Derivatives Forward&Options
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Transcript of Derivatives Forward&Options
Points to remember……….
• Long – Buy …(going long) [Bullish view]
• Short – Sell …(going short) [Bearish view]
• Squaring off (turn around trades) – opposite transaction to the previous one
• Buy low, sell high - gives a profit
• Sell high, buy low - also gives a profit
• Sell low, buy high – gives a loss
• Buy high, sell low – also gives a loss
Derivatives
• Derivatives are instruments whose value is derived from the value of underlying assets in a cantractual manner.
• The underlying could be stock, exchange rate, commodity etc.
Derivatives- Milestones
• In India derivatives trading started on exchange in June 2000 after SEBI granted final approval to this effect in May 2000
• First to be traded were futures contract on Index.• After this came, options on individual securities
and index• Futures contract on individual stocks were
launched in November,2001
Forward
• A forward contract is an agreement between two parties to buy or sell an asset on a specified date for specified price.
Features:• These are bilateral contract• These contracts are customised• There is a counter party risk
Derivatives – An example
• 10th Feb 2013– A Wheat Farmer will have crop ready by
March 2013– Worried about price fluctuations– A Bread maker needs wheat in March 2013– Worried about price fluctuations
• Both face a Price Risk
Transaction
• The Wheat Farmer and Bread maker enter into a contract on Feb 10, 2013
Farmer Bread Marker
Will give 100 kgs. wheat Will receive 100 kgs. wheat
Will receive Rs. 101 per kg. Will pay Rs. 101 per kg
Date of settlement : March 10, 2013
This is a Forward contract, trade happens today, settlement in future
Contract
Farmer Bread Marker
Will give 100 kgs. wheat Will receive 100 kgs. wheat
Will receive Rs. 101 per kg. Will pay Rs. 101 per kg
Date of settlement : March 10, 2013
Farmers OBLIGATION is to give wheat and the Bread Maker’s OBLIGATION is to pay
ContractTerms :
– Underlying : Wheat– Contract Date : Feb 10, 2013– Contract Price : Rs. 101 per kg– Quantity : 100 kg.– Settlement date : March 10, 2013
• By entering into the contract on Feb 10, 2013 what have the two parties done?Locked in a future price of Rs. 101/- per kg.
Settlement
• On March 10, 2013 :– Farmer gives 100 kg of wheat to the Bread
Maker– Farmer receives Rs. 101/- per kg of wheat
from the Bread maker– The contract entered on Feb 10, 2013 is
settled.– Price of wheat quoting in the spot market
(underlying price) is Rs. 75/- per kg.
Cash Settlement
• On March 10, 2013 :– Price of wheat quoting in the market is Rs. 75/-
per kg.– Who gains? By how much?– Farmer Rs. 26/- per kg.
• Settlement :– Loser pays to the Gainer the profit / loss – Farmer receives Rs. 26/- per kg. from the Bread
Maker
Derivatives
• Instruments whose value is derived from an underlying (Wheat,
Gold, Shares etc.)
• Derivatives cannot exist without the underlying
• Derivatives do not convey any ownership in the underlying
• Settlement : Cash settled or delivery of underlying
– Physical Delivery : Exchange money and goods on final
settlement
– Cash : Settle profit / loss on final settlement
Introduction to Futures
• Futures were designed to solve the problems that existed in the forward markets– Counter Party risk– Liquidity
• Futures contracts are standardized forward contracts that are traded on an exchange
• What are Futures?
• How do they trade on stock exchange?
Trade SettlementInitial margin
Daily Mark to Market Settlement
Futures …….exchange traded forwards
1. Exchange Traded (transperancy)
2. Standardised contracts (reduce complexity)
3. Counter - Party Risk is absent (settlement is guaranteed by a Clearing Corporation)
Daily Mark to Market Settlement – Futures contracts
Date
S ep1,2013 11:00 am
Spot Price ofABC Ltd. :
Rs. 490
Mr. Raju BuysABC Ltd. Futures @
Rs. 510
MTM Gain / Loss
Mr. Ajay SellsABC Ltd. Futures @
Rs. 510
MTM Gain / Loss
Remarks :Gainer receives MTM amount from the loser on a daily basis
S ep1,2013 3:30 pm
Rs. 500 Rs. 512 + Rs. 2 Rs. 512 - Rs. 2Ajay Pays Rs. 2 to Raju
S ep2,2013 3:30 pm
Rs. 510 Rs. 520 + Rs. 8 Rs. 520 - Rs. 8Ajay Pays Rs. 8 to Raju
S ep3,2013 3:30 pm
Rs. 495 Rs. 510 - Rs. 10 Rs. 510 + Rs. 10Raju Pays Rs. 10 to Ajay
S ep4,2013 3:30 pm Rs. 505 Rs. 515 + Rs. 5 Rs. 515 - Rs. 5
Ajay Pays Rs. 5 to Raju
S ep5,2013 3:30 pm
Rs. 515 Rs. 525 +Rs. 10 Rs. 525 - Rs. 10Ajay Pays Rs. 10 to Raju
Futures terminology
• Spot price : Price at which asset trades in the
spot market
• Futures : Price at which Futures contracts
trade in the futures market
• Contract cycle : The period over which a contract
trades
• Expiry Date : Last date of the contract
• Contract size : Amount or value of each contract
Futures terminology (cont.)
• Initial margin : Amount deposited initially to
trade futures (by both buyer & seller)
• Cost of Carry : Relationship between futures and spot
price is determined by cost of
carry. For financial assets it is
interest cost.
Contract Life Cycle - example
Futures contracts in NIFTY on Sep 2013: Any given time upto 3months duration contracts.
Contract Month Expiry/settlement date Sep 2013 258h Sep Oct 2013 25th Oct Nov 2013 29th Nov
*Expiry – last Thursday of the month
You are on Sep 22.You have a Near Month, Middle Month and Far Month contractsto choose from.
Initial Margin (IM)Stock (ABC Ltd.) Futures (ABC Ltd. Futures)
Rs. 500 Rs. 510
Buy 1000 shares Buy 1000 Futures
Value = Rs. 5,00,000 Value = Rs. 5,10,000
Pay Rs. 5,00,000 Pay IM = Rs. 51,000
After 10 days :
Rs. 600 Rs. 610
RETURN = 20% RETURN = 196%
Steps in trading Futures
• Pay Initial Margin
• Buy or Sell Futures
• Daily Mark to Market Settlement
Pricing of Futures
• Futures price = Spot Price + Cost of carry
• Cost of carry = interest rate*
• At expiry : Futures price = Spot price
*for financial futures
Pricing - Futures
Feb 10, you have Rs. 100.
How much will it become on March 10.
Depends on how much interest you can earn
If it is 12% p.a., then after 1 month Rs. 100 will become =
Rs. 101
F = S + Int.
Rs. 101 = Rs. 100 + Re. 1
Futures Payoff
• A payoff is the likely profit or loss that would accrue to a market participant with change in the price of the underlying asset
• Futures have a linear payoff, i.e. the losses as well as profits for the trader of futures contract are unlimited
Payoff diagram for futures
PROFITS
LOSSES
Rs. 2500 Rs. 500
Buy RELIANCE FUTURES @ Rs. 250
Rs. 300
Sell @ Rs. 300
Linear Pay Off
Rs. 50
PROFITS
LOSSES
Payoff diagram for futures
Sell RELIANCE FUTURES @ Rs. 250
Buy @ Rs. 200
Linear Pay Off
Rs. 250Rs. 200
Final Settlement – convergence of Futures to Spot
Time
(a)
FuturesPrice
Spot Price
• On the final settlement day/ expiry day, the Futures contract is settled at the underlying closing price (spot price)
• Cash Settlement
Futures
Contract Descriptor:
• FUTSTK ACC 28 SEP2013
• FUTIDX NIFTY28 SEP2013
• Trading in Index Futures
Options
• Hyundai is launching a car - SONATA
• Price is Rs. 15 Lacs. [Purchase price]
• You can book the car by paying Rs. 50,000 [deposit]
Options
• By booking the car, what have you bought?» A RIGHT to buy the car
• When booking matures, can Hyundai force you to buy SONATA?
» Hyundai has only OBLIGATION
• Can you force Hyundai to sell SONATA?
Introduction to Options
An options contract gives the buyer the
right, but not the obligation to Buy or Sell a
specified underlying at a set price on or
before a specified date
: eg. Car Purchase, Insurance
Options
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy. Puts give the buyer the right to sell but not the obligation to sell.
Options
• CALL OPTIONS : Gives the buyer of the Call Option the RIGHT to buy at the STRIKE PRICE
• CALL OPTIONS : The Seller of the Call Option has to meet his OBLIGATION of selling when the buyer EXERCISES his right
• The Buyer retains the RIGHT to Exercise or not Exercise
Call Option
• The Buyer of an Options needs to pay to the
Seller the PRICE of the Option.
• This is called as the PREMIUM.
• It is paid immediately on buying the Option.
• The Seller receives the Premium on T+1 day.
Call Option
Sep 15,Underlying Price Strike Price Premium
Rs. 100 Rs. 80 Rs. 30
Sep 28,Underlying Price can be above, at or below Strike Price
Rs. 112Rs. 81Rs. 75
At which underlying price Buyer will exercise the Option ?
Call Option
Sep 15, 2013
Underlying Price
Rs. 100
Strike price
Rs. 80
Premium
Rs. 30
Buyer’s Pay – Off (Dec. 24)
Underlying Pay off Net P/L
Rs. 200 Rs. 120 +Rs. 90
Rs. 160 Rs. 80 + Rs. 50
Rs. 120 Rs. 40 + Rs. 10
Rs. 110 Rs. 80 Rs. 0
Rs. 90 Rs. 10 - Rs. 20
Rs. 80 Nil - Rs. 30
Rs. 70 Nil - Rs. 30
Rs. 50 Nil - Rs. 30
Call Option• Buyer : Unlimited Profits, Limited Losses
• Seller : Unlimited Losses, Limited Profits
• Buyer : Losses Limited to the premium (max. loss)
• Seller : Profits Limited to the premium
(max. gain)
Call Option
• Exercise Point : U > SP
• Break Even point : U = SP + Premium
• Net profit : U > SP + Premium
Classification of Options• Type
– Call or Put
• Exercise style
– EUROPEAN is an option that can be exercised only on its expiration date
– AMERICAN is an option that can be exercised any time up until and including its expiration date
• Settlement– Cash or physical
Options Terminology• Index options: Have index as the underlying
• Stock Options: Have stock as the underlying
• Option buyer: Buys the option by paying premium and gets the right to exercise options on writer/seller
• Option seller: Sells/writes the option and receives the premium and is hence under obligation to buy/sell asset if the buyer exercises option
• Option premium: Price paid by the buyer to seller to acquire the right. Comprises of Intrinsic Value and Time Value
• Strike / Exercise price: Price at which the underlying may be purchased or sold
• Expiry date: It’s last Thursday of the month for options to be exercised/ traded. Options cease to exist after expiry
Options Terminology
Options Payoff
• Optional characteristics of options results in a non linear payoff for options. Non linear payoffs provide flexibility to create combinations
• Losses of the buyer is limited to the premium paid and profits are unlimited
• For writers/sellers losses are unlimited and profits limited to the premium received
THE PAY OFF DIAG. - OPTIONS
• PROFITS AND LOSSES ON CALLS AND PUTS• Security – ACC
100
PROFITS
CALLS
LOSSES
100
LOSSES
PROFITS
PUTS
20 120
20
80
Exercises……….
Options
Contract Descriptor:
• OPTSTK ACC 420 28SEP2013 CE
• OPTIDX CNXIT 2200 24NOV2013 PE
• OPTIDX NIFTY 6000 24NOV2013 PE
RIGHTCALLS Buyer Buy at the strike price at expiry
OBLIGATIONSeller Sell at the strike price at expiry
RIGHTPUTS Buyer Sell at the strike price at expiry
OBLIGATIONSeller Buy at the strike price at expiry
CALLS & PUTS – RIGHTS AND OBLIGATION
BUYER OF AN OPTION
PAYS PREMIUM
PREMIUM IS THE MAXIMUM LOSS THE BUYER CAN SUFFER
SELLER OF AN OPTION
RECEIVES PREMIUM
PREMIUM IS THE MAXIMUM PROFIT THE SELLER CAN MAKE
APPLICABLE FOR BOTH CALLS AND PUTS
Understanding Premium
Premium is the price paid buy the Buyer to acquire an Option
Premium = Intrinsic Value of the Option + Time Value
Call Option Strike Price = Rs. 150 Underlying = Rs. 165
Calculate Premium?
Put Option Strike Price = Rs. 167 Underlying = Rs. 178
Calculate Premium
Spot value of NIFTY is 2240. An investor buys a oneMonth NIFTY 2227 put option for a premium of Rs.17.The option is________.
• Out of the money
• In the money
• At the money
• Above the money
NCFMNCFM
A call option that is out-of-the-money or at-the-money has ________.
only time value only intrinsic value
face value no value
NCFMNCFM
A put option is in-the-money if the price ofthe underlying asset is __________ thestrike price.
• Above• Below• Equal to• Between the premium and strike price
NCFMNCFM
Spot value of NIFTY is 2230. An investor buys a one
Month NIFTY 2245 call option for a premium of Rs.5.
After One month the spot value of NIFTY is 2250. The
Option is _________.
• In the money
• At the money
• Above the money• Out of the money
NCFMNCFM
An index put option at a strike of Rs. 2176 is selling at a premium of Rs. 28. At what index level will it break even for the buyer of the option?
•Rs. 2148•Rs. 2196•Rs. 2204•Rs. 2194
NCFMNCFM
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Certain Concepts - Options
• In the money- positive cash flow if
exercised
immediately
• At the money - zero cash flow if
exercised immediately
• Out of the money - negative cash flow if
exercised
immediately
Options
• New contracts are introduced at the ‘End of Day’ based on the underlying prices
• There would be minimum :
5 ITM
1 ATM &5 OTM contracts available
Options contracts (example)
Underlying - ACC Ltd. Rs. 100 Rs. 120 Rs. 125
Rs. 115 OTM contracts Rs. 110
Rs. 105ATM Rs. 100
Rs. 95 ITM contracts Rs. 90
Rs. 85 Rs. 80 Rs. 75
• Each month, Calls & Puts• Minimum number of strikes – 66(11 X 2 X 3)
Option - Strike Price Intervals• For Nifty Options - 10• For Options on Individual Securities:
Price of UnderlyingStrike Price Interval
Rs.
Less than or equal to Rs. 50 2.5
>50 ≤Rs.250 5
>250 ≤Rs.500 10
>500 ≤Rs.1000 20
>1000 ≤Rs.2500 30
>Rs.2500 50
Intrinsic value
Price of an option is called ‘Premium’
Premium = Intrinsic value + time value
Intrinsic value is the amount the contract is inthe money –e.g. Spot = 1000, Strike Price = 990 March CallPremium = Rs 15 (Intrinsic value = Rs. 10, timevalue = 5)
Exercises…………..
Options Pricing
• Intrinsic Value (IV )
Difference between spot and strike
ITM has IV, ATM and OTM have zero IV
• Time Value ( TV )
Difference between the premium and intrinsic value
ITM have both IV and TV, ATM and OTM have only TV
Longer the expiry more the TV, on expiry TV is 0
APPLICATIONS
Has a directional view on the market.
No position in the underlying.
Bullish : Buy Futures
Bearish : Sell Futures
Have a view on a security?•Believe market would go up
•What you can do today•Buy the security•Pay the entire money and take delivery
•What is the issue?•Costly to buy the security
•Opportunity cost of the investment
• What you could do •Buy Futures
Have a view on a Stock? Assumed figures
• 01 Sep 2013
• feels the market will rise– Buys 1 contract of Near month ABC Ltd. futures at Rs. 260 (market lot : 1000)
• 09 Sep 2013–ABC Ltd. futures has risen to Rs. 280– Sells off the position at Rs. 280
–Makes a profit of Rs.20000 (1000*20)
Have a view on the Market?• Believe market would go down
•What you can do today•Sell the security•Arrange for delivery by borrowing of security
• What is the issue?•Procedures of borrowing of securities•Cost of borrowing•Limited lenders and stringent conditions
• What you could do•Sell Futures
Have a view on a Stock? Assumed figures
• 1st Sep 2013• feels the market will fall•Sells 1 contract of March ABC Ltd. futures at Rs. 285 (1 contract is 1000 shares)
25th Sep 2013•ABC Ltd. Futures contract is trading at Rs. 265•Squares off his position at 265 •Makes a profit of Rs.20000 (1000*20)
Leverage
• Beginning of investment
– Shares of Reliance are trading at Rs.250– March futures are trading at Rs.260
• End of Investment– Shares of Reliance are trading at Rs.260
– March futures are trading at Rs.270
• Assume a margin of 15% for SSFs• Compare returns in securities with SSFs
Leverage
ABC Ltd. ABC Ltd. Futures
Initial price Rs.250 Rs.260
Initial Investment Rs.250 Rs.39 (IM)
Squaring up price Rs.260 Rs.270
Net gain Rs.10 Rs.10
Retn on investment 4.00% 25.64%
Hedging
• HEDGERS are traders who buy or sell to offset a risk exposure in the spot market
• Beta measures relationship between movement of the market (index) to the movement of the stock, e.g. HINDLEVER has a Beta of 1.30
• Index has beta of 1
• To hedge, sell Index Futures
• This is known as hedging
Hedging• When you Buy a Stock what do you get?
RISK
UNSYSTEMATIC SYSTEMATIC
•Company Specific Risk
•Diversifiable Risk
•Market Specific Risk
•Non-Diversifiable Risk
Nifty Futures
• It is a Futures contract on the Nifty index• Just like Reliance Futures is a futures contract
on Reliance Industries Ltd., Nifty Futures is a contract on the Nifty index
• If you feel Reliance share price will go up you buy Reliance Futures
• If you feel Nifty will go up, buy Nifty Futures• Cash settled
Have a view on the Market? Assumed figures
• 01 March 2007– feels the market will rise– Buys 1 contract of Near month Nifty futures at Rs. 2800 (market lot : 50)
• 09 March 2007–Nifty futures has risen to Rs. 2850– Sells off the position at Rs. 2850
–Makes a profit of Rs. 2500 (50*50)
Hedging – Managing market risk•14th March
• An investor buys HLL worth Rs. 900,000 @ Rs. 290 per share (3100 shares)•The expiry date of Nifty March futures is 27th Mar •Nifty index is at 4100 and Nifty futures is trading at Rs. 4110•The beta of Hindlever is 1.13•To hedge the investor needs to sell [Rs. 9,00,000*1.13] = Rs. 10,17,000 worth of index futures (= 250 Nifty Futures)
•19th March•Nifty futures is trading at Rs. 3915 and HLL is trading at Rs. 275 •Investors loss in HLL is Rs. 46,500•Nifty Futures position gains by Rs. 48,750•Investor gains Rs. 2250/-
Hedging• What has hedging done :
– Prevented losses inspite of a fall in the value of the underlying
– Investor can continue to hold the underlying while taking care of intermittent losses
– Hedging can be done by anyone with an exposure to an underlying asset class
Hedging using Stock Futures
– Investor buys 2000 shares of Infosys @ Rs. 390
– Portfolio value is Rs. 7,80,000
– Infosys near month futures trades at Rs. 402
– To hedge, sell 2000 Infosys futures
– Underlying spot price falls to Rs. 300 on expiry
– Loss on Shares – Rs. 180,000
– Profit on Futures – Rs. 204,000
– Net gain = Rs. 24,000
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Arbitrage - How ?• 04/03/2007
• Satyam Ltd. price: Rs.280
• Near month futures on Satyam: Rs.286
• Diff. for 1 month (6/280) = 26% p.a.
– Buy Satyam Ltd. : 1200 shares (investment Rs.336,000)
– Sell 1 futures contract (contract size assumed 1200)
• 27/03/2007 (date of expiry) Satyam price: Rs.310
– Sell Satyam Shares & Futures contract expires at Rs.310 per unit
• Payoff (for a month)
– Gain on spot (310-280)*1200 = Rs. 36000
– Loss on futures (286-310)*1200 = Rs. 28800
– Total gain = Rs.7200; 26% p.a.
Strategy to be adopted when the diff. between futures & spot is greater than prevailing
interest rate
Options
Share Call Option
Initial price Rs.250 Rs.260
Initial Investment Rs.250 Rs. 2
Squaring up price Rs.300 Rs.300
Net gain Rs.50 Rs.38
Retn on investment 20.00% 1900.00%
Options
Share Call Option
Initial price Rs.250 Rs.260
Initial Investment Rs.250 Rs. 250
Squaring up price Rs.300 Rs.300
Net gain Rs.50 Rs.4750
Retn on investment 20.00% 1900.00%
ADVANCE OPTION STRATEGIES
• Bullish Vertical Spreads Using Calls Using Puts
• Bearish Vertical Spreads Using Calls• Straddle Long Straddle Short Sraddle• Strangle Long Strangle Short Strangle• CoveredCall
• Butterfly Spread
Bullish Vertical SpreadsUsing Calls
• View- Underlying price will go up– But likes to reduce the cost – Buy a lower strike call and sell a higher strike call
– Example– Spot is 6000, Go long on 5800 strike Call by paying premium of Rs.
300 and sells a call of 6200 strike receiving a premium of Rs.145
– If price goes to 6200– Net position= 400-300+145=245 (max profit)– If price goes to 5500– Net Position=-300+145=155 (Max loss) – It is a limited profit and limited loss position– BEP is 5955
Bullish Vertical SpreadsUsing Puts
• View- Underlying price will go up– Net premium receipt strategy – Buy a lower strike put and sell a higher strike put
– Example– Spot is 6000, Go short on 6200 strike put by receiving premium of
Rs. 220 and buys a put of 6000 strike paying a premium of Rs.170
– If price goes to 5500– Net position= 220-700+500-170=-150 (max loss)– If price goes to 6500– Net Position=220-170=50 (Max profit) – It is a limited profit and limited loss position– BEP is 6150
Bearish Vertical SpreadsUsing Calls
• View- Underlying price will go down
– Short a lower strike high premium call and long a higher strike call with lesser premium
– Example– Spot is 6000, Go long on 6200 strike call by paying premium of Rs.
145 and shorts a call of 5800 strike receiving a premium of Rs.300
– If price goes to 5500– Net position= -145+300=155 (max profit)– If price goes to 6500– Net Position=-145+300-700+300=-245(Max loss) – It is a limited profit and limited loss position– BEP is 5955
Long Straddle
• View- Underlying price will move up or down significantly• Position: It involves two options of same strike price and same maturity
– Buy a ATM call and Put– Example
– Spot is 6000, Go long on 6000 strike call by paying premium of Rs.
257 and long a put of 6000 strike receiving a premium of Rs.136
– If price goes to 5300– Net position= -257+700-136=307 – If price goes to 6700– Net Position=700-257-136=307– As long as price keeps on moving up, call option position will
make unlimited profit and long put is limited to premium– BEP is beyond 6393 and 5607
Short Straddle
• View- Underlying price would not move much or stable• Position: It involves two options of same strike price and same maturity
– Net receipt of premiums– Example
– Spot is 6000, Go short on 6000 strike call by receiving premium of Rs. 257 and short a put of 6000 strike receiving a premium of
Rs.136
– If price goes to 5800– Net position= 257-200+136=193 – If price goes to 6400– Net Position=257-400+136=-7– It is limited profit and unlimited strategy.– Will make profit if the price closes between 6393 and 5607