amit dhariwal

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Dissertation submitted in partial fulfillment ofthe requirements of the two year full-time PostGraduate Diploma in Management Programme.

Finance Project

ON

Derivatives: AComplete Study

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SUBMITTED TO:PROF. F. M. A. KHAN


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April 2010

DECLARATION FORM

I hereby declare that the Project work entitled Derivatives: A Complete Studysubmitted by me

for the partial fulfillment of the Post Graduate Diploma in ManagementProgram to Institute

for Integrated Learning in Management, Greater Noida is my own original work and has not

been submitted earlier either to IILM GSM or to any other Institution for the fulfillment of the

requirement for any course of study. I also declare that no chapter of this manuscript in whole or

in part is lifted and incorporated in this report from any earlier / other work done by me or others.

Place : Greater Noida

Date : 23-04-2010 Signature:

ACKNOWLEDGEMENT


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I take this opportunity with much pleasure to thank all the people who have helped me through the

course of my journey towards producing this project.

The satisfaction and euphoria that accompany the successful completion of a task is incomplete

without mentioning the names of those who provided their support and help in making it a success.

No task, however small can be completed without proper guidance and encouragement. This

acknowledgement transcends the reality of formality, hence I would like to express my deep

gratitude to all those behind the scene who have helped me in successful completion of this project.

I extend my heartiest thanks to PROF. F. M. A. KHAN(Faculty-IILM-GSM, Greater Noida) for

his guidance and help towards completion of this project.

I would also like to thank all my faculties at IGSM for their able guidance and supervision.

Also I would like to convey my gratitude towards IGSM for giving me a platform to gain both

technical as well as professional experiences.

I hereby present my report, which is based on the information collected by me through various

sources, and on the procedures and methods that I have learnt during my Post Graduation

ABSTRACT

Market conditions can lead to substantial profit or loss. Investors are advised to seek adequate

product and market knowledge as well as proper investment advice before trading futures. The

material provided here is for general information purposes only. While care has been taken to


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ensure accuracy, the information furnished to reader with no warranty as to the accuracy or

completeness of its contents and on condition that any changes, omissions or errors shall not be

made the basis for any claim, demand or cause for action. "Standard & Poor's" and "S&P" are

trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by India Index

Services & Products Limited, which has sublicensed such marks to NSE. The S&P CNX Nifty

Index is not compiled, calculated or distributed by Standard & Poor's and Standard & Poor's makes

no representation regarding the advisability of investing in the products that utilize any such Index

as a component.

INDEX


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S. No. CONTENTS

1 Introduction

2 Futures contract

3 Hedging in futures

4 Speculating in futures

5 Arbitrage in futures

6 Options

7 Options strategies

8 Derivatives products

9 References

10 Bibliography


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Introduction

DERIVATIVES

The word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a

future image or copy of a underlying asset which may be shares, stocks, commodities, stock

indices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and

borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives is derived from the following products:

A. Shares

B. Debuntures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and

other is bearish in the market having opposite views regarding the market. There cannot be a

derivatives having same views about the market. In short it is like a INSURANCE market where

investors cover their risk for a particular position.

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Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from

the value of an underlying primary financial instrument, commodity or index, such as: interest

rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in

foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.

Hedging is the most important aspect of derivatives and also its basic economic purpose. There has

to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as

means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in

pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are

essential.Derivatives trading has been a new introduction to the Indian markets. It is, in a sense

promotion and acceptance of market economy, that has really contributed towards the growingawareness of risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced

derivatives in the local currency Interest Rate markets, which have not really developed, but with

the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in

hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index futures

BACKGROUND

Consider a hypothetical situation in which ABC trading company has to import a raw material for

manufacturing goods. But this raw material is required only after 3 months. However in 3 months

the prices of raw material may go up or go down due to foreign exchange fluctuations and at this

point of time it can not be predicted whether the prices would go up or come down. Thus he is

exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur

heavy interest and storage charges. However, the availability of derivatives solves the problem of

importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would

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be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk

through the use of derivatives

DEFINATIONS

According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value

depends on (or derives from) the values of other, more basic underlying variables.

According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even

more simply an agreement between two people) which has a value determined by the price of

something else. With Securities Laws (Second Amendment) Act,1999, Derivatives has beenincluded in the definition of Securities. The term Derivative has been defined in Securities

Contracts (Regulations) Act, as:-

A Derivative includes: -

a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk

instrument or contract for differences or any other form of security;

b. contract which derives its value from the prices, or index of prices, of underlying

securities.

Derivatives were developed primarily to manage, offset or hedge against risk but some were

developed primarily to provide the potential for high returns.

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Literature Review

[ Source : http://129.3.20.41/eps/mac/papers/0504/0504004.pdf]

A derivative is defined by the BIS (1995) as a contract whose value depends on the price of

underlying assets, but which does not require any investment of principal in those assets. As a

contract between two counterparts to exchange payments based on underlying prices or yields, any

transfer of ownership of the underlying asset and cash flows becomes unnecessary. This definition

is strictly related to the ability of derivatives of replicating financial instruments2.

Derivatives can be divided into 5 types of contracts: Swap, Forward, Future, Option and Repo, the

last being the forward contract used by the ECB to manage liquidity in the European inter-bank

market. For a further definition of contracts, which should although be known by the reader, see

Hull (2002). These 5 types of contracts can be combined with each other in order to

create a synthetic asset/liability, which suits any kind of need; this extreme flexibility and freedom

widely explain the incredible growth of these instruments on world financial markets.

In section 2 I will look at some micro-economic results about derivatives; in section 3 the issue of

risk is addressed; in section 4 monetary policy results about derivatives are shown, and in section 5

fiscal policy results are shortly presented. In a brief statistical appendix some relevant data are

presented Derivatives are financial instruments widely used by all economic agents

to invest, speculate and hedge in financial market (Hull, 2002). These functions are strictly related

with the financial and mathematical definition of instruments and do not consider the economic

contents of financial assets. Generally speaking, the introduction of exchange traded derivative

products 1. increases information about the underlying; 2. does not seem to

increase volatility and risks of and on the underlying market; 3. Price discovery effect improves; 4.

bid-ask spread and the noise component of prices both decrease.

Micro-economic results about derivatives can be summed up also looking at the single instrument:

a. Future contracts increase market efficiency (by lowering trading costs and information

asymmetry) and liquidity (given all expiration dates and daily setting of margins).

Transparency depends on the international and national laws and is generally very high.

Futures are widely used to hedge and speculate, both on financial and commodity markets.

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Notional value of future contract does not represent the exposure of the two counterparts, as

long as they settle their position each day through margins.

b. Option contracts have the same effects of futures on markets. The only drawback can be

the unclear effect on volatility of the underlying, because futures tend to lower underlying

assets volatility, whereas option do not give unique empirical results. The option notional

value is not a proxy of the exposure, but the premium paid to open/close the position

represents resources invested.

c. Swaps are generally OTC contracts with a longer duration than futures and options, and

satisfy the need of a single client of the bank (a firm or financial institution). They tend to

create new investment opportunities in order to hedge against any type of risk or speculate

(currency, interest rate, hearth-quake, credit default, and so on). In these contracts the

notional value of the contract do not represent the risk taken by the two (or more)

counterparts, but periodical payments.

d. d. Forwards are OTC future contracts, not standardised and created on the client needs.

They showed to have almost the same properties of futures

e. . Repos are time financing operations between the ECB and the European inter-bank

system; they are used to finance liquidity and not to speculate or hedge, so that the

inclusion of them is given only to their structure of time operations, but not to their

financial function. The legal risk related with the absence in some countries of a

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Objective

The word DERIVATIVES is derived from the word itself derived of an underlying asset. It is a

future image or copy of an underlying asset which may be shares, stocks, commodities, stock

indices, etc.Derivatives are a financial product (shares, bonds) any act which is concerned with lending and

borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives are derived from the following products:A. Shares

B. Debentures

C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

The objectives of this comprehensive project are to understand the:-

Futures contract

Hedging in futures

Speculating in futures

Arbitrage in futures

Options

Options strategies

Derivatives products

Open interest

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INTRODUCTION TO FUTURE MARKET

Futures markets were designed to solve the problems that exit in forward markets. A futures con

tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a

certain price. There is a multilateral contract between the buyer and seller for a underlying asset

which may be financial instrument or physical commodities. But unlike forward contracts the

future contracts are standardized and exchange traded

PURPOSE

The primary purpose of futures market is to provide an efficient and effective mechanism formanagement of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts are affected mainly

by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the

margin to trade in the futures market

It is essential that both the parties compulsorily discharge their respective obligations on the

settlement day only, even though the payoffs are on a daily marking to market basis to avoiddefault risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with

a fresh opening value. Here both the parties face an equal amount of risk and are also required to

pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based

financial futures are settled in cash unlike futures on individual stocks which are very rare and yet

to be launched even in the US. Most of the financial futures worldwide are index based and hence

the buyer never comes to know who the seller is, both due to the presence of the clearing

corporation of the stock exchange in between and also due to secrecy reasons

EXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

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There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish

in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased

the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is

300 shares.

Suppose the stock rises to 2200.

Profit

20

2200

10

0

1400 1500 1600 1700 1800 1900-10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the

buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400

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Profit

20

10

0

1400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the seller = Rs.75, 000.[(1650-1400*300)] and notional profit for the seller is

250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some date

in the future. Futures are often used by mutual funds and large institutions to hedge their positions

when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability

to control a sizable amount of an asset for a cash outlay, which is distantly small in proportion to

the total value of contract

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MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract.

Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based

on the value at risk of the stock/index margins are calculated. In general margin ranges between

10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on

their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin

approximately equals the maximum daily price fluctuation permitted for the contract being traded.

Upon proper completion of all obligations associated with a traders futures position, the initial

margin is returned to the trader.

OBJECTIVE

The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and

seller have to deposit margins. The initial margin is deposited before the opening of the position in

the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than

initial margin. This is set to ensure that the balance in the margin account never becomes negative.

If the balance in the margin account falls below the maintenance margin, the investor receives a

margin call to top up the margin account to the initial level before trading commencing on the next

level.

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ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty

futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%.

The lot size of nifty futures =200.suppose on MAY 16th

The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the

market. The profit for the buyer will be 10,000 [(1350-1300)*200]

Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)

Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th nifty futures settled at 1400.

Profit of buyer will be 10,000[(1450-1350)*200]

Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)

Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600 While

the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.

Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]

Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)

Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

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Therefore in this way each account each account is credited or debited according to the settlement

price on a daily basis. Deficiencies in margin requirements are called for the broker, through

margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin may be called for by the

exchange. This is generally imposed when the exchange fears that the markets have become too

volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by

exchange to prevent breakdown.

CROSS MARGINING:

This is a method of calculating margin after taking into account combined positions in Futures,

options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done.

E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script

of SATYAM falls then the investor is required to pay the mark-to-market margin also called as

variation margin for trading in the future contract

HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already

exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their

price risk. Hedgers are those persons who dont want to take the risk therefore they hedge their

risk while taking position in the contract. In short it is a way of reducing risks when the investor

has the underlying security.

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PURPOSE:

TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK

Figure 1.1

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional

offload holding available risk latter by paying premium. cost is only

during adverse reward dependant 2)For Long, buy ATM Put premium.

market conditions on market prices Option. If market goes up,

as circuit filters long position benefit else

limit to curtail losses. exercise the option.3)Sell deep OTM call option

with underlying shares, earn

premium + profit with increase prcie

Advantages

Availability of Leverage

STRATEGY:

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The basic hedging strategy is to take an equal and opposite position in the futures market to the

spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the

investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification.

Diversification and hedging do not have cost in cash but have opportunity cost. Hedging isimplemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging

eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes

risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk).

Diversification is affected by choosing a group of assets instead of a single asset (technically, by

adding positively and imperfectly correlated assets).

ILLUSTRATION

Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of

manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is

completed.

COST SELLING PRICE PROFIT

400 1000 600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in thecontract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if

Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.

Shyam defaults Shyam honors

400 (Initial Investment) 600 (Initial profit)

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400 (penalty from Shyam (-100) discount given to Shyam

- (No gain/loss) 500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial

investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of

Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and

protected his initial investment.

Now lets see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that the

market would go down due to some news. Then, to minimize your downside risk you could hedge

your position by buying a Put Option. This will hedge your downside risk in the market and your

loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging is the

removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits than

the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make

excess profits for sure; all that can come out of hedging is reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are not

subject to margins as in hedging through futures. Options buyers are however required to pay

premium which are sometimes so high that makes options unattractive.

ILLUSTRATION:

With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the investor

excepts that price will fall by 100.So he decided to buy the put Option b y paying the premium of

Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls by

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100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered Rs.75 a

share by buying ACC put.

HEDGING STRATEGIES:

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of

Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position.

Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the

security, without any extra risk from fluctuations of the market index. Finally the investor has

HEDGED AWAY his index exposure.

EXAMPLE:

LONG SECURITY, SELL FUTURES

Here stock futures can be used as an effective risk management tool. In this case the

investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the

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risk the Hedger enters into a future contract and takes a short position. However the losses suffer in

the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390

Market action = 350

Loss = 40

Strategy = BUY SECURITY, SELL FUTURES

Two month Futures= 390

Premium = 12

Short position = 390

Future profit = 40(390-350)

As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures

will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made

on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of HLL.The

spot price of HLL is 232 suddenly the investor worries about the fall of price. Therefore the

solution is buy put options on HLL.

The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the

investor has two possible scenarios three months later.

1) IF PRICE RISES

Market action: 215

Loss : 17(232-15)

Strike price : 240

Premium : 08

Profit : 17(240-215-8)

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Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option

bought.

2) IF PRICE RISES:

Market share : 250

Loss : 10

Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike price investor chooses) and an

unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investors are holding the portfolio of stocks and selling nifty futures. In the case

of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a

position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the

LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on

1st May, 2001.

Company Beta Amount of Holding ( in Rs)

Infosys 1.55 400,000.00

Global Tele 2.06 200,000.00

Satyam Comp 1.95 175,000.00

HFCL 1.9 125,000.00

Total Value of Portfolio 1,000,000.00

Trading Strategy to be followed

The investor feels that the market will go down in the next two months and wants to protect him

from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY

futures i.e he has to sell June Nifty. This strategy is called Short Hedge.

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Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level

Beta of the above portfolio

=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1st May 2001

= (1,000,000.00 * 1.61) / 1150

= 1400 Units

Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

Short Hedge

Stock Market Futures Market

1st May Holds Rs 1,000,000.00 in

stock portfolio

Sell 7 NIFTY futures

contract at 1150.

25th June Stock portfolio fall by 6% to

Rs 940,000.00

NIFTY futures falls by 4.5%

to 1098.25

Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00

Net Profit: + Rs 15,450.00

SPECULATORS:

If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take

such risk. speculators are those who do not have any position and simply play with the others

money. They only have a particular view on the market, stock, commodity etc. In short, speculators

put their money at risk in the hope of profiting from an anticipated price change. Here if

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speculators view is correct he earns profit. In the event of speculator not being covered, he will

loose the position. They consider various factors such as demand supply, market positions, open

interests, economic fundamentals and other data to take their positions.

SPECULATION IN THE FUTURES MARKET

Speculation is all about taking position in the futures market without having the underlying.

Speculators operate in the market with motive to make money. They take:

Naked positions - Position in any future contract.

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Spread positions - Opposite positions in two future contracts. This is a conservative

speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price

discovery in the market

Figure 1.2

Speculators

Existing SYSTEM New


1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum

Trading, margin loss to extent of on delivery basis loss possible

trading& carry price change. 2) Buy Call &Put to premium

forward transactions. by paying paid

2) Buy Index Futures premiumhold till expiry. Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

The Speculator has a view on the market and accepts the risk in anticipating of profiting from the

view. He studies the market and plays the game with the stock market

TYPES:

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POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until their target

is met.

DAY TRADERS:

. Day traders square off the position during the curse of the trading day and book the profits.

SCALPERS:

Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he can buy put or call option

depending upon his perception about future price. If speculator has a bullish outlook, he will buy

calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If

speculators view is correct he earns profit. In the event of speculator not being covered, he will

loose the position. A Speculator will buy call or put if his price outlook in a particular direction is

very strong but if is either neutral or not so strong. He would prefer writing call or put to earn

premium in the event of price situations.

ILLUSTRATION:

Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of

Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit

otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE

TELEFILMS stock will come down then he will buy put on the stale price until he can write either

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call or put. Finally Speculators provide depth an liquidity to the futures market an in their

absence; the price protection sought the hedger would be very costly.

STRATEGIES:

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator

buys the shares of the company an makes the profit. At the same time the Speculator enters into the

future contract i.e. buys futures and makes profit.

Spot Price of RELIANCE = 1000

Value = 1000*100shares = 1, 00,000Market action = 1010

Profit = 1000

Initial margin = 20,000

Market action = 1010

Profit = 400(investment of Rs.20, 000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes a

profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the

Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

BUY STOCK

ACC spot price : 150

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No of shares : 200

Price : 150*200 = 30,000

Market action : 160

Profit : 2,000

Return : 6.6% returns over 2months

BUY CALL OPTION:

Strike price : 150

Premium : 8

Lot size : 200 shares

Market action :160

Profit : (160-150-8)*200 = 400

Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a

investment of 2months as compared to 6.6% returns over a investment in stocks

BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall in price. Here simple arbitrage

ensures that futures on an individual securities more correspondingly with the underlying security

as long as there is sufficient liquidity in the market for the security. If the security price rises the

future price will also rise and vice-versa.

Two month Futures on SBI = 240

Lot size = 100shares

Margin = 24

Market action = 220

Future profit = 20(240-220)

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Finally on the day of expiration the spot and future price converges the investor makes a profit

because the speculator is bearish in the market and all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can BUY OR SELL the

entire index trading on one single security. Once a person is LONG NIFTY using the futures

market, the investor gains if the index rises and loss if the index falls.

ARBITRAGEURS:

Arbitrage is the concept of simultaneous buying of securities in one market where the price is low

and selling in another market where the price is higher.

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person

and ready to take the risk He is basically risk averse. He enters into those contracts were he can

earn risk less profits. When markets are imperfect, buying in one market and simultaneously

selling in other market gives risk less profit. Arbitrageurs are always in the look out for such

imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower

priced market and selling at the higher priced market.

JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where the

investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operating in them

simultaneously.

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Figure 1.3

Arbitrageurs

Existing SYSTEM New


1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free

one and selling in whichever way the promising as still game.another exchange. Market moves. in weekly settlement

forward transactions. 2) Cash &Carry

2) If Future Contract arbitrage continues

more or less than Fair price

Fair Price = Cash Price + Cost of Carry

Example:

Current market price of ONGC in BSE= 500

Current market price of ONGC in NSE= 510

Lot size = 100 shares

Thus the Arbitrageur earns the profit of Rs.1000 (10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES:

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In this the investor observing that futures have been overpriced, how can the investor

cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC

futures = 1025.

This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make

risk less profits entering into the following set f transactions.

On day one, borrow funds, buy security on the spot market at 1000

Simultansely, sell the futures on the security at1025

Take delivery of the security purchased and hold the security for a month

on the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.1015. Sell the security Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures

position

Return the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit possible,

it makes sense for the investor to enter into the arbitrage. This is termed as cash and- carry

arbitrage.

BUY FUTURES, SELL SPOT:

In this the investor observing that futures have been under priced, how can the investor

cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC

futures = 965.

This shows that futures have been under priced and therefore as an Arbitrageur, investor can make

risk less profits entering into the following set f transactions.

On day one, sell the security on the spot market at 1000

Mae delivery of the security

Simultansely, buy the futures on the security at 965

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On the futures expiration date, the spot and futures converge . Now unwind the position

Sa y the security closes at Rs.975. Sell the security

Futures position expires with the profit f Rs.10

The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from the

arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash

and- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between two markets. An

arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to arbitraged

between NIFTY in the futures market and the cash market. If the futures price is any of the prices

given below other than the equilibrium price then the strategy to be followed is

CASE-1

Spot Price of INFOSEYS = 1650

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Future Price Of INFOSEYS = 1675

In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the

futures at Rs.1675 and finally earn risk free profit Of Rs.25.

CASE-2

Future Price Of ACC = 675

Spot Price of ACC = 700

In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at

Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer

(holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets,

at a specific (strike) price on or before a specified time (expiration date). The underlying may be

physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/

stock index/ bonds etc.

MONTHLY OPTIONS :

The exchange trade option with one month maturity and the contract usually expires on last

Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as the

premium paid for hedging is very high. Also the trader has to pay more money to take a long or

short position which results into iiliquidity in the market.Thus to overcome the problem the BSE

introduced WEEKLY OPTIONS

WEEKLY OPTIONS:

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The exchange trade option with one or weak maturity and the contract expires on last Friday of

every weak

ADVANTAGES

Weekly Options are advantageous to many to investors, hedgers and traders.

The premium paid for buying options is also much lower as they have shorter time to

maturity.

The trader will also have to pay lesser money to take a long or short position.

the trader can take a larger position in the market with limited loss. On account of low cost,

the liquidity will improve, as more participants would come in.

Weekly Options would lead to better price discovery and improvement in market depth,

resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity ofthe underlying asset at the strike price on or before expiration date. The seller (one who is short

call) however, has the obligation to sell the underlying asset if the buyer of the call option decides

to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller)

of the contract.

ILLUSTRATION

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Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market

and other is Rakesh (call seller) who is bearish in the market.

The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be

excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will

earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has

crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the

seller at Rs.600 and sell in the market at Rs.660.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

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Unlimited profit for the buyer = Rs.35{(spot price strike price) premium}

Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock

price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20

10

0

590 600 610 620 630 640

-10

-20

-30

Loss

Profit for the Seller limited to the premium received = Rs.25

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Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost

the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimited

losses and have limited losses to the certain extent

Thus call option indicates two positions as follows:

LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call

option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call

option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of

the underlying asset at the strike price on or before a expiry date. The seller of the put option (one

who is short put) however, has the obligation to buy the underlying asset at the strike price if the

buyer decides to exercise his option to sell.

ILLUSTRATION

Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market

and other is Amit (put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):

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Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be

excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyers

breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the share

price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised

the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the seller at

Rs.800

Profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike price spot price) premium}

Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Putoption will choose not to exercise his option to sell as he can sell in the market at a higher rate.

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profit

20

10

0

600 700 800 900 1000 1100

-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for

the seller because the seller is bullish in the market = 780 - 750 = 30

Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITION

If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put

option.

SHORT POSITION

If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put

option

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CALL OPTIONS PUT OPTIONS

Option buyer or

option holder

Buys the right to buy the

underlying asset at the

specified price

Buys the right to sell the

underlying asset at the

specified price

Option seller or

option writer

Has the obligation to sell the

underlying asset (to the

option holder) at the

specified price

Has the obligation to buy the

underlying asset (from the

option holder) at the

specified price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)

Changes in the underlying asset price can increase or decrease the premium of an option. These

price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and the

premium of a put will decrease. A decrease in the price of the underlying assets value will

generally have the opposite effect.

THE SRIKE PRICE: (K)

The strike price determines whether or not an option has any intrinsic value. An options premium

generally increases as the option gets further in the money, and decreases as the option becomes

more deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value, for puts and calls, decreases.

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Volatility:

Volatility is simply a measure of risk (uncertainty), or variability of an options underlying. Higher

volatility estimates reflect greater expected fluctuations (in either direction) in underlying price

levels. This expectation generally results in higher option premiums for puts and calls alike, and is

most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of

an option seller or received from alternative investments in the case of an option buyer for the

premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:

a) Developmental institutions

b) Mutual Funds

c) Domestic & Foreign Institutional Investors

d) Brokers

e) Retail Participants

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION :

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a

price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are

obligated to buy/sell the underlying asset.

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

asset.

RISK

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Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While

options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the

downside is limited to the premium (option price) he has paid while the profits may be unlimited.

For a seller or writer of an option, however, the downside is unlimited while profits are limited to

the premium he has received from the buyer.

PRICES:

The Futures contracts prices are affected mainly by the prices of the underlying asset. While the

prices of options are however, affected by prices of the underlying asset, time remaining for expiry

of the contract & volatility of the underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options

contract, termed as Premium.

STRIKE PRICE

In the Futures contract the strike price moves while in the option contract the strike price remains

constant .

Liquidity:

As Futures contract are more popular as compared to options. Also the premium charged is high in

the options. So there is a limited Liquidity in the options as compared to Futures. There is no

dedicated trading and investors in the options contract.

Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of

the underlying only. While trading in option is two-dimensional as the price of the option depends

upon the price and volatility of the underlying.

PAY OFF:

As options contract are less active as compared to futures which results into non linear pay off.

While futures are more active has linear pay off .

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OPTION STRATAGIES:

1. BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call

Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of

the same month. However, the total investment is usually far less than that required to purchase

the stock.

Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of

1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)


BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

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On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at

Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will

expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5

which is less than premium paid result in loss of 5.While 1510 call option sold will not expire

which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10

i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium

receive generate profit .

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While

1510 call sold result in Rs.10 loss i.e. deep out the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the

money. While 1510 call sold will have no intrinsic value and expire worthless and profit is thepremium received of Rs. 10

iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10

while the 1510 option i.e. strike prices-premium paid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in

loss to the premium paid.

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Profit

20

10

0

1490 1500 1510 1520 1530 1540

-10

-20

Loss

2. BEAR PUT SPREAD:

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It is implemented in the bearish market with a limited downside. The Bear put Spread consists of

the purchase a higher strike price put and sale of a lower strike price put, of the same month. It

provides high leverage over a limited range of stock prices. However, the total investment is

usually far less than that required to buy the stock shares. Current price of INFOSYS

TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one

month put of 4490 (lower price) and receive 45 ticks per contract. Premium = 10 ticks per

contract(55 paid- 45 received)


BREAK- EVEN- POINT= 5510-10 = 5500.




Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid

while the 4490 put option sold will expire worthless and also reduce the premium received.


If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5

which is less than premium paid result in loss of 5.While 4490 call option sold will not expire

which will reduce the loss of Rs.10 through receiving the net premium. If the index is between

5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money

While 4490 put option sold will have no intrinsic value the premium receive will generate profit .

iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless.

While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium

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received If the index is at 4490 the 5510 put option will have maximum profit deep in the money.

While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium

received between the strike price an premium paid.

iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic

value. While the 4490 put option sold result in maximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic

value. While the 5510 put option sold result in the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490

option sold will be assigned (strike price premium paid) = profit.

Profit

20

10

0

3000 3500 4000 4500 5000 5500 6000 6500 7000

-10

-20

Loss

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3. BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market

to provide high leverage over a limited range of stock prices. The investor buys a lower strike put

and selling a higher strike put with the same expiration dates. The strategy has both limited profit

potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell one

month put of 1310 (higher price) and receive 15 ticks per contract. Premium = 10 ticks per

contract (25 paid- 15 received)

Lot size = 600 shares BREAK- EVEN- POINT= 1300-10 = 1290



On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an

intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an

intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no

intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of

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iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless.

While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money

and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t

the premium received

iv. ABOVE STRIKE PRICE:

If the index is above1300 say 1310, the 1300 put option buyer has lost the premium while the

1310 put option seller receive premium to the limited profit

If the index is above 1310, say 1320 the 1290 put option buyer will have maximum loss results in

deep out the money while the 1310 put option will have the limited profit.

v. BELOW STRIKE PRICE:

If the index is below 1300 say (1290) , the 1300 put option buyer will have an intrinsic value

of 10 while the 1310 put option sold receive only premium as the profit is limited for the seller

OPTION PAYOFF Profit

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Loss

4.BEAR CALL SPREAD:

This strategy is best implemented in a moderately bearish or stable market to provide high leverage

over a limited range of stock prices. Here the investor buys a higher strike call and sells a lower

strike call with the same expiration dates. However, the total investment is usually far less than that

required to buy the stock or futures contract. The strategy has both limited profit potential and

limited downside risk. Current price of ACC is Rs. 1500

Here the investor buys one month call of 1510 at 25 ticks per contract and sell one month call of

1490 and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid - 15 received)


BREAK- EVEN- POINT= 1510+10=1520




Breakeven. The call of 1510 will have an intrinsic value of 10 while the 1490 call option sold will

expire worthless and also reduce the premium with the premium outflow.

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If the index is between 1490 and 1500 then the 1510 call option will have no intrinsic value and

expire worthless, While 1490 call option sold will not expire which will reduce the loss through

receiving the net premium.

If the index is between 1500 and 1510 then the 1510 call option will have an intrinsic value of 0,

while 1490 call option sold will have no intrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1510 the 1510 call option will have no intrinsic value and expire worthless. While

1490 call sold receive only premium

If the index is at 1490, the 1510 call option will have no intrinsic value result in deep out the

money, While 1490 call sold will have no intrinsic value and expire worthless

iv. ABOVE HIGHER PRICE :

IF the underlying stock is above 1510 say 1520, the 1510 call option will be in the money of Rs.10

while the 1490 option will incur loss to the premium receive

IF the underlying stock is above 1490 say Below1510, the 1510 call option will not be exercised

while the 1490 option will incur loss to the premium receive because seller is bearish in the market.

v. BELOW STRIKE PRICE :

IF the underlying stock is below 1510, the 1510 call option will result in deep out the money and1490 option sold result in loss to the premium paid

OPTION PAYOFF Profit

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Loss

5). STRADDLE:

In this strategy the investor purchase and sell the call as well as the put option of the same strike

price, the same expiration date, and the same underlying. In this strategy the investor is neutral in

the market.

This strategy is often used by the SPECULATORS who believe that asset prices will move in one

direction or other significantly or will remain fairly constant.

TYPES:

LONG STRADDLE:

Here the investor takes a long position(buy) on the call and put with the same strike price and same

expiration date. In this the investor is beneficial if the price of the underlying stock move

substantially in either direction. If prices fall the put option will be profitable an if the prices rises

the call option will give gains. Profit potential in this strategy is unlimited ,While the loss is limited

up to the premium paid. This will occur if the spot price at expiration is same as the strike price ofthe options.

SHORT STRADDLE:

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This strategy is reverse of long straddle. Here the investor write(sell) the call as well as the put in

equal number for the same strike price an same expiration. This strategy is normally used when the

prices of the underlying stock is stable but the investor start suffering losses if the market

substantially moves in either direction .

Detailed example of a long straddle Current market price of BAJAJ AUTO is Rs.600

Here the investor buys one month call of strike price 600 at 20 ticks per contract and two month

put of strike price 600 for 15 ticks per contract.

Premium Paid = 35 ticks


Lower Break- Even- Point = 600 35 = 565

Higher Break- Even- Point = 600 + 35 = 635

i. AT BREAK- EVEN- POINT:

If the stock is at 565 or at 635, this option strategy will be at Break- Even- Point. At 565 the 600

call will have no intrinsic value an expire worthless but the 600 put will have an intrinsic value of

35.

At 635 the 600 call will have an intrinsic value of 35, while the put 600 will expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 550 then the 600 call will have no intrinsic value and expire worthless

while 600 put will have an intrinsic value of 50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 650 the 600 call will have an intrinsic value of 50, while 600 put will

have no intrinsic value an will expire worthless.

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iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 6oo then the both call and put option will expire worthless which results

in the loss of 35(premium).

Profit

40

30

20

10

550 560 570 580 590 600 610 620 630 640 650

-10

-20

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-30

-40

Loss

6. STRANGLE:

In this strategy the investor is neutral in the market which involves the purchase of a higher call

and a lower put that are slightly out of the money with different strike price and with the different

expiration date. The premiums are lower as compared to straddle also the risk is more involved as

compare to straddle which not leads to the profit.

TYPES

1) LONG STRANGLE: Here the investor purchases a higher call and a lower put with

different strike price and with the different expiration date. A long strangle strategy is used to profitfrom a volatile price an loss from stable prices.

2) SHORT STRANGLE: In this the investor sells a higher call and a lower put with different

strike price and with the different expiration date. A short strangle strategy is used to profit from a

stable prices an loss starts when price is volatile.

Detailed example of a short strangl Current market price of BSE INDEX is Rs.4000

Here the investor sells a two month call of strike price 4050 for 20 ticks per contract and two

month put of strike price 3950 for 15 ticks per contract.

Premium Received = 35 ticks


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Lower Break- Even- Point = 3950 35 = 3915

Higher Break- Even- Point = 4050 + 35 = 4085

On Expiration:

i. AT BREAK EVEN POINT:

If the stock is at 3915 or at 4085, this option strategy will be at Break- Even- Point. At 3915 the

4050 call will have no intrinsic value and expire worthless but the 3950 put will have an intrinsic

value of 35

At 4085 the 4050 call will have an intrinsic value of 35, while the put 400 will have no intrinsic

value and expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 3900 then the 4050 call will have no intrinsic value and expire worthless

while 3950 put will have an intrinsic value of 50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 4100 the 4050 call will have an intrinsic value of 50, while 3950 put will

have no intrinsic value and will expire worthless.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 4000 then the both call and put option will expire worthless and limited

profit up to the premium received

v. AT STRIKE PRICE:

If the price is settled at 4050 then 4050 call and 3950 put will have limited profit upto the

premium received

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Profit

20

10

0

3900 3925 3950 3975 4000 4025 4050 4075 4100

-10

-20

Loss

7) COVERED CALL:

Under this strategy investors buys the shares which shows that they are bullish in the market but

suddenly they are scared about the market falls thus they sells the call option. Here the seller is

usually negative or neutral on the direction of the underlying security. This strategy is best

implemented in a bullish to neutral market where a slow rise in the market price of the underlying

stock is anticipated.

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Thus if price rises he will not participate in the rally. However he has now reduced loss by the

amount of premium received, if prices fall. Finally if prices remain unchanged obtains the

maximum profit potential.

EXAMPLE:

Portfolio: 100 shares purchased at Rs.300

Components: Sell a two month Reliance call of 300 strike at 25

Net premium: 25 ticks

Premium received: Rs.2500 (25*100, the multiplier)

Break-even-point: Rs.275:Rs.300-25 (Premium received)


If the stock closes at 300, the 300 call option will not exercise and seller will receive the premium.

If the stock ends at 275, the 300 call option expires worthless equitant to the premium received

results into no profit no loss.

If the stock ends above 300, the 300 call option is exercised and call writer receives the premium

results into the maximum profit potential.

The payoff diagram of a covered call with long stock + short call = short put

Profit

:

50

25

0

250 275 300 325 350

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-25

-50 Loss

8) COVERED PUT:

Here the writer sell stock as well as put because he overall moderate bearish on the market and

profit potential is limited to the premium received plus the difference between the original share

price of the short position and strike price of the put. The potential loss on this position, however is

substantial if price increases above the original share price of the short position. In this case the

short stock will suffer losses which will be offset by the premium received.

Profit

:

Premium Received

Lower

Loss

9) UNCOVERED CALL:

This strategy is reverse of the covered call. There is no opposite position in the naked call. A call

option writer (seller) is uncovered if the shares of the underlying security represented by the option

is not owned by the option writer.

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The object of an uncovered call writer is to realize income by writing (selling) option without

committing capital to the ownership of the underlying shares.

This shows that the seller has one sided position in the contract for this the seller must deposit and

maintain sufficient margin with the broker to assure that the stock can be purchased for delivery if

option is exercised.

RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE AS FOLLOWS:-

If the market price of the stock rises sharply the calls could be exercised, while as far as

the obligation is concerned the seller must buy the stock more than the option strike price,

which results in a substantial loss.

The rise of buying uncovered calls is similar to that of selling stock although, as an option

writer, the risk is cushioned somewhat by the amount of premium received.

ILLUSTRATION:

Portfolio: Write reliance call of 65 strikeNet premium: 6

Lot size: 100 shares

Market action: price settled at 55

Therefore the option will not be assigned because the seller has no stock position and price decline

has no effect on the profit of the premium received.

Suppose the price settled at Rs.75 the option assigned and the seller has to cover the position at a

net loss of Rs.400 [1000 (loss on covering call)- 600(premium income)]

Finally the loss is unlimited to the increase in the stock price and profit is limited to the declining

stable stock price.

10) PROTECTIVE PUT:

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Under this strategy the investor purchases the stock along with the put option because the investor

is bearish in the market. This strategy enables the holder of the stock to gain protection from a

surprise decline in the price as well as protect unrealized profits. Till the option expires, no matter

what the price of underlying is, the option buyer will be able to sell the stock at strike price of put

option.

SCENARIO

Price of HLL: 200

Components: Buy a one-month put of strike 200

Net premium: 10 ticks per contract

Premium paid: 1000 (10*100 multiplier)

Break-even-point: 210 (Rs.200+10, Premium paid)

Here the investor pays an additional margin of Rs.10 along with the price of Rs.210 combining

a share with a put option is referred as a Protective Put.

Possible outcomes at expiration

AT BREAK-EVEN-POINT:

Previously if the price rises to 200 the investor will gain but now the investor pays an margin of

Rs.10. If price rises to Rs.210 then only the investor will gain.

BELOW STRIKE PRICE:

In case of fall in the stock price the loss is limited to Rs.18. This means that he maximum loss that

the investor would have to bear is limited to the extent of premium paid.

If the price falls at 190 the investor will sell at 200.

ABOVE STRIKE PRICE :

In case of rise in prices then the put option will expire worthless and the investor will benefit from

rise in the stock price.

Finally uncertainty is the biggest curse of the market and a protective put helps override the

uncertainty in the markets. Protective put removes the uncertainty by limiting the investor loss at

Rs.10. In this case no matter what happens to the investor is protected by the loss of Rs.10. The put

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option makes the investor life by telling the investor in advance how much it stands to loss. This is

also referred to as PORTFOLIO INSURANCE because it helps the investor by insuring the value

of investment just like any other asset for which the investor would purchase insurance.

profit

:

20

10

0

180 190 200 210 220

-10

-20

Loss

PRICING OF AN OPTION

DELTA

A measure of change in the premium of an option corresponding to a change in the price of the

underlying asset.

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Change in option premium

Delta = --------------------------------

Change in underlying price

FACTORS AFFECTING DELTA OPTION:

Strike price

Risk free interest rate

Volatility

Underlying price

Time to maturity

ILUSTRATION

The investor has buys the call option in the future contract for the strike price of Rs.19. The

premium charged for the strike price of 19 at 0.80 The delta for this option is 0.5.Here if the price

of the option rises to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The new

option premium will be 0.80 + 0.50 = Rs 1.30.

Here in the money call option will increase the delta by 1.which will make the value more and

expensive while at the money option have the delta to 0.5 and finally out the money call option

will have the delta very close to 0 as the change in underlying price is not likely to make them

valuable or cheap and reverse for the put option

Delta is positive for a bullish position (long call and short put) as the value of the position

increases with rise in the price of the underlying. Delta is negative for a bearish position (short

call and long put) as the value of the position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from 1 to 0 for put options. Some people refer to

delta as 0 to 100 numbers.

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ADVANTAGE

The delta is advantageous for the option buyer because it can tell him much of an option and

accordingly buyer can expect his short term movements by the underlying stock. This can help the

option of an buyer which call/put option should be bought.

DERIVATIVES PRODUCTS OFFERED BY BSE

SENSEX FUTURES

A financial derivative product enabling the investor to buy or sell underlying sensex on a

future date at a future price decided by the market forces First financial derivative product

in India. Useful primarily for Hedging the index based portfolios and also for expressing

the views on the market

SENSEX OPTIONS:

A financial derivative product enabling the investor to buy or sell call or put options (to be

exercised on a future date) on the underlying sensex at a premium decided by the market

forces Useful primarily for Hedging the Sensex based portfolios and also for expressing

the views on the market

STOCK FUTURES:

A financial derivative product enabling the investor to buy or sell underlying stock on a

future date at a price decided by the market forces Available on ____ individual stocks

approved by SEBI Useful primarily for Hedging, Arbitrage and for expressing the views on

the market

STOCK OPTIONS:

A financial derivative product enabling the investor to buy or sell call options(to be

exercised at a future date) on the underlying stock at a premium decided by the market

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forces Available on ____ individual stocks approved by SEB Useful primarily for Hedging,

Arbitrage and for expressing the views on the market.

CONTRACT SPECIFICATIONS

PARTICULARS SENSEX FUTURES AND

OPTIONS

STOCK FUTURES AND

OPTIONS

Underlying Asset Sensex Corresponding stock in the

cash market

Contract Multiplier 50 times the sensex

(futures)

100 times the sensex

(options)

Stock specific E.g. market

lot of RIL is 600, Infosys is

100 & so on

Contract Months 3 nearest serial months

(futures)

1, 2 and 3 months(options)

1, 2 and 3 months

Tick size 0.1 point 0.01*

Price Quotation Sensex point Rupees per share

Trading Hours 9:30a.m. to 3:30p.m. 9:30a.m. to 3:30p.m.

Settlement value In case of sensex options

the closing value of the

sensex on the expiry day

In case of stock options the

closing value of the

respectative in the cash

segment of BSE

Exercise Notice Time In case of sensex options

Specified time (exercise

session) on the last trading

day of the contract. All in

the money options would

deem to be exercised

unless communicated

otherwise by the

In case of stock options

Specified time (exercise

session) on the last trading

day of the contract. All in

the money options would

deem to be exercised

unless communicated

otherwise by the

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participant. participant.

Last Trading Day Last Thursday of the

contract month. If it is a

holiday, the immediately

preceding business day

Last Thursday of the

contract month. If it is a

holiday, the immediately

preceding business dayFinal Settlement On the last trading day, the

closing value of the Sensex

would be the final

settlement price of the

expiring futures/option

contract.

The difference is settled in

cash on the expiration day

on the basis of the closing

value of the respectative

underlying scrip in the cash

market on the expiration

day

DERIVATIVES PRODUCTS OFFERED BY NSE

INDEX FUTURES

Index Futures are Future contracts where the underlying asset is the Index. This is of great help

when one wants to take a position on market movements. Suppose you feel that the markets are

bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index

you can buy the market by taking a position on the Index future

Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset

allocation. The S&P 500 futures products are the largest traded index futures product in the world.

Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched

index futures in June 2000

ADVANTAGES OF INDEX FUYTURES

The contracts are highly liquid

Index Futures provide higher leverage than any other stocks

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It requires low initial capital requirement

It has lower risk than buying and holding stocks

Settled in cash and therefore all problems related to bad delivery,

forged, fake certificates, etc can be avoided.

INDEX OPTIONS

An index option provides the buyer of the option, the right but not the obligation to buy or sell the

underlying index, at a pre-determined strike price on or before the date of expiration, depending on

the type of option.

Index option offer investors an opportunity to either capitalize on an expected market move or

hedge price risk of the physical stock holdings against adverse market moves.

NSE introduce index option in June 2001.

FUTURES ON INDIVIDUAL SECURITIES

A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading

in futures on individual securities on November 9, 2001. NSE defines the characteristics of the

futures contract such as the underlying security, market lot, and the maturity date of the contract.

The futures contracts are available for trading from introduction to the expiry date.

CONTRACT SPECIFICATIONS

PARTICULARS INDEX FUTURES AND

OPTIONS

FUTURES AND OPTIONS

ON INDIVIDUAL

SECURITIES

Underlying S&P CNX Nifty and CNX IT

Individual Securities, at present

53 stocks

Contract Size S&P CNX Nifty Futures /

Permitted lot size 200 and

multiples

Futures / Options on Minimum

value of Rs 2 Lakh for each

individual securities Individual

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S&P CNX Nifty Options there of

(minimum value Rs.2 lakh)

Security

Strike Price Interval S&P CNX Nifty Options Rs. 10/-

2.

Options on individual Between

Rs.2.50 and Rs. 100.00

securities : depending on the

price of underlying

Trading Cycle Maximum of three month trading

cycle- near month(one), the nextmonth (two)and the far month

(three). New series of contract

will be introduced on the next

trading day following expiry of

near month contract

Maximum of three month

trading cycle- near month(one),the next month (two)and the far

month (three). New series of

contract will be introduced on

the next trading day following

expiry of near month contract.

Expiry Date The last Thursday of the expiry

month or the Previous trading day

if the last Thursday of the month

is a trading holiday

The last Thursday of the expiry

month or the Previous trading

day if the last Thursday of the

amit dhariwal

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