1. 1. P Aiyappa Achappa Derivatives
2. 2. Example for Derivative Contract A farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production. Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period). In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton.. If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable. This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying
3. 3. History Of Derivatives Derivative products were predominantly used as hedging devices against fluctuations in commodity prices. Since1970 financial derivatives came into spotlight and have become very popular by 1990s. Since the emergence of the class of equity, F&O on stock indices have gained more popularity than on individual stocks in cash market.
4. 4. Derivatives Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be Equity, Forex, Commodity, or any other asset.
5. 5. Derivatives Financial Derivatives Equity Derivatives Real Estate Foreign Exchange Debt Derivatives Interest Rate GOI Sec Bonds T-Bills Index Stocks Commodity Derivatives
6. 6. Types of Derivatives Traded In India Forwards Futures Options Swaps
7. 7. Risk Control : An investor can use derivative in risk control as his risk profile dictates. High Leverage : Derivative contracts enables the investor to take an exposure to the full value of underlying shares for a fraction of its value in the form of margin. High Liquidity : Derivative contracts offers very high liquidity compared to cash market. Hedge : Minimize the impact of fluctuations in asset prices by locking in asset prices. Price Discovery Protection Flexibility Derivative instruments in Risk Management
8. 8. Participants in Derivatives Markets There are three kinds of players in the derivatives market: 1. Speculators 2. Hedgers 3. Arbitrageurs. Speculators provide liquidity, Hedgers the Market depth Arbitrageurs the finesse of pricing
9. 9. Forwards A forward contract is a particularly simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. The contract is usually between two financial institutions or between a financial institution and one of its corporate clients. It is not traded on the exchange
10. 10. Comparison b/w Forwards & Futures Forward Futures Over the Counter Traded in Organized Exchange Customized Contract Standardized Contract Low Liquidity High Liquidity No Margin Payment Margin Payment Settlement on the last day Daily Settlement
11. 11. Futures are derivative contracts to buy or sell a specified quantity or underlying assets at an agreed price, on or before a specified time. They are standardized forward contracts, which are traded on the exchanges mainly BSE & NSE. Since they are traded on the exchange on electronic platform, it provides them transparency, liquidity, and also eliminates the counter party risk due to guarantee provided by the exchange. Derivative market is a leverage market since Investor/Trader has to pay only fraction of total value of the contract as a margin to his broker, who in turn has to pay to the exchange. Currently in India we have 3 months contracts available for trading On last Thursday of each month these contracts expires and then they are settled at a closing price of underlying cash market. Future Contract
12. 12. Spot price :- Price at which an asset trades in the spot market Future price :- Price at which the future contract trades in the futures market. Contract cycle :- Period over which a contract trades. Expiry date :- It is the date specified in the futures contracts. This is the last day on which the contract will be traded, at the end of which it will cease to exit. Contract size :- The amount of asset that has to be delivered under one contract. Basis :- Basis means future price minus spot price. Cost of carry :- The relationship between future price and spot price. Initial margin :-The amount that must be deposit in the margin account at the time a future contract is first entered into is known is initial margin. Futures Terminology
13. 13. Marking to market :- At the end of each day, the margin account is adjusted to the investors gain or loss depending upon the futures closing price. Maintaining margin :- If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Futures Terminology
14. 14. Lot Size Settlement/ Closing Price Per Contract % NIFTY 25 8635.85 21810 10% ACC 250 1572.2 61738 16% ARVIND 1000 286.75 48008 17% ASHOKLEY 8000 70.95 101500 18% CIPLA 500 711.6 55955 16% COALINDIA 1000 365.75 57508 16% COLPAL 125 2040.25 40042 16% HDFCBANK 250 1056 41583 16% ICICIBANK 1250 330.3 64894 16% LT 250 1685.2 66218 16% M&M 250 1207.75 47427 16% M&MFIN 1000 265.75 41748 16% MARUTI 125 3669.15 72131 16% NHPC 10000 19.8 32000 16% RELIANCE 250 858.05 33728 16% RELINFRA 500 454.55 44559 20% TATASTEEL 500 337.45 26536 16% TCS 125 2596.45 50984 16% Unitech 9000 19.4 51388 29% ZEEl 1000 360.85 56763 16%
15. 15. Pricing of futures is based on cost-of-carry method. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. Pricing Futures = Spot +Cost of carry dividend (if any) Therefore Cost of carry method :- F = Cost of carry r = Cost of financial T = Time till expiration in years e = 2.71828 Example:- Security XYZ ltd trades in the spot market at Rs. 100. Money can be invested at 12% p.a.. The fair value of a one month futures contract on XYZ will be 100.99 according to cost of carry method. Future Price= 100*2.718^(0.12*30/365)=100.99 Pricing Futures F = S* ert
16. 16. Application of Futures in Speculation Nifty LOT SIZE 50 Current SPOT Nifty Price 7600 Speculator Expects NIFTY Price to move up by 7900 by Aug Buy Aug 14 Futures at 7610 Margin to be paid Rs at 7% =26635 If Nifty Purchased in spot Market amount required is 380000 Profit 7600-7900=300 *50=15000 Returns of Futures is 56% Returns on buy SPOT NIFTY 3.9%
17. 17. Payoff for long Nifty at 7600 7300 7600 7900 -300 0 +300 Nifty Profit Loss
18. 18. Application of Futures by Arbitrageurs. Mr A Buys 400 Reliance Shares 1030 on 21st Jul 14 . Total purchase price 257500 Sell Reliance Sep 14 Futures at 1044 Margin to Be paid exchange 27622.5 on Futures Position Total investment is 285122 On Expiry sep if Reliance spot Closing Price is 1000 Profit on Futures earned 44 *250=11000 Loss on SPOT Market -30*250=7500
19. 19. Application of Futures Hedging Investor purchase HDFC BANK 500 shares Nov 2013 at price of Rs 650 Current Market Price 850 Investor expects HDFC bank share price to decline in month Oct If he sells shares at current market price his profit would 200*500 shares=100000 Short term capital gain tax @ 15% would be 15000 . If he defers his selling decision to another it another 2 months to avoid tax .there is high probability of decline in share price 30%. How can he manage the Risk ?
20. 20. Solution HDFC BANK @ 890 HDFC BANK @ 750 Sell 2 lots of Nov 2014 HDFC Futures at 855 On Nov 2014 Profit on Underlying shares 240*500=120000 ( Rs 890-650) Loss on futures Rs - 35*500= 17500 (Rs 855-890) Total Profit 102500 Profit on Underlying shares 100*500=50000 ( Rs 750-650) Profit on futures Rs 105*500= 52500 (Rs 855-750) Total Profit 102500
21. 21. Application of Futures Leverage Nifty LOT SIZE 50 Current SPOT Nifty Price 7600 Speculator Expects NIFTY Price to move up by 7900 by Aug Buy Aug 14 Futures at 7610 Margin to be paid Rs at 7% =26635 If Nifty Purchased in spot Market amount required is 380000 Profit 7600-7900=300 *50=15000 Returns of Futures is 56% Returns on buy SPOT NIFTY 3.9%
22. 22. Payoff for long Nifty at 7600 7300 7600 7900 -300 0 +300 Nifty Profit Loss
23. 23. Payoff for Short Nifty at 7800 7740 7800 7860 -60 0 +60 Nifty Profit Loss
24. 24. Application of Futures by Arbitrageurs. Mr A Buys 400 Reliance Shares 1030 on 21st Jul 14 . Total purchase price 257500 Sell Reliance Sep 14 Futures at 1044 Margin to Be paid exchange 27622.5 on Futures Position Total investment is 285122 On Expiry sep if Reliance spot Closing Price is 1000 Profit on Futures earned 44 *250=11000 Loss on SPOT Market -30*250=7500
25. 25. Contract Cycle Jan Feb Mar Apr TimeJan 31 Feb 28 Mar 27 April 24 May 29 June 26
26. 26. Maturity of futures contracts These contracts of different maturities are called near month (one month), middle month (two months) and far month (three months) contracts. At any point of time there will be three futures contracts available for trading.
27. 27. Remember- Features of Futures in Indian 144 Scrips are available for trading futures and options Three series to trade at any point of time. The market lot is 50 for Nifty Contract expires on last Thursday of the Month No. of contracts existing at any given point of time is called Open Interest. Squared off in cash on expiration. Can be downloaded from www.sharekhan.com/Upload/Derivatives/Derivativekit.xls
28. 28. Mark to Market Margin Mark to Market is a procedure used to organize trading so that possibilities of the defaults are minimized. Mark to market calculations are done on a daily basis. The Mark to market is a perfect risk management for not only the client or the broker but also for the system as a whole as the risk exposure of one trader is a risk to the system as a whole. Moreover, Derivatives ( Futures in this context) are high leverage products i.e. you can trade a contract worth Rs. 2 lakh by paying a fraction of a cost of somewhere around Rs. 10,000 to Rs. 20,000. This leverage makes futures high-risk high return payoff products.
29. 29. Illustration (MTM Margin) An investor takes the view that the NIFTY is about to rise after a period of consolidation. The index futures contract is trading at a spread of 5531 to 5533. The investor buys the futures at 5533. Over the next seven working days the index rises to 5589 and the investor then sells the futures contract. The profit on the trade is the difference between the two index levels multiplied by 50 (the multiplier for NSE Futures). However, with the purchase of futures being on a margined basis, the flow of the profits takes place on a daily basis as described in the following table:
30. 30. Example An investor takes the view that the NIFTY is about to rise after a period of consolidation. The index futures contract is trading at a spread of 3531 to 3533. The investor buys the futures at 3533. Over the next seven working days the index rises to 3589 and the investor then sells the futures contract. The profit on the trade is the difference between the two index levels multiplied by 50 (the multiplier for NSE Futures). However, with the purchase of futures being on a margined basis, the flow of the profits takes place on a daily basis as described in the following table:
31. 31. Mark to market margin Day Index Action Mark to Market Funds 1 3533 buy Initial margin Rs 12,000 2 3577 44*50 = 2200 (Inflow) 3 3563 14*50 = 700 (Outflow) 4 3565 02*50 = 100 (Inflow) 5 3564 01*50 = 50 (Outflow) 6 3570 06*50 = 300 (Inflow) 7 3589 sell 19*50 = 950 (Inflow) + Initial Margin
32. 32. Question 1 One Lot size of trading for SBI futures 200 Shares . A trader sells 3 Lots of SBI futures Rs.2500 on the futures market. A week later he buys 2 lots 2600 and on the expiry date sbi futures is settlement rate 2450. How much profit/loss has he made on his position?
33. 33. Calculate MTM and Initial & Span Margin to paid on Buying future contract of HDFC Bank Stock Futures at Rs 885 and lot size is 500 and span and In Margin charged by exchange is 18%. What is Margin payable Date Closing Price MTM loss Span & Intial Margin (+/-) Day 1 870 Day 2 890 Day 3 902 Day 4 896 Day 5 908 Day 6 Sold @ 916
34. 34. Date Closing Price MTM loss MTM loss Span & Intial Margin (+/-) Day 1 870 15 -7500 -79650 Day 2 890 20 10000 Day 3 902 12 6000 Day 4 896 -6 -3000 Day 5 908 12 6000 Day 6 Sold @ 916 8 4000 79650
35. 35. Basis -Convergence at Expiration The illustration given below highlights the narrowing basis (defined later) or in other words the narrowing difference between cash and futures price as the futures contracts approaches expiry.
36. 36. Contango
37. 37. Backwardation
38. 38. Settlement of Index Futures Index based derivatives, worldwide, are cash settled i.e. settlement of these trades takes place only through the settlement of the difference in the buy /sell price and the final settlement price of the contract. They are designed as cash settled derivative contracts as its next to impossible to deliver a NIFTY futures in term of its component stocks in respective weightage.
39. 39. Open Interest Period Trader 1 Trader 2 Trader 3 Open Interest 0 0 1 Short Long 1 2 Short Long 1 3 Long Short 0
40. 40. Forecasting Price, Volume and Open Interest are three significant parameters which help you in forecasts. A grid in the following lines will be useful.
41. 41. Maturity of futures contracts These contracts of different maturities are called near month (one month), middle month (two months) and far month (three months) contracts. At any point of time there will be three futures contracts available for trading.
42. 42. Contract Cycle Jan Feb Mar Apr TimeJan 31 Feb 28 Mar 27 April 24 May 29 June 26
43. 43. Trading Mechanism
44. 44. Options
45. 45. What is Options Options are derivative contracts where the person gets a right (but not obligation) to buy or sell a specified quantity of the underlying asset at an agreed price (strike price) on or before the specified future date (expiration date).
46. 46. Options Options Option Buyer Risk limited to premium paid Returns UNLIMTED Option Seller (Writer) Risk UNLIMTED Returns limited to premium received
47. 47. Types of Options Types of Options CALL Bullish view PUT Bearish View
48. 48. Illustration -Options After 30 days ,can Tata Motors Dealer force you to buy NANO? Can you force TATA Motors dealer to deliver NANO? Tata has launched Nano Car Price of the car is fixed at Rs 1.00 Lakh You can book the car by paying Rs 3,000 Dealer agrees to Deliver car within 30 days By booking the car, what have you bought?
49. 49. So Options Gives the buyer the right Not the obligation To buy or sell A specified underlying At a set price On or before a specified date
50. 50. Option Terminology Option Premium Price paid by the buyer to acquire the right Strike Price or Exercise Price Price at which the underlying may be purchased Expiration Date Last date for exercising the option Exercise Date Date on which the option is actually exercised
51. 51. Types of Options based on Settlement American Option (options on stocks) can be exercised any time on or before the expiration date European Option (options on index) can be exercised only on the expiration date (options on index)
52. 52. Call Option A call option gives the buyer, the right to buy specified quantity of the underlying asset at the set strike price on or before expiration date. The seller (writer) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.
53. 53. 6000 60 0 Nifty Profit Loss Payoff for Buyer of Call option Premium paid
54. 54. Payoff for Seller of call option 6000 60 0 Nifty Profit Loss Premium Received
55. 55. NIFTY FUT :- 5200 | BUY 5200 CALL @ 85 | Lot Size = 50 BEP :- 5200 + 85 = 5285 | RISK :- 85*50 = 4250 | REWARD = UNLIMITED -100 -50 0 50 100 150 200 4950 5000 5050 5100 5150 5200 5250 5300 5350 5400 5450 Spot onExpiry Profit&Loss StrategyPayoff BUY CALL :- Buy Nifty 5200 Call @ 85 Market Expectation : Bullish Example :- If Nifty goes up to 5500 Gain = 5500-5200-85 = 115 Net Profit = 115 * 50 = 5750 ------------------------------------------------- If Nifty goes down to 4900 or 4700 Buyer will not exercise his right : Loss = Premium he has paid Rs 85/- only Net Loss = 85 * 50 = 4250
56. 56. SELL CALL :- Sell Nifty 5200 Call @ 85 -200 -150 -100 -50 0 50 100 4950 5000 5050 5100 5150 5200 5250 5300 5350 5400 5450 Spot on Expiry Profit&Loss Strategy Payoff NIFTY FUT :- 5200 | SELL 5200 CALL @ 85 | Lot Size = 50 BEP :- 5200 + 85 = 5285 | RISK :- UNLIMITED | REWARD = 85 * 50 = 4250
57. 57. Put Option A buyer of Put option has the right but not the obligation to sell the underlying at the set price by paying the premium upfront. He can exercise his option on or before expiry.
58. 58. Put Buyer v/s Seller Put Buyer Pays premium Has right to exercise resulting in a short position in the underlying Time works against buyer Risk limited, Reward unlimited Put Seller Collects premium Has obligation if assigned resulting in a long position in the underlying Time works in favor of seller Risk unlimited, Reward limited
59. 59. Payoff for Buyer of Put Option 6000 60 0 Nifty Profit Loss Premium paid
60. 60. Payoff for the Writer of Put Option 6000 60 0 Nifty Profit Loss Premium received
61. 61. BUY PUT :- Buy IFCI 60 Put @ 3.00 Market Expectation : Bearish Example :- If IFCI goes down to 55 Gain = 65-55-3 = 7 Net Profit = 7875 * 7 = 55125 ------------------------------------------------- If IFCI goes up to 75 Buyer will not exercise his right : Loss = Premium paid Rs 3/- only Net Loss = 7875 * 3 = 23625 IFCI FUT :- 65 | BUY 65 PUT @ 3.00 | Lot Size = 7875 BEP :- 65-3 = 62 | RISK :- 7875 * 3 = 23625 | REWARD = UNLIMITED
62. 62. Market Expectation : Bullish Example :- If IFCI goes up to 75 Gain = Only Premium Paid Net Profit = 7875 * 3 = 23625 ------------------------------------------------- If IFCI goes down to 55 Loss = Unlimited in falling market 55-65+3 = -7 Net Loss = 7875 * 7 = 55125 SELL PUT :- SELL IFCI 65 Put @ 3.00 IFCI FUT :- 65 | SELL 65 PUT @ 3.00 | Lot Size = 7875 BEP :- 65-3 = 62 | RISK :- UNLIMITED | REWARD = 7875 * 3 = 23625 UNLIMITED
63. 63. Generations of Strikes for Nifty Options
64. 64. Strike Intervals for Stock Options Less than or equal to Rs.50 2.5 > Rs. 50 to < Rs. 150 5 > Rs. 150 to < Rs. 250 10 >Rs. 250 to < Rs. 500 20 >Rs. 500 to < Rs. 1000 30 >Rs. 1000 to < Rs. 2500 50 > Rs. 2500 100
65. 65. Market Scenario Call Option Put Option Market price > Strike price in-the-money out-of-the-money Market price < Strike price out-of-the-money in-the-money Market price = Strike price at-the-money at-the-money Any option with intrinsic value is known as in-the-money. An option without intrinsic value is known as out-of-the-money. An option with an exercise price equal to the underlying security price is known as at-the- money.
66. 66. SL Strike Price Option Type Market Price ITM/ATM/OTM 1 40 CE 35 2 150 CE 165 3 350 PE 345 4 125 PE 125 5 2500 CE 2678 6 170 PE 150 7 50 CE 50 8 200 PE 215 Identify ITM/ATM/OTM
67. 67. Components of Option Value Options Premium = Intrinsic value + Time Value. Intrinsic value = Intrinsic value is the value which you can get back if you exercise the option. Time Value = The price (premium) of an option less its intrinsic value. Satyam Example Spot Price Rs. 223.7 26-Jun-02 Satyam Jun Call Premium Intrinsic Value Time Value Satyam 200 24 23.7 0.3 Satyam 220 5.5 3.7 1.8 Satyam 230 1.75 0 1.75 Satyam 240 0.5 0 0.5 Satyam 260 0.15 0 0.15
68. 68. SL Strike Price Option Type Market Price Premium Time Value Intrinsic Value 1 50 CE 65 17 2 150 CE 135 4 3 350 PE 345 10 4 125 PE 125 4 5 2500 CE 2678 180 6 170 PE 150 32 7 50 PE 42 11 8 200 PE 215 6
69. 69. Miscellaneous
70. 70. Put Call Ratio Put call ratio is an important indicator that can help one in gauging the future direction of the market. If the Put call ratio rises then there is hope of higher prices in the near future. If the Put call ratio falls it is a sign of weakness in the market. Generally put call ratio is read along with volatility. PCR can be calculated for Open Interest/positions or no of puts and calls traded.
71. 71. Impact of rollover is more important at the end of the contract, by analyzing the rollover along with the price movement one can predict the direction of the stock. Mainly stocks which have a rollover of more than 90% with a price rise or price consolidation in the previous contract have more chances to move up immediately in the next contract whereas, the stocks which have good rollover with the fall in price indicates that market participants are rolling it over in anticipation that the stock may rise in the next contract, thus increasing the selling pressure on that particular stock. Impact of Rollover
72. 72. Dividend and Stock Split Exchange traded options are adjusted for stock splits. A stock split occurs when existing shares are split into more shares. Example :- A 20% stock dividend means that investor receive one new shares for each five already owned. The stock price can be expected to go down as a result of a stock dividend. The 20% stock dividend referred to is essentially the same as a 6 for 5, stock price to decline to 5/6 of its previous value A call option to buy 100 shares of a company for Rs 15 per share. Suppose that company declares a 25% stock dividend so that it gives the holder the right to buy 125 shares for Rd 12 per shares.
73. 73. Buy ITC CALL OPTION of 350 Strike at Premium 14 Rs Lot size 1000 Scenario 1 settlement price 385 Scenario 2 settlement price 349 Buy RCOM PUT OPTION of 125 Strike at premium 6 Rs Lot size 2000 Scenario 1 settlement price 135 Scenario 2 settlement price 119
74. 74. RaJ sell Ashok leyland CALL OPTION of 20 Strike at Premium 1.20 Rs Lot size 1000 Scenario 1 settlement price 25 Scenario 2 settlement price 19 Sell PTC PUT OPTION of 65 Strike at premium 3 Rs Lot size 2000 Scenario 1 settlement price 69 Scenario 2 settlement price 61
75. 75. Mail Me Aiyappaa.A@gmail.com