DERIVATIVES:

FUTURES & OPTIONS

Defining Derivatives

• A derivative is a financial instrument whose

value depends on – is derived from – the

value of some other financial instrument,

called the underlying asset

• Common examples of underlying assets are

stocks, bonds, corn, pork, wheat, rainfall,

etc.

Basic purpose of derivatives• In derivatives transactions, one party’s loss is

always another party’s gain

• The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance

• If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant

• Derivatives improve overall performance of the economy

Major categories of derivatives

1. Forwards and futures

2. Options

3. Swaps

Forwards

• A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

• Example: interest rate forwards

• Forwards are highly customized, and are

much less common than the futures

Futures• An agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. Futures contacts are special types of forward contracts in the contracts in the sense that the former are standardized exchange-traded contracts.

•  Structure of a futures contract:

• Seller (has short position) is obligated to deliver

the commodity or a financial instrument to the

buyer (has long position) on a specific date

This date is called settlement, or delivery, date

• Part of the reason forwards are not as common is that it is hard to provide assurances that the parties will honor the contract

• In futures trading, this is done through the clearing corporation

• Basis is defined as the difference between cash and futures prices: Basis = Cash prices - Future prices.

• Basis can be either positive or negative (in Index futures, basis generally is negative).

• Basis may change its sign several times during the life of the contract.

• Basis turns to zero at maturity of the futures contract i.e. both cash and future prices

• converge at maturity

Operators in the derivatives market

• Hedgers - Operators, who want to transfer a risk component of their portfolio.

• Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.

• Arbitragers - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.

• Often, agents hedge against adverse events in the

market using futures

• E.g., a manager wishes to insure the firm against the

rise in interest rates and the resulting decline in the

value of bonds the firm holds

• Can sell a futures contract and lock in a price.

• Speculators try to use futures to make a profit by betting on price movements:

• Sellers of futures bet on price decreases

• Buyers of futures bet on price increases

Options• Options are instruments whereby the right is given by

the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

• Call Option - The right to buy a specified amount of currency at a specified rate

• Put Option -The right to sell a specified amount of

currency at a specified rate

• Premium - The price of an option

• Strike - The rate at which the right can be exercised

• Expiry Date - The date at which the right can be exercised

• Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.

• Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.

• Call Option - Option to buy.

• Put Option - Option to sell.

• American Option - An option which can be exercised anytime on or before the expiry date.

• Expiration Date - Date on which the option expires.

• European Option - An option which can be exercised only on expiry date.

• Exercise Date - Date on which the option gets exercised by the option holder/buyer.

• Option Premium - The price paid by the option buyer to the option seller for granting the option.  

• Like futures, options are agreements between 2parties.

• Seller is called an option writer - Incurs obligations

• Buyer is called an option holder - Obtains rights

2 types of options

• Call option

• Put option

• Call option – a right to buy an asset at a

predetermined price (strike price ) on or before a

specific date

• If asset price is higher than the strike price Option is In The Money

• If asset price is exactly at the strike price Option is At The Money

• If asset price is below the strike price Option is Out Of The Money

• Obviously would not exercise an option that Is out

Of the money

• Put option – a right to sell an asset at a predetermined price on or before a specific date

• If asset price is lower than the strike price Option is In The Money

• If asset price is exactly at the strike price Option is At The Money

• If asset price is higher than the strike price Option is Out Of The Money

STRATEGIES OF TRADING IN FUTURE AND OPTIONS

USING STOCK FUTURES

1. Hedging: long security, sell future

2. Speculation: bullish security, buy Futures

3. Speculation : bearish Security, Sell Futures

4. Arbitrage: overpriced Futures: buy spot, sell futures

5. Arbitrage: underpriced Futures: sell spot, buy futures

USING STOCK OPTIONS

• Hedging:Have stock, buy puts

• Speculation: bullish stock, buy calls or sell puts

• Speculation : bearish Stock, buy put or sell calls

BULLISH STRATEGIES

LONG CALL• Market Opinion – Bullish Most popular strategy with

investors Used by investors because of better leveraging compared to buying the underlying stock – insurance against decline in the value of the underlying.

Risk Reward ScenarioMaximum Loss = Limited (Premium Paid)Maximum Profit = UnlimitedProfit at expiration = Stock Price at expiration – Strike Price – Premium paidBreak even point at Expiration = Strike Price + Premium paid

SHORT PUT

• Maximum Loss – Unlimited

• Maximum Profit – Limited (to the extent of option premium)

• Makes profit if the Stock price at expiration > Strike price – premium

BULL CALL SPREAD• For Investors who are bullish but at the same time

conservative

• Buy A Call Closer To Spot Price & Write A Call With A Higher Price

• In a market that has bottomed out, when stocks rise, they rise in small steps for a short duration. Bull Call Spread can be Used where gains & losses are limited. 

BEARISH STRATEGIES:LONG PUTMarket Opinion – Bearish. For investors who want to make

money from a downward price move in the underlying stock Offers a leveraged alternative to a bearish or short sale of the underlying stock

Risk Reward Scenario Maximum Loss – Limited (Premium Paid)Maximum Profit - Limited to the extent of price of stockProfit at expiration - Strike Price – Stock Price at expiration - Premium paidBreak even point at Expiration – Strike Price - Premium paid

SHORT CALL•  Risk Reward Scenario

• Maximum Loss – Unlimited

• Maximum Profit - Limited (to the extent of option premium)

• Makes profit if the Stock price at expiration < Strike price + premium

BEAR CALL SPREAD

• Low Risk Low Reward Strategy

• Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike Price

BEAR PUT SPREAD• Again a LOW RISK, LOW RETURN Strategy 

• Gains as Well as Losses are Limited 

• BUY PUT OPTION AT A HIGHER STRIKE PRICE AND SELL ANOTHER WITH A

• LOWER STRIKE PRICE

• Profit Accrues when the price of underlying stock goes down. 

NEUTRAL STRATEGIES

LONG STRADDLE

• Buy one call option and buy one put option at the same strike price

• Maximum Loss: Limited to the total premium paid for the call and put options

• Maximum Gain: Unlimited as the market moves in either direction.

• A long straddle is like placing an each-way bet on price action: you make money if the market goes up or down

SHORT STRADDLE• Short one call option and short one put option at the

same strike price

• Maximum Loss: Unlimited as the market moves in either direction.

• Maximum Gain: Limited to the net premium received for selling the options

• Short straddles are a great way to take advantage of time decay and also if you think the market price will trade sideways over the life of the option.

VOLATILITY STRATEGIES

LONG STRANGLE

• Long one put option with a lower strike price and long one call option at a higher strike price.

• Maximum Loss:Limited to the total premium paid for the call and put options

• Maximum Gain:Unlimited as the market moves in either direction.

SHORT STRANGLE: • Short one put option with a lower strike price and

short one call option at a higher strike price. • Maximum Loss: Unlimited as the market moves in

either direction.

• Maximum Gain: Limited to the net premium received for selling the options.

• A short strangle is similar to the Short Straddle except the strike prices are further apart, which lowers the premium received but also increases the chance of a profitable trade.