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CONTENTS

Derivativesan overviewFutures contractHedging in futuresSpeculating in futuresArbitrage in futuresOptionsOptions strategiesDerivatives productsOpen interestFutures price = spot price + cost of carry

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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 lendingand borrowing (bank) does not have its value borrow the value from underlying asset/

basic variables.

Derivatives is derived from the following products:

A. SharesB. DebunturesC. Mutual funds

D. GoldE. SteelF. Interest rateG. 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. Therecannot 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.

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

derived from the value of an underlying primary financial instrument, commodity orindex, 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 asrisk 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 soundderivatives 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 thegrowing awareness of risk and hence the gradual introduction of derivatives to hedge

such risks.

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

introduced derivatives in the local currency Interest Rate markets, which have not reallydeveloped, 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 wasindex 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 foreignexchange 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 buycurrency derivatives. Now any loss due to rise in raw material prices would be offset by

profits on the futures contract and vice versa. Hence the company can hedge its riskthrough the use of derivatives

DEFINATIONS

According to JOHN C. HUL A derivatives can be defined as a financial instrumentwhose 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 been included 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 orunsecured, risk instrument or contract for differences or any other form of

security;

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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.

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 buyerand 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 effectivemechanism for management of inherent risks, without counter-party risk.

It is a derivative instrument and a type of forward contract The future contracts areaffected 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 onthe settlement day only, even though the payoffs are on a daily marking to market basis

to avoid default 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 ofrisk 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 ofthe 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.

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

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Suppose the stock rises to 2200.

Profit

20

220010

01400 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

Profit

20

10

0

1400 1500 1600 1700 1800 1900-10

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-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

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 at99% 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 contractbeing 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.

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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 initiallevel before trading commencing on the next level.

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 amaintenance 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)

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 thebroker, through margin calls. Till now the concept of maintenance margin is not used in

India.

ADDITIONAL MARGIN:

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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 havebecome 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 theInitial 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

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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 ofreducing risks when the investor has the underlying security.

PURPOSE:

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

Figure 1.1

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril

&Prize1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload 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

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STRATEGY:

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 themarket 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 have cost in cash but have opportunity cost.

Hedging is implemented by adding a negatively and perfectly correlated asset to anexisting asset. Hedging eliminates both sides of risk: the potential profit and the potentialloss. 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 imperfectlycorrelated assets).

ILLUSTRATION

Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. Thecost 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 the contract that if Shyam fails to honour the contract he will have to pay a penalty ofRs.400. And if Shyam honours the contract Ram will offer a discount of Rs 100 as

incentive.

Shyam defaults Shyam honors

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400 (Initial Investment) 600 (Initial profit)

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 againstdefault 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 youcould 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 PutOption.

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 ahedging 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 optionsbuyers 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 ypaying the premium of Rs.25. Thus the investor has hedge their risk by purchasing the

put Option. Finally stock falls by 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.

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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- securityposition. 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 riskmanagement tool. In this

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

to maximize the risk the Hedger enters into a future contract and takes a short position.However the losses suffers in the security will be offset by the profits he makes on his

short future position.

Spot Price of ACC = 390

Market action = 350Loss = 40

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Strategy = BUY SECURITY, SELL FUTURES

Two month Futures= 390Premium = 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 ofprice. 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)

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 : 250Loss : 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 investor 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

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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 1

st

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.

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 Sell 7 NIFTY futures

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stock portfolio contract at 1150.

25t

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 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 fundamentalsand 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.

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.

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Figure 1.2

Speculators

Existing SYSTEM New


&Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, 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 premium

hold till expiry. Advantages Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

ILLUSTRATION:

Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500

Strategy: Buy February PATNI futures contract at 1500

Lot size = 100 shares

Contract value = 1,50,000 (1500*100)

Margin = 15000 (10% of 150000)

Market action = rise to 1550

Future Gain:Rs. 5000 [(1550-1500)*100]

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Market action = fall to 1400

Future loss: Rs.-10000 [(1400-1500)*100]

Thus the Speculator has a view on the market and accept the risk in anticipating of

profiting from the view. He study the market and play the game with the stock market

TYPES:

POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days untiltheir target is met.

DAY TRADERS:

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

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 pricesituations.

ILLUSTRATION:

Here if speculator excepts that ZEE TELEFILMS stock price will rise from present levelof 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 untilhe can write either call or put.

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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 = 1,00,000

Market action = 1010

Profit = 1000Initial margin = 20,000

Market action = 1010Profit = 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 gotreturn 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 : 150No of shares : 200

Price : 150*200 = 30,000Market action : 160

Profit : 2,000Return : 6.6% returns over 2months

BUY CALL OPTION:

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Strike price : 150

Premium : 8Lot 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. Ifthe security price rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240

Lot size = 100shares

Margin = 24Market action = 220

Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes aprofit 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 ORSELL 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.

1st

July = Index will rise

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Buy nifty July contract = 960

Lot =200

14th July nifty risen= 967.35

Nifty July contract= 980

Short position =980

Profit = 4000(200*20)

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 futuremarket.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operatingin them simultaneously.

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Figure 1.3

Arbitrageurs

Existing SYSTEM New


&Prize1) 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 ofONGC in BSE= 500

Current market price ofONGC in NSE= 510


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

STRATEGIES:

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BUY SPOT, SELL FUTURES:

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

andOne month ACC futures = 1025.

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

can make riskless 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 theposition

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 thefutures position

Return the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than the arbitrageprofit possible, it makes sense for the investor to enter into the arbitrage. This is termed

as cashand- 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

andOne month ACC futures = 965.

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

can make riskless 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 theposition

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 cashand- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between twomarkets. 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 thefutures 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

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.

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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 theSpot 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 (expirationdate). 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 onlast 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 along or short position which results into iiliquidity in the market.Thus to overcome the

problem the BSE introduced WEEKLY OPTIONS

WEEKLY OPTIONS:

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

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TYPES OF OPTION:

CALL OPTIONA call option gives the holder (buyer/ one who is long call), the right to buy specified

quantity of the 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

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish inthe 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 isRs.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

0590 600 610 620 630 640

-10

-20

-30

Loss

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Unlimited profit for the buyer = Rs.35{(spot pricestrike 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.25Loss 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

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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 OPTIONA Put option gives the holder (buyer/ one who is long Put), the right to sell specifiedquantity 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):

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

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Unlimited profit for the buyer = Rs.80 {(Strike pricespot 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 Put option will choose not to exercise his option to sell as he can sell in the marketat a higher rate.

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

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Thus Put option also indicates two positions as follows:

LONG POSITIONIf the investor expects price to fall i.e. bearish in the market he takes a long position by

buying Put option.

SHORT POSITIONIf the investor expects price to rise i.e. bullish in the market he takes a short position by

selling Put option

CALL OPTIONS PUT OPTIONS

Option buyer or

option holder

Buys the right to buy the

underlying asset at thespecified price

Buys the right to sell the

underlying asset at thespecified price

Option seller oroption writer

Has the obligation to sellthe underlying asset (to the

option holder) at the

specified price

Has the obligation to buythe 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 assetsvalue will generally have the opposite effect

Premium of the Premium of the

Price of the CALL Price of CALLUnderlying Underlying

asset asset

Premium of the

Premium of the PUT

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PUT

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 theoption 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.

Volatility:Volatility is simply a measure of risk (uncertainty), or variability of an optionsunderlying. Higher volatility estimates reflect greater expected fluctuations (in either

direction) in underlying price levels. This expectation generally results in higher optionpremiums 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 institutionsb)Mutual Fundsc)Domestic & Foreign Institutional Investorsd)Brokerse)Retail Participants

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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.

RISKFutures 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 isunlimited 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:

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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 chargedis 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 ofthe 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 linearpay 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 lessthan 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:

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 optionsold 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 valueof 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 intrinsicvalue the premium receive generate profit .

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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 inthe money. While 1510 call sold will have no intrinsic value and expire worthless and

profit is the premium 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 soldresult in loss to the premium paid.

The pay-off table:

PATNI COMPUTERS

AT EXPIRATION

1485

(below

lower

price)

1490

(At the

lower

price)

1495

(Between

lower strike

&BEP

1500

(At BEP)

1510

Intrinsic value of 1490

long call at expiration (a)

0 0 5 10 20

Premium paid (b) 25 25 25 25 25


short call at expiration

(c)

0 0 0 0 0

Premium received (d) 15 15 15 15 15

profit/loss(a-c)-(b- d) -10 -10 -5 0 10

PATNI COMPUTERS

AT EXPIRATION

1495

(below

higherprice)

1510

(At the

higherprice)

1505

(Between

higher strike&BEP

1500

(At BEP)

1520

(Above BEP

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short call at expiration

(a)

0 0 0 0 10

Premium paid (b) 15 15 15 15 15


long call at expiration (c)

5 20 15 10 30


profit/loss(c-a)-( d - b) -5 10 5 0 10

Profit

20

10

0

1490 1500 1510 1520 1530 1540

-10

-20

Loss

2.BEAR PUT SPREAD:

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, ofthe 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)

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



On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close atBreakeven. 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 willnot 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 intrinsicvalue 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 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:

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

and 4490 option sold will be assigned (strike pricepremium paid) = profit .

The pay-off table:

INFOSYS ATEXPIRATION

5520

(Above

strike)

5510

(At the

strike)

5505

(Between

lower strike&BEP

5500

(At BEP)

4480


long put at expiration (a)

0 0 5 10 30

Premium paid (b) 55 55 55 55 55


short put at expiration (c)

0 0 0 0 10


profit/loss(a-c)-(b- d) -10 -10 -5 0 10

INFOSYS AT

EXPIRATION

5505

(Above

strike)

4490

(At the

strike)

4495

(Between

strike &BEP

5500

(At BEP)

4480

(below

strike price)


short put at expiration (a)

0 0 0 0 10

Premium received (b) 45 45 45 45 45

Intrinsic value of 5510 5 30 15 10 30

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long put at expiration (c)

Premium paid (d) 55 55 55 55 55

profit/loss[(c-a)-( d - b)] -5 20 15 0 10

Profit

20

10

03000 3500 4000 4500 5000 5500 6000 6500 7000

-10

-20

Loss

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 alower 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)


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BREAK- EVEN- POINT= 1300-10 = 1290



On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option willhave 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 anintrinsic value of 5.

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 anintrinsic value of 10 while the 1310 put option sold receive only premium as the profit is

limited for the seller.

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OPTION PAYOFF

Profit

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 strikecall 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)


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BREAK- EVEN- POINT= 1510+10=1520



On expiration if the stock of PATNI COMPUTERS is 1520 then the option will close atBreakeven. 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.


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 intrinsicvalue 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 isbearish 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 and 1490 option sold result in loss to the premium paid.

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OPTION PAYOFF

Profit

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 theinvestor 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 profitablean if the prices rises the call option will give gains. Profit potential in this strategy is

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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 of the options.

SHORT STRADDLE:

This strategy is reverse of long straddle. Here the investor write(sell) the call as well asthe 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 startsuffering 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 = 60035 = 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 anintrinsic value of 35.

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

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.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

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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).

The pay-off table:

BAJAJ AUTO ATEXPIRATION 550

(BELOW

STRIKEAN D

BELOW

BEP )

600

(At the

strike)

618

(BETWEEN

STRIKE &HIGHERBEP

635

(At BEP)

650

(ABOVE

STRIKEAN D

ABOVE

HIGHER

BEP


long call at expiration

(a)

0 0 18 35 30

Premium paid (b) 20 20 20 20 20


long put at expiration

(c)

50 0 0 0 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -15 -17 0 5

BAJAJ AUTO ATEXPIRATION

550

(BELOW

STRIKE

AN DBELOW

BEP )

600

(At the

strike)

583

(BETWEEN

STRIKE &

LOWERBEP

565

(At

LOWER

BEP)

650

(ABOVE

STRIKE

AN DABOVE

HIGHER

BEP


long call at expiration

(a)

0 0 0 0 30

Premium paid (b) 20 20 20 20 20


long put at expiration

(c)

50 0 17 35 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -15 -18 0 5

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Profit

40

30

20

10

550 560 570 580 590 600 610 620 630 640 650

-10

-20

-30

-40

Loss

BEP

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6. STRANGLE:

In this strategy the investor is neutral in the market which involves the purchase of ahigher 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 straddlealso 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 priceand with the different expiration date. A long strangle strategy is used to profit from 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 withthe 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 strangle

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


Lower Break- Even- Point = 395035 = 3915

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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. At3915 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, while3950 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 worthlessand 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

The pay-off table:

BSE INDEX AT

EXPIRATION

3900

(BELOW

STRIKE

AN DBELOW

4050

(At the

strike)

4070

(BETWEEN

STRIKE &

HIGHERBEP)

4085

(At

HIGHER

BEP)

4100

(ABOVE

STRIKE

AN DABOVE

HIGHER

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BEP ) BEP


Short call at expiration

(a)

0 0 20 35 50

Premium Receive(b) 20 20 20 20 20

Intrinsic value of 3950short put at expiration

(c)

50 0 0 0 0

Premium Receive (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -35 -15 0 15

BSE INDEX AT

EXPIRATION

3900

(BELOW

STRIKEAN DBELOW

BEP )

3950

(At the

strike)

3930

(BETWEEN

STRIKE &LOWERBEP

3915

(At

LOWERBEP)

(ABOVE

LOWER

STRIKE

AN DABOVE

LOWERBEP

Intrinsic value of 600Short call at expiration

(a)

0 0 0 0 0

Premium Receive(b) 20 20 20 20 20


short put at expiration(c)

50 0 20 35 0

Premium Receive (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d) 15 -35 -15 0 -35

Profit

20

10

0

3900 3925 3950 3975 4000 4025 4050 4075 4100-10

-20

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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.

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 falls.Finally if prices remains unchangedobtains the maximum profit potential.

EXAMPLE:

Portfolio: 100 shares purchased at Rs.300

Components: Sell a two month Reliance call of 300 strike at 25Net 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 exercised and seller will receive thepremium.

If the stock ends at 275, the 300 call option expires worthless equilant 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

Break- Even- Point

BreakEven - Point

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0

250 275 300 325 350-25

-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 ofthe 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:

breakeven- oint

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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 securityrepresented by the option is not owned by the option writer.

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 bepurchased for delivery if option is exercised.

RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE ASFOLLOWS:-

If the market price of the stock rises sharply the calls could be exercised, while asfar 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, asan option writer, the risk is cushioned somewhat by the amount of premium

received.

ILLUSTRATION:

Portfolio: Write reliance call of 65 strike

Net 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 tothe declining stable stock price.

10) PROTECTIVE PUT:

Under this strategy the investor purchases the stock along with the put optionbecause the investor is bearish in the market. This strategy enables the holder of the

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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.210combining 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 anmargin 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 willbenefit 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 option makes the investor life by telling the investor in advancehow 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.

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profit:

20

10

0180 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 theprice of the underlying asset.

Change in option premiumDelta = --------------------------------

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

Break- Even- Point

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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 isnot 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 theprice 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.

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.

GAMMA

A measure of change in the delta that may occur corresponding to the rise or fall in the

price of the underlying asset.

Gamma = change in option delta

__________________

change in underlying price

The gamma of an option tells you how much the delta of an option would increase or

decrease for a unit change in the price of the underlying. For example, assume the gamma

of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying,

the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option atchanged underlying price is 0.54; so the rate of change in the premium has increased.

suppose the delta changed to 0.5-0.04 = 0.46 thus the rate of premium will decreased .

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In simple terms if delta is velocity, then gamma is acceleration. Delta tells you how muchthe premium would change; gamma changes delta and tells you how much the next

premium change would be for a unit price change in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negative for shortpositions (short call and short put). Gamma does not matter much for options with long

maturity. However for options with short maturity, gamma is high and the value of the

options changes very fast with swings in the underlying prices

THETA:

A measure of change in the value of an option corresponding to its time to maturity. It is

a measure of time decay (or time shrunk). Theta is generally used to gain an idea of howtime decay is affecting your portfolio.

Change in an option premiumTheta = --------------------------------------

Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value

decreases. This is due to the fact that the uncertainty element in the price decreases.

ILLUSTRATION

Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when

Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. Thismeans that if the price of Infosys and the other parameters like volatility remain the same

and one day passes, the value of this option would reduce by Rs.4.5.

ADVANTAGE

Theta is always positive for the seller of an option, as the value of the position of the seller

increases as the value of the option goes down with time.

DISADVANTAGE

Theta is always negative for the buyer of an option, as the value of the option goes

down each day if his view is not realized.

In simple words theta tells how much value the option would lose after one day, with all

the other parameters remaining the same.

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VEGA

The extent of extent of change that may occur in the option premium, given a change in

the volatility of the underlying instrument.

Change in an option premiumVega = -----------------------------------------

Change in volatility

ILLUSTRATION

Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatility of the

underlying is 35%. As the volatility increases to 36%, the premium of the option

would change upward to Rs15.6.

Vega is positive for a long position (long call and long put) and negative for a short position

(short call and short put).

ADVANTAGE

Simply put, for the buyer it is advantageous if the volatility increases after he has

bought the option.

DISADVANTAGE

For the seller any increase in volatility is dangerous as the probability of his option getting in

the money increases with any rise in volatility.

In simple words Vega indicates how much the option premium would change for a unit

change in annual volatility of the underlying.

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

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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 premiumdecided 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 forces

Available on ____ individual stocks approved by SEBI

Useful primarily for Hedging, Arbitrage and for expressing the views on the market.

CONTRACT SPECIFICATIONS

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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, Infosysis 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 optionsthe closing value of thesensex on the expiry day

In case of stock optionsthe closing value of therespectative in the cash

segment of BSE

Exercise Notice Time In case of sensex options

Specified time (exercise

session) on the last tradingday of the contract. All in

the money options would

deem to be exercised

unless communicated

otherwise by theparticipant.

In case of stock options

Specified time (exercise

session) on the last tradingday of the contract. All in

the money options would

deem to be exercised

unless communicated

otherwise by theparticipant.

Last Trading Day Last Thursday of the

contract month. If it is a

holiday, the immediatelypreceding business day

Last Thursday of the

contract month. If it is a

holiday, the immediatelypreceding business day

Final Settlement On the last trading day, theclosing value of the

Sensex would be the final

settlement price of the

expiring futures/option

contract.

The difference is settled incash on the expiration day

on the basis of the closing

value of the respectative

underlying scrip in the

cash market on theexpiration day

DERIVATIVES PRODUCTS OFFERED BY NSE

INDEX FUTURES

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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 feelthat 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 futuresproduct in the world.

Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) havelaunched index futures in June 2000

ADVANTAGES OF INDEX FUYTURES

The contracts are highly liquid Index Futures provide higher leverage than any other stocks

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 orhedge 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 fortrading from introduction to the expiry date.

CONTRACT SPECIFICATIONS

PARTICULARS INDEX FUTURES AND OPTIONS FUTURES AND OPTIONS ON

INDIVIDUAL SECURITIES

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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

S&P CNX Nifty Options there of

(minimum value Rs.2 lakh)

Futures / Options on Minimum

value of Rs 2 Lakh for each

individual securities Individual

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 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.

Expiry Date The last Thursday of the expirymonth or the Previous trading day if

the last Thursday of the month is a

trading holiday

The last Thursday of the expirymonth or the Previous trading day

if the last Thursday of the month

is a trading holiday

Settlement Basis Index Futures / Futures Mark to

Market and final settlement on

individual securities be settled in

cash on T+1 basis

Index Options Premium settlement

on T+1 Basis andFinal Exercise settlement on T+1

basis

Options on individual Premium

settlement on T+1 basis and

securities option Exercise

settlement on T+2 basis.

Settlement Price S&P CNX Nifty Futures / Dailysettlement price will be the closing

value of the underlying index

Index Options The settlement price

shall be closing value of underlying

index

Final settlement price shall be theclosing value of the underlying

security on the last trading day

The settlement price shall be

closing on individual security

price of underlying security.

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OPEN INTEREST(OPTIONS)

Open Interest is a crucial measure of the derivatives market. The total number of optionscontracts outstanding in the market at any given point of time. In short Sum of all

positions taken by different traders reflects the Open Interest in a contract. Opposite

positions taken by a trader in a contract reduces the open interest. However, opposing

positions taken (in the same contract) by two different traders are added to the openinterest.

Assuming that the market consists of three traders only following table indicates how

Open Interest changes on different days trades in PATNI COMPUTERS with a callAmerican option at a strike price of Rs. 180

DAY

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