Post on 19-Nov-2014
transcript
DERIVATIVES:
FUTURES & OPTIONS
Defining Derivatives
• A derivative is a financial instrument whose
value depends on – is derived from – the
value of some other financial instrument,
called the underlying asset
• Common examples of underlying assets are
stocks, bonds, corn, pork, wheat, rainfall,
etc.
Basic purpose of derivatives• In derivatives transactions, one party’s loss is
always another party’s gain
• The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance
• If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant
• Derivatives improve overall performance of the economy
Major categories of derivatives
1. Forwards and futures
2. Options
3. Swaps
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.
• Example: interest rate forwards
• Forwards are highly customized, and are
much less common than the futures
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.
• Structure of a futures contract:
• Seller (has short position) is obligated to deliver
the commodity or a financial instrument to the
buyer (has long position) on a specific date
This date is called settlement, or delivery, date
• Part of the reason forwards are not as common is that it is hard to provide assurances that the parties will honor the contract
• In futures trading, this is done through the clearing corporation
• Basis is defined as the difference between cash and futures prices: Basis = Cash prices - Future prices.
• Basis can be either positive or negative (in Index futures, basis generally is negative).
• Basis may change its sign several times during the life of the contract.
• Basis turns to zero at maturity of the futures contract i.e. both cash and future prices
• converge at maturity
Operators in the derivatives market
• Hedgers - Operators, who want to transfer a risk component of their portfolio.
• Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
• Arbitragers - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.
• Often, agents hedge against adverse events in the
market using futures
• E.g., a manager wishes to insure the firm against the
rise in interest rates and the resulting decline in the
value of bonds the firm holds
• Can sell a futures contract and lock in a price.
• Speculators try to use futures to make a profit by betting on price movements:
• Sellers of futures bet on price decreases
• Buyers of futures bet on price increases
Options• Options 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.
• Call Option - The right to buy a specified amount of currency at a specified rate
• Put Option -The right to sell a specified amount of
currency at a specified rate
• Premium - The price of an option
• Strike - The rate at which the right can be exercised
• Expiry Date - The date at which the right can be exercised
• 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.
• 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.
• Like futures, options are agreements between 2parties.
• Seller is called an option writer - Incurs obligations
• Buyer is called an option holder - Obtains rights
2 types of options
• Call option
• Put option
• Call option – a right to buy an asset at a
predetermined price (strike price ) on or before a
specific date
• If asset price is higher than the strike price Option is In The Money
• If asset price is exactly at the strike price Option is At The Money
• If asset price is below the strike price Option is Out Of The Money
• Obviously would not exercise an option that Is out
Of the money
• Put option – a right to sell an asset at a predetermined price on or before a specific date
• If asset price is lower than the strike price Option is In The Money
• If asset price is exactly at the strike price Option is At The Money
• If asset price is higher than the strike price Option is Out Of The Money
STRATEGIES OF TRADING IN FUTURE AND OPTIONS
USING STOCK FUTURES
1. Hedging: long security, sell future
2. Speculation: bullish security, buy Futures
3. Speculation : bearish Security, Sell Futures
4. Arbitrage: overpriced Futures: buy spot, sell futures
5. Arbitrage: underpriced Futures: sell spot, buy futures
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.
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
• Maximum Loss – Unlimited
• Maximum Profit – Limited (to the extent of option premium)
• Makes profit if the Stock price at expiration > Strike price – premium
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.
BEARISH STRATEGIES:LONG PUTMarket Opinion – Bearish. For investors who want to make
money from a downward price move in the underlying stock Offers a leveraged alternative to a bearish or short sale of the underlying stock
Risk Reward Scenario Maximum Loss – Limited (Premium Paid)Maximum Profit - Limited to the extent of price of stockProfit at expiration - Strike Price – Stock Price at expiration - Premium paidBreak even point at Expiration – Strike Price - Premium paid
SHORT CALL• Risk Reward Scenario
• Maximum Loss – Unlimited
• Maximum 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
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.
NEUTRAL STRATEGIES
LONG STRADDLE
• Buy one call option and buy one put option at the same strike price
• Maximum Loss: Limited to the total premium paid for the call and put options
• Maximum Gain: Unlimited as the market moves in either direction.
• A long straddle is like placing an each-way bet on price action: you make money if the market goes up or down
SHORT STRADDLE• Short one call option and short one put option at the
same strike price
• Maximum Loss: Unlimited as the market moves in either direction.
• Maximum Gain: Limited to the net premium received for selling the options
• Short straddles are a great way to take advantage of time decay and also if you think the market price will trade sideways over the life of the option.
VOLATILITY STRATEGIES
LONG STRANGLE
• Long one put option with a lower strike price and long one call option at a higher strike price.
• Maximum Loss:Limited to the total premium paid for the call and put options
• Maximum Gain:Unlimited as the market moves in either direction.
SHORT STRANGLE: • Short one put option with a lower strike price and
short one call option at a higher strike price. • Maximum Loss: Unlimited as the market moves in
either direction.
• Maximum Gain: Limited to the net premium received for selling the options.
• A short strangle is similar to the Short Straddle except the strike prices are further apart, which lowers the premium received but also increases the chance of a profitable trade.