Options and Futures

Derivatives

Derivatives are financial contracts which derive their values from the underlying assets or securities.

Some examples are:

Options

Futures

Swaps

Option An option is the right, but not the obligation to

buy or sell something on a specified date at a specified price.

In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

Three parties are involved in the option trading, the option seller, buyer and the broker.

Process

The option seller or writer is a person who grants someone else the option to buy or sell. He receives a premium on its price.

The option buyer pays a price to the option writer to induce him to write the option.

The securities broker acts as an agent to find the option buyer and the seller, and receives a commission or fee for it.

Call Options The call option that gives the right to buy. The contract gives the particulars of:

The name of the company whose shares are to be bought or the underlying asset.

The number of shares to be purchased.

The purchase price or the exercise price or the strike price of the shares to be bought.

The expiration date, the date on which the contract or the option expires.

Put Options

S t r o n g l y e f f i c i e n t m a r k e tA l l i n f o r m a t i o n i s r e f l e c t e d o n p r i c e s .

W e a k l y e f f i c i e n t m a r k e tA l l h i s t o r i c a l i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y

S e m i s t r o n g e f f i c i e n t m a r k e tA l l p u b l i c i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y p r i c e s

S t r o n g l y e f f i c i e n t m a r k e tA l l i n f o r m a t i o n i s r e f l e c t e d o n p r i c e s .

W e a k l y e f f i c i e n t m a r k e tA l l h i s t o r i c a l i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y

S e m i s t r o n g e f f i c i e n t m a r k e tA l l p u b l i c i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y p r i c e s

S t r o n g l y e f f i c i e n t m a r k e tA l l i n f o r m a t i o n i s r e f l e c t e d o n p r i c e s .

W e a k l y e f f i c i e n t m a r k e tA l l h i s t o r i c a l i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y

S e m i s t r o n g e f f i c i e n t m a r k e tA l l p u b l i c i n f o r m a t i o n i s r e f l e c t e d o n s e c u r i t y p r i c e s

Put option gives its owner the right to sell (or put) an asset or security to someone else.

Like the call option the contract contains:

The name of the company whose shares are to be sold.

The number of shares to be sold.

The selling price or the striking price.

The expiration date of the option.

Factors Affecting the Value of Call Option

1. The market price of the underlying asset

2. The striking price

3. Option period

4. Stock volatility

5. Interest rates

6. Dividends

Intrinsic Value and Time Value

The price of an option has two components intrinsic value or expiration value and time value.

Call option intrinsic valueor expiration value = Stock price – Striking price

Put option intrinsic valueor expiration value = Striking price – Stock price

Time value = Premium – Intrinsic value

Gain or Loss of Call Buyer When the market price exceeds the strike

price by just enough to cover the premium, the profit is zero for the buyer if he exercises the option.

This is the point of no profit and no loss and hence known as break-even point.

If there is a rise in the price of the stock beyond the break-even point, the call buyer gains profit.

Call Buyer’s Position

10 20 30 40 60 70 80 90 100

– 25

– 20

– 15

– 10

– 5

0

5

10

15

20

25

30

Option Profit

Loss of PremiumBreak-even Rs 55

Exercise Price(Rs 50)

Profit line toCall option buyer

Intrinsicvalue

Market price ofoptioned stock

Call Writer’s Gain or Loss When the market price is lower than the

strike price, the call buyer may not exercise his option, hence the premium is the only profit the call writer can gain.

If the price increases further it would be a loss to the call writer.

Writing a Call

10 20

O ption profit

– 25

– 20

– 15

– 10

– 5

0

5

10

15

20

25

30 40 60 70 80 90 100

In trins ic va lueM arke t price ofop tioned stock

E xerc ise P rice(R s 50)

P rem ium ga in

B reak-even R s 55

Loss line tocall w riter

Put Buyers Position Put buyer gains in the bearish market

when the price falls.

When the price increases, the put buyer has to pay the premium alone and his liability is limited to the premium amount he has paid.

Put Buyers Gain or Loss40

30

20

10

10

20

30 70 90Premium loss

Break-even Rs 45

Exercise Price Rs 50

Intrinsic value

Profit line to put buyer

Price of the optioned stock

Put Writer’s Position The gains of the put buyer are the losses

of the put writer.

If the market price increases the put writer will gain the premium because the put buyer may not be willing to sell the shares at the lower rate i.e., the strike price is lower than the market price.

Writing a Put

10

20

30

– 5

– 15

– 25

– 35

20 40 60 80Price of theoptioned stock

Break-even Rs 45

Strike Price Rs 50

Intrinsic value

Premium gain

Loss line of put writer

0

Profits inStocks, Bonds and Options

Stock, Bond and Option Details

Stock Bond Call PutCurrent price Rs 70 Rs 100 Rs 5 Rs 5Exercise price - - - - - - Rs 70 Rs 70Terms to expiration - - - 6 months 6 months 6 monthsPrices at termination Variable Rs 100 Variable Variable

Bond Return

40 50 60 80 90 100

30

20

10

10

20

30

Profit Rs

ReturnStock Price atTermination

LOSS Rs

Exercise Price= 70

Stock Return

40 50 60 80 90 100

30

20

10

10

20

30

PROFIT Rs

Stock Price atTermination

LOSS Rs

Exercise Price= 70

Selling the Stock Short

40 50 60 80 90 100

30

20

10

10

20

30

PRO FIT Rs

Stock Price atTerm ination

LO SS Rs

Exercise P rice= 70

Investment in Calls

Protective – buy the stock and buy a put

Covered call writing – own the stock and sell a call

Artificial convertible bonds – buy bonds and buy calls

The Black-Scholes Option Pricing Model

The Black-Sholes model (1973) is given below: RT

1 2V = P{N(d )} e S{N(d )}2

1

ln(P/S) + (R + 0.5σ )Td =

σ T

2 1d = d T

where V = Current value of the optionP = Current price of the underlying

shareN(d1), N(d2) = Areas under a standard

normal functionS = Striking price of the optionR = Risk free rate of interestT = Option period

= Standard deviatione = Exponential function

Futures Futures is a financial contract which derives

its value from the underlying asset.

There are commodity futures and financial futures.

In the financial futures, there are foreign currencies, interest rate, stock futures and market index futures.

Market index futures are directly related with the stock market.

Forward and Futures In a forward contract, two parties agree to

buy or sell some underlying asset on some future date at a stated price and quantity.

The forward contract involves no money transaction at the time of signing the deal.

Forward contract safeguards and eliminates the price risk at a future date.

But the forward market has the problem of:(a) lack of centralisation of trading (b) liquidity (c) counterparty risk

Future MarketThe three distinct features of the future markets are:

Standardised contracts

Centralised trading

Settlement through clearing houses to avoid counterparty risk

Benefits of the Index Based Futures

Liquidity: The index based futures attract a much more substantial order flow and have greater liquidity in the market.

Information: Information flow is more in the index than in the case of securities. The insiders are privileged to have more information in securities.

Settlement: In the settlement, stocks have to be delivered either in the physical mode or in the depository mode. No such delivery is needed in the index based futures. They are settled through cash.

Less volatile: The changes that occur in index values are less compared to the price changes that occur in the individual securities. This leads to lower prices for the index futures and can work with lower margins.

Manipulation: The securities in the index are carefully selected, keeping the liquidity considerations and as such are hard to manipulate. But security prices could be manipulated more easily than the index.

Beneficial to the mutual funds.