A Study for Management of Risks Through Derivatives

8/9/2019 A Study for Management of Risks Through Derivatives

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Project Report

For

A Study of

MANAGEMENT OF RISKS THROUGH DERIVATIVES

Submitted in partial fulfillment of the award of degree of

Master of Business Administration

Under the Supervision of Submitted By

Name : Neha Bhatnagar Name: ANISH MATHUR

Address: 54,Abhay Garh Scheme,Jodhpur Session: 2006-2007

Enro. No.: 05061506005

Submitted to :Directorate of Distance EducationGuru Jambheshwar University of

Science and TechnologyH I S A R 125001Session : 2006-2007


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A Study For Management Of Risks Through Derivatives

Forwards

What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealingsand comes across as an instrument which is the prerogative of a few smart financeprofessionals. In reality it is not so. In fact, a derivative transaction helps cover risk, which wouldarise on the trading of securities on which the derivative is based and a small investor, canbenefit immensely.

A derivative security can be defined as a security whose value depends on the values of otherunderlying variables. Very often, the variables underlying the derivative securities are the pricesof traded securities.

Let us take an example of a simple derivative contract:

Ram buys a futures contract.

He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.

If the price is unchanged Ram will receive nothing.

If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the

underlying security. Similarly, futures trading has already started in Sensex futures and Niftyfutures. The underlying security in this case is the BSE Sensex and NSE Nifty.

Derivatives and futures are basically of 3 types:

Forwards and Futures

Options

Swaps

Forward contract

A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy orsell an asset (of a specified quantity) at a certain future time for a certain price. No cash isexchanged when the contract is entered into.


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Illustration 1:

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He canonly buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months fromnow. So in order to protect himself from the rise in prices Shyam enters into a contract with theTV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that

he is locking the current price of a TV for a forward contract. The forward contract is settled atmaturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turnwill pay cash equivalent to the TV price on delivery.

Illustration 2:

Ram is an importer who has to make a payment for his consignment in six months time. In orderto meet his payment obligation he has to buy dollars six months from today. However, he is notsure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into acontract with a bank to buy dollars six months from now at a decided rate. As he is entering into acontract on a future date it is a forward contract and the underlying security is the foreigncurrency.

The difference between a share and derivative is that shares/securities is an asset whilederivative instrument is a contract.

What is an Index?

To understand the use and functioning of the index derivatives markets, it is necessary tounderstand the underlying index. A stock index represents the change in value of a set of stocks,which constitute the index. A market index is very important for the market players as it acts as abarometer for market behavior and as an underlying in derivative instruments such as indexfutures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSESensex has 30 stocks comprising the index which are selected based on market capitalization,industry representation, trading frequency etc. It represents 30 large well-established andfinancially sound companies. The Sensex represents a broad spectrum of companies in a varietyof industries. It represents 14 major industry groups. Then there is a BSE national index and BSE200. However, trading in index futures has only commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty was launched by theNational Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty indexconsists of shares of 50 companies with each having a market capitalization of more than Rs 500crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes isessential. Choosing the right index is important in choosing the right contract for speculation orhedging. Since for speculation, the volatility of the index is important whereas for hedging thechoice of index depends upon the relationship between the stocks being hedged and thecharacteristics of the index.


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Choosing and understanding the right index is important as the movement of stock index futuresis quite similar to that of the underlying stock index. Volatility of the futures indexes is generallygreater than spot stock indexes.

Everytime an investor takes a long or short position on a stock, he also has an hidden exposureto the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment

and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index withtheir portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time inthe future at a certain price. Index futures are all futures contracts where the underlying is thestock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he cansimply buy a futures contract and hope for a price rise on the futures contract when the rally

occurs. We shall learn in subsequent lessons how one can leverage ones position by takingposition in the futures market.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near3 months duration contracts are available at all times. Each contract expires on the last Thursdayof the expiry month and simultaneously a new contract is introduced for trading after expiry of acontract.

Example:

Futures contracts in Nifty in July 2001

Contract month Expiry/settlementJuly 2001 July 26

August 2001 August 30

September 2001 September 27

On July 27

Contract month Expiry/settlement

August 2001 August 30

September 2001 September 27

October 2001 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contractthe total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the totalvalue will be 50*4000 (Sensex value)= Rs 2,00,000.

The index futures symbols are represented as follows:


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BSE NSE

BSXJUN2001 (June contract) FUTDXNIFTY28-JUN2001

BSXJUL2001 (July contract) FUTDXNIFTY28-JUL2001

BSXAUG2001 (Aug contract) FUTDXNIFTY28-AUG2001

In subsequent lessons we will learn about the pricing of index futures.

Options

Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more oftenthan not the scenario is the reverse. Investing in stocks has two sides to it a) Unlimited profitpotential from any upside (remember Infosys, HFCL etc) or b) a downside which could make youa pauper.

Derivative products are structured precisely for this reason -- to curtail the risk exposure of aninvestor. Index futures and stock options are instruments that enable you to hedge your portfolioor open positions in the market. Option contracts allow you to run your profits while restricting

your downside risk.

Apart from risk containment, options can be used for speculation and investors can create a widerange of potential profit scenarios.

We have seen in the Derivatives School how index futures can be used to protect oneself fromvolatility or market risk. Here we will try and understand some basic concepts of options.

What are options?

Some people remain puzzled by options. The truth is that most people have been using optionsfor some time, because options are built into everything from mortgages to insurance.

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell sharesof the underlying security at a specific price on or before a specific date.

Option, as the word suggests, is a choice given to the investor to either honour the contract; or ifhe chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In thisway, Call options are like security deposits. If, for example, you wanted to rent a certain property,and left a security deposit for it, the money would be used to insure that you could, in fact, rentthat property at the price agreed upon when you returned. If you never returned, you would give

up your security deposit, but you would have no other liability. Call options usually increase invalue as the value of the underlying instrument rises.

When you buy a Call option, the price you pay for it, called the option premium, secures your rightto buy that certain stock at a specified price called the strike price. If you decide not to use theoption to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way,Put options are like insurance policies


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If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence,protected if the asset is damaged in an accident. If this happens, you can use your policy toregain the insured value of the car. In this way, the put option gains in value as the value of theunderlying instrument decreases. If all goes well and the insurance is not needed, the insurancecompany keeps your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If something happens whichcauses the stock price to fall, and thus, "damages" your asset, you can exercise your option andsell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," thenyou do not need to use the insurance, and, once again, your only cost is the premium. This is theprimary function of listed options, to allow investors ways to manage risk.

Technically, an option is a contract between two parties. The buyer receives a privilege for whichhe pays a premium. The seller accepts an obligation for which he receives a fee.

We will dwelve further into the mechanics of call/put options in subsequent lessons.

Types of Options

Call option

An option is a contract between two parties giving the taker (buyer) the right, but not theobligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before apredetermined date. To acquire this right the taker pays a premium to the writer (seller) of thecontract.

There are two types of options:

Call Options

Put Options

Call options

Call options give the taker the right, but not the obligation, to buy the underlying shares at apredetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between

the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eighta share for 100 shares).

The buyer of a call has purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he haspurchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55


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(40+15) he will break even and he will start making a profit. Suppose the stock does not rise andinstead falls he will choose not to exercise the option and forego the premium of Rs 15 and thuslimiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.

Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contract Strike price Call premium

Dec Nifty 1325 Rs 6,000

1345 Rs 2,000

Jan Nifty 1325 Rs 4,500

1345 Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take therisk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays apremium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option andtakes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 percontract. Total profit = 40,000/- (4,000*10).

He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option isRs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to forego hispremium of Rs 5,000. So, in the event the index falls further his loss is limited to thepremium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish.

When you expect prices to fall, then you take a short position by selling calls. You are bearish.


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Put Options

A Put Option gives the holder of the right to sell a specific number of shares of an agreedsecurity at a fixed price for a period of time.

eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200

This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time betweenthe current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000(Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Illustration 2:Raj is of the view that the a stock is overpriced and will fall in future, but he doesnot want to take the risk in the event of price rising so purchases a put option at Rs 70 on X. Bypurchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit ifthe stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does notwant to take the risk in the event the prices rise. So he purchases a Put option on Wipro.

Quotes are as under:

Spot Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs30,000/- as Put premium.

His position in following price position is discussed below.


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1. Jan Spot price of Wipro = 1020

2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- theprice of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put,

which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the investor will not sell at alower price by exercising the Put. He will have to allow the Put option to expire unexercised. Helooses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.

When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

CALL OPTIONS PUT OPTIONS

If you expect a fall in price(Bearish) Short Long

If you expect a rise in price (Bullish) Long Short

SUMMARY:

CALL OPTION BUYER CALL OPTION WRITER (Seller)

Pays premium

Right to exercise and buy the shares

Profits from rising prices

Limited losses, Potentially unlimited gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining neutral

Potentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, Potentially unlimited gain

Receives premium

Obligation to buy shares if exercised

Profits from rising prices or remaining neutral

Potentially unlimited losses, limited gain


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Hedging

We have seen how one can take a view on the market with the help of index futures. The otherbenefit of trading in index futures is to hedge your portfolio against the risk of trading. In order tounderstand how one can protect his portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dressesfor Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs3000 if the sale is completed.

Cost (Rs) Selling price Profit

1000 4000 3000

However, Ram fears that Shyam may not honour his contract six months from now. So he insertsa new clause in the contract that if Shyam fails to honour the contract he will have to pay apenalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 asincentive.

Shyam defaults Shyam honours

1000 (Initial Investment) 3000 (Initial profit)

1000 (penalty from Shyam) (-1000) discount given to Shyam

- (No gain/loss) 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initialinvestment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ramhas hedged his risk against default and protected his initial investment.

The above example explains the concept of hedging. Let us try understanding how one can usehedging in a real life scenario.

Stocks carry two types of risk company specific and market risk. While company risk can beminimized by diversifying your portfolio market risk cannot be diversified but has to be hedged.So how does one measure the market risk? Market risk can be known from Beta.


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Beta measures the relationship between movement of the index to the movement of the stock.The beta measures the percentage impact on the stock prices for 1% change in the index.Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, thebeta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%.The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse pricemovements. In order to hedge a position, a market player needs to take an equal andopposite position in the futures market to the one held in the cash market. Every portfoliohas a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolioof Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn ofS&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe toassume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would

offset the losses on the rest of his portfolio. This is achieved by multiplying the relativevolatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues:

Index up 10% Index down 10%

Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)

Gain/(Loss) in Futures (Rs 120,000) Rs 120,000

Net Effect Nil Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in marketsentiment. But as a cost, one has to forego any gains that arise out of improvement in the overallsentiment. Then why does one invest in equities if all the gains will be offset by losses in futuresmarket. The idea is that everyone expects his portfolio to outperform the market. Irrespective ofwhether the market goes up or not, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of the scrip andtaking a reverse position in the futures market.

Thus, we have seen how one can use hedging in the futures market to offset losses in the cashmarket.


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Speculation

Speculators are those who do not have any position on which they enter in futures and optionsmarket. 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. Theyconsider various factors such as demand supply, market positions, open interests, economic

fundamentals and other data to take their positions.

Illustration:

Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances inpredicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise infuture. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number ofcontracts to close out his position.

Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However,if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish hecould have sold Sensex futures and made a profit from a falling profit. In index futures playerscan have a long-term view of the market up to atleast 3 months

Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless

profits. When markets are imperfect, buying in one market and simultaneously selling in othermarket gives riskless 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 lowerpriced market and selling at the higher priced market. In index futures arbitrage is possiblebetween the spot market and the futures market (NSE has provided a special software for buyingall 50 Nifty stocks in the spot market.

Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300.

The futures price of Nifty futures can be worked out by taking the interest cost of 3months into account.

If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs1070.


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Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40

These kind of imperfections continue to exist in the markets but one has to be alert to theopportunities as they tend to get exhausted very fast.

Bull Market Strategies

Calls in a BullishStrategy

Puts in a BullishStrategy

Bullish Call SpreadStrategies

Bullish PutSpread

Strategies

Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect the market price ofthe underlying asset to rise, then you would rather have the right to purchase at a specified priceand sell later at a higher price than have the obligation to deliver later at a higher price.
http://172.16.35.31/Derivatives/#callbullhttp://172.16.35.31/Derivatives/#callbullhttp://172.16.35.31/Derivatives/#putbullhttp://172.16.35.31/Derivatives/#putbullhttp://172.16.35.31/Derivatives/#bullcallspreadhttp://172.16.35.31/Derivatives/#bullcallspreadhttp://172.16.35.31/Derivatives/#bullputspreadhttp://172.16.35.31/Derivatives/#bullputspreadhttp://172.16.35.31/Derivatives/#bullputspreadhttp://172.16.35.31/Derivatives/#callbullhttp://172.16.35.31/Derivatives/#callbullhttp://172.16.35.31/Derivatives/#putbullhttp://172.16.35.31/Derivatives/#putbullhttp://172.16.35.31/Derivatives/#bullcallspreadhttp://172.16.35.31/Derivatives/#bullcallspreadhttp://172.16.35.31/Derivatives/#bullputspreadhttp://172.16.35.31/Derivatives/#bullputspreadhttp://172.16.35.31/Derivatives/#bullputspread


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The investor's profit potential buying a call option is unlimited. The investor's profit is the themarket price less the exercise price less the premium. The greater the increase in price of theunderlying, the greater the investor's profit.

The investor's potential loss is limited. Even if the market takes a drastic decline in price levels,the holder of a call is under no obligation to exercise the option. He may let the option expireworthless.

The investor breaks even when the market price equals the exercise price plus the premium.

An increase in volatility will increase the value of your call and increase your return. Because ofthe increased likelihood that the option will become in- the-money, an increase in the underlyingvolatility (before expiration), will increase the value of a long options position. As an option holder,your return will also increase.

A simple example will illustrate the above:

Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100.The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strikeprice). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this wouldnot be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid.

The profit can be derived as follows

Profit = Market price - Exercise price - PremiumProfit = Market price Strike price Premium.2200 2000 100 = Rs 100

Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investoranticipating a bull market could write Put options. If the market price increases and puts becomeout-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlyingasset increases and the option expires worthless. The maximum profit is limited to the premiumreceived.

However, the potential loss is unlimited. Because a short put position holder has an obligation topurchase if exercised. He will be exposed to potentially large losses if the market moves againsthis position and declines.


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The break-even point occurs when the market price equals the exercise price: minus thepremium. At any price less than the exercise price minus the premium, the investor loses moneyon the transaction. At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your return. As an optionwriter, the higher price you will be forced to pay in order to buy back the option at a later date ,

lower is the return.

Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but withdifferent exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with ahigher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price andwrites a call with a lower exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allowsthe investor to participate to a limited extent in a bull market, while at the same time limiting riskexposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call.The combination of these two options will result in a bought spread. The cost of Putting on this


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position will be the difference between the premium paid for the low strike call and the premiumreceived for the high strike call.

The investor's profit potential is limited. When both calls are in-the-money, both will be exercisedand the maximum profit will be realised. The investor delivers on his short call and receives ahigher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He

pays a higher premium for the lower exercise price call than he receives for writing the higherexercise price call.

The investor breaks even when the market price equals the lower exercise price plus the netpremium. At the most, an investor can lose is the net premium paid. To recover the premium, themarket price must be as great as the lower exercise price plus the net premium.

An example of a Bullish call spread:

Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with astrike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another Novembercall option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you arebuying a lower strike price option and selling a higher strike price option. This would result in a

net outflow of Rs 10 at the time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the firstposition established in the spread is the long lower strike price call option with unlimited profitpotential. At the same time to reduce the cost of puchase of the long position a short position at ahigher call strike price is established. While this not only reduces the outflow in terms of premiumbut his profit potential as well as risk is limited. Based on the above figures the maximum profit,maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price - Lower strike price - Net premium paid

= 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100


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Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put options but withdifferent exercise prices.

To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a

lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writesa put with a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread"allows the investor to participate to a limited extent in a bull market, while at the same timelimiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.The bull spread can be created by buying the lower strike and selling the higher strike of eithercalls or put. The difference between the premiums paid and received makes up one leg of thespread.

The investor's profit potential is limited. When the market price reaches or exceeds the higherexercise price, both options will be out-of-the-money and will expire worthless. The trader willrealize his maximum profit, the net premium


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The investor's potential loss is also limited. If the market falls, the options will be in-the-money.The puts will offset one another, but at different exercise prices.

The investor breaks-even when the market price equals the lower exercise price less the netpremium. The investor achieves maximum profit i.e the premium received, when the market pricemoves up beyond the higher exercise price (both puts are then worthless).

An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option ona scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price ofRs 110 at a premium of Rs 15.

The first position is a short put at a higher strike price. This has resulted in some inflow in terms ofpremium. But here the trader is worried about risk and so caps his risk by buying another putoption at the lower strike price. As such, a part of the premium received goes off and the ultimateposition has limited risk and limited profit potential. Based on the above figures the maximumprofit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit

= 15 - 5 = 10

Maximum loss = Higher strike price - Lower strike price - Net premium received

= 110 - 90 - 10 = 10

Breakeven Price = Higher Strike price - Net premium income

= 110 - 10 = 100

Bear Market Strategies

Puts in a BearishStrategy

Calls in aBearish Strategy
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Bearish Put Spread

Strategies

Bearish Call

SpreadStrategies

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put option is a bearishposition. It will increase in value if the market falls. An investor with a bearish market outlook shallbuy put options. By purchasing put options, the trader has the right to choose whether to sell theunderlying asset at the exercise price. In a falling market, this choice is preferable to beingobligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlyingasset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises instead of fallingas the investor has anticipated, he may let the option expire worthless. At the most, he may losethe premium for the option.

The trader's breakeven point is the exercise price minus the premium. To profit, the market pricemust be below the exercise price. Since the trader has paid a premium he must recover thepremium he paid for the option.
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An increase in volatility will increase the value of your put and increase your return. An increasein volatility will make it more likely that the price of the underlying instrument will move. Thisincreases the value of the option.

Calls in a Bearish Strategy

Another option for a bearish investor is to go short on a call with the intent to purchase it back inthe future. By selling a call, you have a net short position and needs to be bought back beforeexpiration and cancel out your position.

For this an investor needs to write a call option. If the market price falls, long call holders will lettheir out-of-the-money options expire worthless, because they could purchase the underlyingasset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is limited to thepremium received for writing the option.

Here the loss potential is unlimited because a short call position holder has an obligation to sell ifexercised, he will be exposed to potentially large losses if the market rises against his position.

The investor breaks even when the market price equals the exercise price: plus the premium. At

any price greater than the exercise price plus the premium, the trader is losing money. When themarket price equals the exercise price plus the premium, the trader breaks even.

An increase in volatility will increase the value of your call and decrease your return.When the option writer has to buy back the option in order to cancel out his position, he will beforced to pay a higher price due to the increased value of the calls.


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Bearish Put Spread Strategies

A vertical put spread is the simultaneous purchase and sale of identical put options but withdifferent exercise prices.

To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a

lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writesa put with a higher exercise price, receiving a net premium for the position.

To put on a bear put spread you buy the higher strike put and sell the lower strike put.You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread.

An investor with a bearishmarket outlook should: buy a put spread. The "Bear Put Spread"allows the investor to participate to a limited extent in a bear market, while at the same timelimiting risk exposure.

The investor's profit potential is limited. When the market price falls to or below the lower exerciseprice, both options will be in-the-money and the trader will realize his maximum profit when herecovers the net premium paid for the options.

The investor's potential loss is limited. The trader has offsetting positions at different exercise

prices. If the market rises rather than falls, the options will be out-of-the-money and expireworthless. Since the trader has paid a net premium

The investor breaks even when the market price equals the higher exercise price less the netpremium. For the strategy to be profitable, the market price must fall. When the market price fallsto the high exercise price less the net premium, the trader breaks even. When the market fallsbeyond this point, the trader profits.

An example of a bearish put spread.


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Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scripwith a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs90 at a premium of Rs 5.

In this bearish position the put is taken as long on a higher strike price put with the outgo of somepremium. This position has huge profit potential on downside. If the trader may recover a part of

the premium paid by him by writing a lower strike price put option. The resulting position is amildly bearish position with limited risk and limited profit profile. Though the trader has reducedthe cost of taking a bearish position, he has also capped the profit portential as well. Themaximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price option - Lower strike price option - Net premium paid

= 110 - 90 - 10 = 10

Maximum loss = Net premium paid

= 15 - 5 = 10

Breakeven Price = Higher strike price - Net premium paid

= 110 - 10 = 100

Bearish Call Spread Strategies

A vertical call spreadis the simultaneous purchase and sale of identical call options but withdifferent exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with ahigher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price andwrites a call with a lower exercise price, receiving a net premium for the position.

To put on a bear call spread you sell the lower strike call and buy the higher strike call. Aninvestor sells the lower strike and buys the higher strike of either calls or puts to put on a bearspread.

An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread"allows the investor to participate to a limited extent in a bear market, while at the same timelimiting risk exposure.


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The investor's profit potential is limited. When the market price falls to the lower exercise price,both out-of-the-money options will expire worthless. The maximum profit that the trader canrealize is the net premium: The premium he receives for the call at the higher exercise price.

Here the investor's potential loss is limited. If the market rises, the options will offset one another.At any price greater than the high exercise price, the maximum loss will equal high exercise priceminus low exercise price minus net premium.

The investor breaks even when the market price equals the lower exercise price plus the netpremium. The strategy becomes profitable as the market price declines. Since the trader isreceiving a net premium, the market price does not have to fall as low as the lower exercise priceto breakeven.

An example of a bearish call spread.

Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option ona scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike priceof Rs 90 at a premium of Rs 15.

In this spread you have to buy a higher strike price call option and sell a lower strike price option.As the low strike price option is more expensive than the higher strike price option, it is a net

credit startegy. The final position is left with limited risk and limited profit. The maximum profit,maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net premium received

= 15 - 5 = 10

Maximum loss = Higher strike price option - Lower strike price option - Net premium received


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= 110 - 90 - 10 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Stable Market Strategies

Straddles in a Stable Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will movebut does not have an opinion on the direction of movement of the market. As long as there issignificant movement upwards or downwards, these strategies offer profit opportunities. A traderneed not be bullish or bearish. He must simply be of the opinion that the market is volatile. This

market outlook is also referred to as "neutral volatility."

A straddle is the simultaneous purchase (or sale) of two identical options, one a call andthe other a put.

To "buy a straddle" is to purchase a call and a put with the same exercise price andexpiration date.

To "sell a straddle" is the opposite: the trader sells a call and a put with the sameexercise price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows thetrader to profit from writing calls and puts in a stable market environment.


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The investor's profit potential is limited. If the market remains stable, traders long out-of-the-money calls or puts will let their options expire worthless. Writers of these options will not have becalled to deliver and will profit from the sum of the premiums received.

The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writerof a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the

call and practically unlimited loss if on the put.

The breakeven points occur when the market price at expiration equals the exercise priceplus the premium and minus the premium. The trader is short two positions and thus, twobreakeven points; One for the call (common exercise price plus the premiums paid), and one forthe put (common exercise price minus the premiums paid).

Strangles in a Stable Market Outlook

A strangle is similar to a straddle, except that the call and the put have different exercise prices.Usually, both the call and the put are out-of-the-money.

To "buy a strangle" is to purchase a call and a put with the same expiration date, but different

exercise prices. Usually the call strike price is higher than the put strike price.

To "sell a strangle" is to write a call and a put with the same expiration date, but different exerciseprices.

A trader, viewing a market as stable, should: write strangles.A "strangle sale" allows the trader to profit from a stable market.

The investor's profit potential is: unlimited.If the market remains stable, investors having out-of-the-money long put or long call positions willlet their options expire worthless.

The investor's potential loss is: unlimited.

If the price of the underlying interest rises or falls instead of remaining stable as the traderanticipated, he will have to deliver on the call or the put.

The breakeven points occur when market price at expiration equals...the high exercise price plusthe premium and the low exercise price minus the premium.The trader is short two positions and thus, two breakeven points. One for the call (high exerciseprice plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle?


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The risk is lower with a strangle. Although the seller gives up a substantial amount of potentialprofit by selling a strangle rather than a straddle, he also holds less risk. Notice that the stranglerequires more of a price move in both directions before it begins to lose money.

Long Butterfly Call Spread Strategy The long butterfly call spread is a combination of a bullspread and a bear spread, utilizing calls and three different exercise prices.

A long butterfly call spread involves:

Buying a call with a low exercise price,

Writing two calls with a mid-range exercise price,

Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45strikes.This spread is put on by purchasing one each of the outside strikes and selling two of the insidestrike. To put on a short butterfly, you do just the opposite.

The investor's profit potential is limited.Maximum profit is attained when the market price of the underlying interest equals the mid-rangeexercise price (if the exercise prices are symmetrical).

The investor's potential loss is: limited.The maximum loss is limited to the net premium paid and is realized when the market price of theunderlying asset is higher than the high exercise price or lower than the low exercise price.

The breakeven points occur when the market price at expiration equals ... the high exercise priceminus the premium and the low exercise price plus the premium. The strategy is profitable whenthe market price is between the low exercise price plus the net premium and the high exerciseprice minus the net premium.


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Bibliography/References :

Gupts, S.L., Financial Derivatives (Theory, Concepts and

Problems), Prentice Hall of India Ltd., New Delhi,2005.

Jain et al., International Financial Management,

Macmillan India Ltd., Delhi 2005.

Hull, J C (2003); fundamentals of futures and options

markets, pearson Education, Delhi.

Vora, ND and Bagri; BR (1998); Futures andoptions,Tata McGraw Hill Publishing Company

Limitied, New Delhi.

Pandey, I.M., Financial Management, Vikas Publishing

House, New Delhi, 9th edition, 2006.

Website of National Stock Exchange www.nseindia.com

Website of Bombay Stock Exchange www.bseindia.com
http://www.nseindia.com/http://www.nseindia.com/

A Study for Management of Risks Through Derivatives

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