUT SPREAD FOR INVESTORS WHO ARE BULLISH BUT AT THE SAME TIME CONSERVATIVE WRITE A PUT OPTION WITH A HIGHER STRIKE PRICE AND BUY A PUT OPTION WITH A LOWER STRIKE PRICE CESE SPOT PRICE = RS.270PREMIUM ON RS. 270 PA = RS.12PREMIUM ON RS. 250 PA = RS. 3 SELL RS.270 PA AND BUY RS.250 PANET INFLOW = RS. 9 

Stock Price at Expiration Net Profit/ Loss

230 - 11 (- 40 + 20+9)

250 - 11 ( -20+9)

270 + 9 (Net Inflow)

300 + 9 (Net Inflow – Both options expire worthless)

350 + 9 (Net Inflow – Both options expire worthless)

COVERED CALL NEUTRAL TO BULLISH BUY THE STOCK & WRITE A CALL  PERCEPTION – BULLISH ON THE STOCK IN THE LONG TERM BUT EXPECTING LITTLE VARIATION DURING THE LIFETIME OF CALL CONTRACT INCOME RECEIVED FROM THE PREMIUM ON CALL   CESE SPOT PRICE = RS.270

PREMIUM ON RS. 270 CA = RS. 12

BUY CESE @ RS.270 AND SELL RS. 270 CA @ RS.12.  STOCK PRICE AT EXPIRATION NET PROFIT/LOSS 230 - 28 (- 40 + 12)250 - 8 ( -20+12)270 + 12 ( + 12)300 + 12 (-30+30+12)350 + 12 (-80 +80+12)

PROFITS ARE LIMITED . LOSSES CAN BE UNLIMITED

COVERED CALL

Profit +

0

Loss -

Strike Price

Stock Price

Lower Higher

BEP

MARRIED PUTA person is bullish on the stock but is concerned about near term downside due to market risks. Buy a PUT Option and at the same time buy equivalent number of shares.  Benefits of Stock ownership & Insurance against too much downside. Maximum Profit – Unlimited Maximum Loss – Limited = Stock Purchase Price – Strike Price + Premium Paid Profit at Expiration = Profit in Underlying Share Value – Premium Paid CESE :  Spot Price = Rs.270

Premium on Rs.250 PA = Rs. 3 Buy shares of CESE @ Rs.270/- and Buy Rs.250 PA @ Rs.3 Stock Price at Expiration Net Profit/ Loss 230 - 23 (- 40 + 20-3)250 - 23 ( -20-3)270 - 3 (Loss of Premium Paid)300 +27 (30-3)350 +77 (80-3) 

Maximum Loss restricted to Rs.23 , Profit Unlimited

MARRIED PUT

Profit +

BEP

Strike Price

Loss - Lower Higher

Stock Price

THE OPTIMAL BULL STRATEGY

LONG CALL : BULLISH BUT RISK AVERSE; INSIDER WITH LIMITED CAPITAL

SHORT PUT : LONG TERM BULLISH BUT LOOKING FOR LOWER COST.

COVERED CALL : LONG TERM BULLISH BUT NOT EXPECTING UPSIDE IN NEAR TERM

MARRIED PUT : BULLISH BUT AFRAID OF NEAR TERM DOWNSIDE RISK

BULL CALL SPREAD : MILDLY BULLISH AS WELL AS RISK AVERSE.

BULL PUT SPREAD : BULLISH BUT LOOKING FOR LOWER COSTS AND SCARED OF A MAJOR FALL.

BEARISH STRATEGIES

LONG PUTMarket Opinion – BearishFor investors who want to make money from a downward price move in the underlying stockOffers a leveraged alternative to a bearish or short sale of the underlying stock.

Profit +

0

DR

Loss -

Underlying Asset Price

S

Stock Price

Lower Higher

BEP

Risk Reward Scenario Maximum Loss – Limited (Premium Paid)Maximum Profit - Limited to the extent of price of stock Profit at expiration - Strike Price – Stock Price at expiration - Premium paidBreak even point at Expiration – Strike Price - Premium paid

SHORT CALLMarket Opinion – Bearish

Profit +

CR

0

Loss -

Underlying Asset Price

S

Stock Price

Lower Higher

BEP

 Risk Reward Scenario Maximum Loss – UnlimitedMaximum Profit - Limited (to the extent of option premium)  Makes profit if the Stock price at expiration < Strike price + premium

BEAR CALL SPREAD Low Risk Low Reward Strategy Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike

Price  CESE Spot Price = Rs.270Premium on Rs. 290 CA = Rs. 5Premium on Rs. 270 CA = Rs. 12 Sell Rs.270 CA and Buy Rs.290 CANet Inflow = Rs. 7 Stock Price at Expiration Net Profit/ Loss 230 + 7 (Both Options expire worthless )250 + 7 (Both Options expire worthless )270 + 7 ((Both Options expire worthless)300 - 13 (-30+10+7)350 - 13 ( -80+60+7)

 Maximum Possible Profit = Rs.7 & Loss = Rs.13

Limited Upside & Downside

 

BEAR PUT SPREAD Again a LOW RISK, LOW RETURN Strategy Gains as Well as Losses are Limited BUY PUT OPTION AT A HIGHER STRIKE PRICE AND SELL ANOTHER WITH A LOWER STRIKE PRICE Profit Accrues when the price of underlying stock goes down. IPCL Spot Price = Rs.260Premium on Rs. 250 PA = Rs. 6Premium on Rs. 230 PA = Rs. 2 BUY Rs.250 PA and SELL Rs.230 PANet Outflow = Rs. 4 Stock Price at Expiration Net Profit/ Loss 200 + 16 (+50-30-4)230 + 16 (+20-4)250 - 4 Both options expire w’thles270 - 4 Both options expire w’thles 300 - 4 Both options expire w’thles  Maximum Possible Profit = Rs.16 & Loss = Rs.4 Limited Upside & Downside

BEAR PUT SPREAD

 

 

Stock Price

Lower Higher

Profit +

0

Loss -

Higher Strike

Price

BEP

Lower Strike

Price

NEUTRAL STRATEGIES

SHORT STRADDLE 

WRITE CALL & PUT OPTIONS If you expect the Stock to show very little volatility, it is worthwhile to write a call & put option. Ashok Leyland – has been range bound for the last 3 months. You don’t expect it to move up or down too much. Ashok Leyland Spot Price Rs. 25 Premium of Rs.25 CA Rs. 1.5Premium on Rs.25 PA Rs. 1.5 Sell Rs.25 CA and Rs.25 PA.  Total Premium Received = Rs.3 .  Investor incurs a loss incase price drops below Rs. 22 or goes up above Rs. 28 Risky Strategy since profits limited but losses unlimited.

SHORT STRANGLE SELL OUT OF MONEY CALL & PUT OPTIONS CESE Spot Price = Rs.270Premium on Rs. 250 PA= Rs.5Premium on Rs. 290 CA = Rs.4

Sell CESE Rs. 250 PA @ Rs.5 and sell Rs.290 CA @ Rs.4.  Total Premium Received = Rs. 9

You start incurring a loss if price goes above Rs. 299 or drops below Rs. 241

 

VOLATILITYSTRATEGIES

 

 

STRADDLE

Long Straddle Buying a Straddle is simultaneous purchase of a CALL & PUT option for a Stock, with same expiration date & Strike Price.  Why Straddle – If you expect the stock to fluctuate wildly but unsure of the direction. Enables investors to make profits on both upward and downward fluctuation of stock. Potential gain can be unlimited  IPCL 

Spot Price = Rs. 250Premium on Rs. 250 CA = Rs. 12Premium on Rs. 250 PA = Rs. 12

 BUY Rs. 250 CA and Rs. 250 PA You Start making profits if Price goes above Rs. 274 or goes below Rs. 226

STRANGLE 

Long Strangle Buying a Strangle is simultaneous purchase of Out of Money CALL & PUT option for a Stock, with same expiration date. IPCL 

Spot Price = Rs. 250

Premium on Rs. 270 CA = Rs. 5Premium on Rs. 230 PA = Rs. 5

  BUY Rs. 270 CA and Rs. 230 PA Total Premium Paid = Rs. 10 You Start making profits if Price goes above Rs. 280 or goes below Rs. 220