A PROJECT REPORT ON

DERIVATIVES MARKET

SUBMITTED BY

JASMEET SINGH NAGPAL

TY BFM (SEM V)

ROLL NO – 25

UNDER THE GUIDANCE OF

PROFESSOR -

GURU NANAK KHALSA COLLEGE

TO THE

UNIVERSITY OF MUMBAI

IN PARTIAL FULFILLMENT OF

BACHELOR OF COMMERCE

(FINANCIAL MARKETS)

2012-2013

CERTIFICATE

I hereby certify that JASMEET SINGH NAGPAL of Guru Nanak Khalsa College of TY BFM of sem v has completed the project on DERIVATIVES MARKET in the academic year 2012- 2013 under the guidance of Professor , the information submitted is true and original to the best of my knowledge.

signature of coordinator signature of the principal

signature of project guide signature of external examiner

College seal

DECLARATION

I JASMEET SINGH NAGPAL of TY BFM of Sem V hereby declare that I have completed this project on DERIVATIVES MARKET in the academic year 2012-2013. This information is true and original to the best of my knowledge.

signature of student

INDEX

CHAPTER UNITS TOPICS PG.NO

1INTRODUCTION

1.1 CONCEPT OF DERIVATIVES

1.2 ORIGIN OF FINANCIAL DERIVATIVES

1.3 ECONOMIC FUNCTIONS OF A DERIVATIVE MARKET

2 FUTURES

2.1Definition of Futures Contract

2.2: Terminologies in Futures Market

2.3: TYPES OF FUTURES CONTRACT

2.4: PURPOSE FOR TRADING IN FUTURES MARKET

2.5: What is a stock index futures contract?

2.6: Advantages of using Stock-Index Futures

3 FORWARDS3.1: Definition of Forwards contract

3.2 Settlement of forward contracts

3.3Default Risk in Forward Contract :

3.4Difference between Forward & Future Contract

4 OPTIONS

4.1 Definition of Options

4.2 Types of Options

4.3Options are different from Futures

4.4 Option Terminology

4.5 How to start Option Trading ?

CHAPTER UNITS TOPICS PG.NO

4.6Factors that affect the value of an option premium

4.7Different pricing models for options

4.8 Option Greeks

4.9 Benefits of Option Trading

5CONCLUSION

6ANALYSIS

CHAPTER 1: INTRODUCTION

1.1: CONCEPT OF DERIVATIVES

One of the most significant events in the securities market has been the

development and the expansion of financial derivatives. The term “derivatives”

is used to refer to financial instruments which derive their value from some

underlying assets. The underlying assets could be equities (shares), debt (bond,

T-bills and notes), currencies and even indices of these various assets such as

Nifty 50 Index. Derivatives derive their name from the respective underlying

asset. A simple example of derivative is butter, which is derivative of milk.

Theprice of butter depends upon price of milk, which in turn depends upon

thedemand and supply of milk.

The general definition of derivatives means toderive something from something

else.Derivatives can be traded either on a regulated exchange such as NSE or

off the exchanges i.e. directly between the different parties which is called “over

the counter” (OTC) trading. The basic purpose of derivatives is to transfer the

price risk (inherent in fluctuations of the asset prices) from one party to another.

They facilitate the allocation of risk to those who are willing to take it. In so

doing, derivatives help mitigate the risk arising from the future uncertainty of

prices. For example, on October 1, 2011 a rice farmer may wish to sell his

harvest at a future date (say January 1, 2012) for a pre- determined fixed price

to eliminate the risk of changes in prices by that date. Such a transaction is an

example of a derivatives contract. The price of derivative is driven by the spot

price of rice which is “underlying”.

According to the Securities Contract Regulation Act, (1956) the term

“derivative” includes:

(i) a security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument or contract for differences or any other form of

security;

(ii) a contract which derives its value from the prices, or index of prices, of

underlying security.

1.2: ORIGIN OF FINANCIAL DERIVATIVES

Financial derivatives have emerged as one of the biggest markets of the world

during the past two decades. A rapid change in technology has increased the

processing power of computers and has made them a key vehicle for

information processing in financial markets. Globalization of financial markets

has forced several countries to change laws and introduce innovative financial

contracts which have made it easier for the participants to undertake derivatives

transactions.

Early forward contracts in the US addressed merchants’ concerns about

ensuring that there were buyers and sellers for commodities. ‘Credit risk’,

however remained a serious problem. To deal with this problem, a group of

Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The

primary intention of the CBOT was to provide a centralized location (which

would be known in advance) for buyers and sellers to negotiate forward

contracts. In 1865, the CBOT went one step further and listed the first

‘exchange traded” derivatives contract in the US. These contracts were called

‘futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of

CBOT, was reorganized to allow futures trading. Its name was changed to

Chicago Mercantile Exchange (CME).

The CBOT and the CME remain the two largest organized futures exchanges,

indeed the two largest “financial” exchanges of any kind in the world today.

The first exchange-traded financial derivatives emerged in 1970’s due to the

collapse of fixed exchange rate system and adoption of floating exchange rate

systems. As the system broke down currency volatility became a crucial

problem for most countries. To help participants in foreign exchange markets

hedge their risks under the new floating exchange rate system. Foreign currency

futures were introduced in 1972 at the Chicago Mercantile Exchange. In 1973,

the Chicago Board of Trade (CBOT) created the Chicago Board Options

Exchange (CBOE) to facilitate the trade of options on selected stocks. The first

stock index futures contract wastraded at Kansas City Board of Trade. Currently

the most popular stock index futures contract in the world is based on S&P 500

index, traded on Chicago Mercantile Exchange. During the mid eighties,

financial futures became the most active derivative instruments generating

volumes many times more than the commodity futures. Index futures, futures on

T-bills and Euro- Dollar futures are the three most popular futures contracts

traded today

1.3: ECONOMIC FUNCTIONS OF A DERIVATIVE MARKET

The following are the various functions that are performed by thederivative

markets:

Prices in an organized derivative market reflect the perception ofmarket

participants about the future and lead the prices of underlyingto the perceived

future level.Derivative market helps to transfer risk from those who are

exposedto it but may like to mitigate it to those who have an appetite for

risk.Derivative market has helped in increasing savings and investmentin the

long run.

It would be useful to be familiar with two terminologies relating tothe

underlying markets:

1) Spot Market: In the context of securities, the spot market or cash marketis a

securitiesmarket in which securities are sold for cash and delivered

immediately. Thedelivery happens after the settlement period. The NSE’s cash

market segment is known as the Capital Market (CM). In this market, shares of

SBI, Reliance, InfosysSegment. In this market, shares of SBI, Reliance, Infosys

ICICI Bank, and other public listed companies are traded. The settlement period

in this market is on a T+2 basis i.e., the buyer of the shares receives the shares

two working days after trade date and the seller of the shares receives the

money two working days after the trade date.

2) Index: Stock prices fluctuate continuosly during any given period. Prices of

some stocks may move up while that of others may move down. In such a

situation,

What can we say about the stock market as a whole?

Has the market moved up or has it moved down during a given

period?

Similarly, have stocks of a particular sector moved up or down?

To identify the general trend in the market or any given sector of the market

such as telecommunication, it is important to have a reference barometer which

can be monitored. Market participants use various indices for this purpose. An

index is a basket of identified stocks, and its value is computed by taking the

weighted average of the prices of the constituent stocks of the index.

For example consists of a group of top stocks traded in the market and itsvalue

changes as the prices of its constituent stocks change. In India, Nifty

Index is the most popular stock index and it is based on the top 50 stockstraded

in the market. Just as derivatives on stocks are called stockderivatives,

derivatives on indices such as Nifty are called index derivatives

CHAPTER 2: FUTURES

2.1: Definition of Futures Contract

A futures contract is an agreement between two parties to buy or sell an asset at

a certain time in future at a certain price. These are basically exchange traded,

standardized contracts. The exchange stands guarantee to all transactions and

counterparty risk is largely eliminated.

The buyers of futures contracts are considered having a long position whereas

the sellers are considered to be having a short position. It should be noted that

this is similar to any asset market where anybody who buys is long and the one

who sells in short. Futures contracts are available on variety of commodities,

currencies, interest rates, stock and other tradable assets. They are highly

popular on stock indices, interest rates and foreign exchange.

A financial futures traded contract is an exchange traded contract for the

delivery of standardized amounts of the underlying financial instrument at a

future date. The price for financial instrument is agreed on the day contract is

bought or sold and gains or losses are incurred as a result of subsequent price

fluctuations. Unlike forward contracts, future contracts are readably tradable,

reflecting the standardization of contract terms.

The purchase or sale of a futures contract is, therefore a commitment to make or

take delivery of a specific financial instrument, at a predetermined price in

future, for which the price is established at the time of initial transaction.

Transactions are actually entered into the futures exchange through the open

outcry method on the exchange floor or through screen based trading

system.Contracts are standardized which mean the participants can buy and sell

freely on the futures exchange with precise knowledge of the contracts being

traded. The contract specifies both the type of the financial instrument and its

quality in terms of such matters as coupoun rate and maturity. The instruments

specified must be delivered at or during the specific month in future known as

delivery date usually in the cycle of March, June, September and December.

Exact delivery details vary according to the nature of investment or indicator.

For contracts based on stock market indices, no physical delivery can take place

and settlement is based on cash payment calculated on the movement of the

index.

Although contracts are traded between the buyer and the seller on the exchange

floor, each has an obligation not to the other, but to the clearing house. This

feature ensures that the future markets are free of credit risk.

Participants may offset equal no of bought and sold contracts of the same type

and delivery month and thereby closeout a position without actually

communicating the original countertparty.The transaction is simply closed

down once the deal is notified to the clearing house.

As the market moves, holders of open futures contract will see corresponding

profits and losses arising out of the positions. The standard nature of each future

contract makes gains or losses easy to measure. Movements are tracked in terms

of minimum price fluctuations allowed by the future exchanges which are

known as “ticks” and which carry a fixed value for each contract type.

2.2: Terminologies in Futures Market

2.2.1: Spot Price: The price at which an underlying asset trades in the spot

market

2.2.2: Futures Price: The price that is agreed upon at the time of the contract

for the delivery of an asset at a specific future date.

2. 2.3: Expiry Date: Is the date on which the final settlement of the contract

takes place

2.2.4: Basis:Basis is defined as the futures price minus the spot price. There

will be a different basis for each delivery month for each contract. In a normal

market, basis will be positive. This reflects that futures prices normally exceed

spot prices.

2.2.5: Contract Size: The amount of asset that has to be delivered under one

contract. This is also called as the lot size.

2.2.6: Contract Cycle: It is the period over which a contract trades. The index

futures contracts on the NSE have one-month, two-month and three-month

expiry cycles which expire on the last Thursday of the month. Thus a January

expiration contract expires on the last Thursday of January and a February

expiration contract ceases trading on the last Thursday of February. On the

Friday following the last Thursday, a new contract having a three-month expiry

is introduced for trading.

2.2.7: Cost of Carry: Measures the storage cost plus the interest that is paid to

finance the asset less the income earned on the asset.

2.2.8: Initial Margin: The amount that must be deposited in the margin account

at the time a futures contract is first entered into is known as initial margin.

2.2.9: Marking to Market: In the futures market, at the end of each trading day,

the margin account is adjusted to reflect the investor’s gain or loss depending

upon the futures account is adjusted to reflect the investor’s gain or loss

depending upon the futures closing price. This is called marking-to market.

2.2.10: Maintenance Margin:Investors are required to place margins with their

trading members before they are allowed to trade. 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.

2.3: TYPES OF FUTURES CONTRACT

On the basis of the underlying asset they derive, the futures are divided into two

types.

Index Futures:

Index futures are the futures, which have the underlying asset as an Index. The

Index futures are also cash settled. The settlement price of the Index futures

shall be the closing value of the underlying index on the expiry date of the

contract

Stock Futures:

The stock futures are the futures that have the underlying asset as the individual

securities. The settlement of the stock futures is of cash settlement and the

settlement price of the future is the closing price of the underlying security

Commodity Futures:

The basic concept of a Futures contract remains the same whether the

underlying happens to be a commodity or a financial asset. Due to the bulky

nature of the underlying assets, physical settlement in commodity, futures create

the need for warehousing.

Currency Futures:

When the underlying of Futures is an exchange rate, the contract is termed a

“currency futures contract”. In other words, it is a contract to exchange one

currency for another currency at a specified date and a specified rate in the

future. Therefore, the buyer and the seller lock themselves into an exchange rate

for a specific value and delivery date. Both parties of the futures contract must

fulfill their obligations on the settlement date

2.4: PURPOSE FOR TRADING IN FUTURES MARKET

1) Investment:Take a view on the market and buy or sell accordingly

2) Price Risk Transfer:Hedging is buying and selling futures contracts to offset

the risks of changing underlying market prices. Thus it helps in reducing the

risk associated with exposures in underlying market by taking a counter -

positions in the futures market. For example, the hedgers who either have

security or plan to have a security is concerned about the movement in the price

of the underlying before they buy or sell the security. Typically he would take a

short position in the Futures markets, as the cash and futures price tend to move

in the same direction as they both react to the same supply/demand factors.

3) Arbitrage:Since the cash and futures price tend to move in the same direction

as they both react to the same supply/demand factors, the difference between

the underlying price and futures price called as basis. Basis is more stable and

predictable than the movement of the prices of the underlying or the Futures

price. Thus arbitrageur would predict the basis and accordingly take positions in

the cash and future markets.

4) Leverage:Since the investor is required to pay a small fraction of the value of

the total contract as margins, trading in Futures is a leveraged activity since the

investor is able to control the total value of the contract with a relatively small

amount of margin. Thus the Leverage enables the traders to make a larger profit

or loss with a comparatively small amount of capital.

Marking to Market:The process of adjusting the amount in an investors margin

account in order to reflect the change in the settlement price of futures contract

on a daily basis is known as Marking to Market.

contract and

(ii) A short position of a contract, varies with the changes in settlement price

from day to day is given below

Profit Opportunities with Futures:

With futures, the trader can profit under a number of different circumstances.

When the trader initially purchases a futures contract he is said to be “long,”

and will profit when the market moves higher. When a trader initially sells a

futures contract he is said to be “short” and will profit.

Going short in a futures market is much easier than going short in other

markets. Other markets sometimes require the trader to actually own the item he

is shorting, while this is not the case with futures. Like most other markets, a

profit is obtained if you initially buy low and later sell high or initially sell high

and later buy low.

Pay off Futures:

Futures contracts have linear payoffs. It means that the losses as well as profits

for the buyer and the seller of a futures contract are unlimited.

Pay off for a Buyer of Futures: Long Future

The payoff for a person who buys a futures contract is similar to the payoff for a

person who holds an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside. Pay-off indicates the amount of profit or loss

one may arrive.

EXAMPLE:

Take the case of a speculator who buys a two month RELIANCE futures

contract when the reliance stands at 2000. The underlying asset in this case is

the reliance shares. When the reliance moves up, the long futures position starts

making profits, and when index moves down it starts making losses.

Profit

Loss

The pay-off for a long position in a futures contract on one unit of an asset is:

Long Pay-off = S T – F

1) Where F is the traded futures price and ST is the spot price of the asset at expiry

of the contract (that is, closing price on the expiry date). This is because the

holder of the contract is obligated to buy the asset worth ST for F.

2) In this case: ST=2500 and F=2000

If ST is greater than F, the investor makes a profit and higher the ST, the higher

is the profit. It shows the profits for a long futures position. The trader bought 1

lot (say 100 futures) when the Reliance spot was trading at 2000. The Reliance

spot went up by 500 points. He made a profit of INR 50,000 (2500-2000 * 100).

If the index falls, his futures position starts showing losses.

Pay off for Seller of Futures: Short Futures

The payoff for a person who sells a futures contract is similar to the payoff for a

person who shorts an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside.

EXAMPLE

Take the case of a speculator who sells a two-month RELIANCE futures

contract when the Reliance stands at 2000. The underlying asset in this case is

the Reliance shares. When the Reliance spot moves down, the short futures

position starts making profits, and when the index moves up, it starts making

losses.

1) The pay-off from a short position in a futures contract on one unit of asset is:

Short Pay-off = F – ST

In this case: ST=2000 and F =1500. If ST is less than F, the investor makes a

profit and the higher the ST, the lower the profit.

2) Above example shows profits for short futures position. The trader short sold

futures when the Reliance spot was trading at 2000. The Reliance spot went

down by 500 points. He made a profit of INR 50,000. (If 1 lot = 100 futures). If

the index rises, his futures position starts showing losses.

2.5: What is a stock index futures contract?

A stock-index futurescontract is a contract to buy or sell the face value of the

underlying stock index, where the face value is defined as being the value of

index multiplied by a specific monetary amount (called the multiplier)

This product makes it possible to equate the value of a stock index with that of a

specific basket of shares having the following specifications.

The total value of shares must match the monetary value of the index.

The shares selected must correspond to the set of shares used to create the

index.

The amount of each holding must be in proportion to the market capitalization

of each of the companies included in the index. The profit or loss from a stock-

index futures contract that is settled on the delivery is difference between the

value of index at delivery date and the value on the date of entering into the

contract. It is important to emphasize that the delivery at settlement date cannot

be underlying stocks of the index, but must be in cash. The futures index at

expiration is set equal to the cash index on that day.

2.6: Advantages of using Stock-Index Futures

1. Actual Purchase of Securities Not Involved: Stock index futures permit

investment in the stock market without the trouble and expense involved

in buying the individual securities.

2. Lower Transaction Costs: The transaction costs are typically 60-75%

lower than those for physical share transactions.

3. High Leverage Due To Margin System: Operating under a margining

system, stock index futures allow full participation in market moves

without significant commitment of capital. The margin levels allow

leverage of between 10 to 40 times.

4. Hedging of Share Portfolio: Portfolio managers for large share portfolios

can hedge the value of their investment against adverse price fluctuations

without having to alter the composition of portfolio periodically.

From the following simplified example, it will be clear how to use futures to

cover a position exposed to risk of upward movement in the equity markets.

Suppose that it is May 1, and an investment manager considers that the market

will rise prior to August 1 when he is due to receive Rs 5 lakhs to purchase a

diversified portfolio of equities. He can get the benefit of investing this sum at

today’s market level by buying sufficient BSE Sensex futures contract.

On May 1, the September contract (The nearest contract following the target

date of August 1) is priced at 2000. This means that one contract is worth Rs

50,000(i.e. the price of the index is 2, 00, 000 which is 2000 ticks each of is

worth Rs 25). Hence the manager needs to purchase 10 contracts (because

10*50,000 = Rs 5,00, 000).

Let us suppose that equity price do rise and by August 1, the BSE Sensex and

the September futures contract both stand at 2,200 i.e. both have increased by

10%. The value of each futures contract has increased by Rs 55,000. Hence the

10 contracts are worth Rs 5.5 lakhs.The investment manager can now sell his

futures contract and realize a Rs 50,000 profit. This added to the Rs 5 lakhs

anticipated receipt, leaves him Rs 5.5 lakhs to invest.

CHAPTER 3: FORWARDS

3.1: Definition of Forwards contract

A forward contract or simply a forward is a contract between two parties to buy

or sell an asset at a certain future date for a certain price that is pre-decided on

the date of the contract. The future date is referred to as expiry date and the pre-

decided price is referred to as Forward Price. It may be noted that Forwards are

private contracts and their terms are determined by the parties involved.

A forward is thus an agreement between two parties in which one party, the

buyer, enters into an agreement with the other party, the seller that he would

buy from the seller an underlying asset on the expiry date at the forward price.

Therefore, it is a commitment by both the parties to engage in a transaction at a

later date with the price set in advance. This is different from a spot market

contract, which involves immediate payment and immediate transfer of asset.

The party that agrees to buy the asset on a future date is referred to as a long

investor and is said to have a long position. Similarly the party that agrees to

sell the asset in a future date is referred to as a short investor and is said to have

a short position. The price agreed upon is called the delivery price or the

Forward Price

Forward contracts are traded only in Over the Counter (OTC) market and not in

stock exchanges. OTC market is a private market where individuals/institutions

can trade through negotiations on a one to one basis.

3.2: Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements possible

to settle the obligation of the parties: physical settlement and cash settlement.

Both types of settlements happen on the expiry date and are given below.

Physical Settlement

A forward contract can be settled by the physical delivery of the underlying

asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and

the payment of the agreed forward price by the buyer to the seller on the agreed

settlement date. The following example will help us understand the physical

settlement process.

Consider two parties (A and B) enter into a forward contract on 1 August, 2009

where, A agrees to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per

share, on 29th August 2011 (the expiry date). In 100 per share on 29 th August

2011 has a short position and B, who has committed to buy 1000 stocks at Rs.

100 per share is said to have a long position.

In case of physical settlement, on 29th August, 2011 (expiry date), A has to

actually deliver 1000 Unitech shares to B and B has to pay the price (1000 * Rs.

100 = Rs. 10,000) to A. In case A does not have 1000 shares to deliver on 29th

August, 2011, he has to purchase it from the spot market and then deliver the

stocks to B.

On the expiry date the profit/loss for each party depends on the settlement price,

that is, the closing price in the spot market on 29 th August 2011. The closing

price on any given day is the weighted average price of the underlying during

the last half an hour of trading in that day Depending on the closing price, three

different scenarios of profit/loss are possible for each

Scenario I: Closing spot price on 29 August, 2011 (S T) is greater than the

Forward price (FT ). Assume that the closing price of Unitech on the settlement

date 29 August, 2011 is Rs. 105. Since the short investor has sold Unitech at Rs.

100 in the Forward market on 1 August, 2011, he can buy 1000 Unitech shares

at Rs. 105 from the market and deliver them to the long investor. Therefore the

person who has a short position makes a loss of (100 – 105) X 1000 = Rs.

5000. If the long investor sells the shares in the spot market immediately after

receiving them, he would make an equivalent profit of (105 – 100 ) X 1000 =

Rs. 5000.

Scenario II. Closing Spot price on 29 August (S T), 2009 is the same as the

Forward price (F T). The short seller will buy the stock from the market at Rs.

100 and give it to the long investor. As the settlement price is same as the

Forward price, neither party will gain or lose anything

Scenario III. Closing Spot price (ST) on 29 August is less than the futures price

(F T) . Assume that the closing price of Unitech on 29 August, 2009 is Rs. 95.

The short investor, who has sold Unitech at Rs. 100 in the Forward market on 1

August, 2009, will buy the stock from the market at Rs. 95 and deliver it to the

long investor. Therefore the person who has a short position would make a

profit of (100 – 95) X 1000 = Rs. 5000 and the person who ha s long position in

the contract will lose an equivalent amount (Rs. 5000), if he sells the shares in

the spot market immediately after receiving them.

The main disadvantage of physical settlement is that it results in huge

transaction costs in terms of actual purchase of securities by the party holding a

short position (in this case A) and transfer of the security to the party in the long

position (in this case B). Further, if the party in the long position is actually not

interested in holding the security, then she will have to incur further transaction

cost in disposing off the security. An alternative way of settlement, which helps

in minimizing this cost, is through cash settlement

Cash Settlement

Cash settlement does not involve actual delivery or receipt of the security. Each

party either pays (receives) cash equal to the net loss (profit) arising out of their

respective position in the contract. So, in case of Scenario I mentioned above,

where the spot price at the expiry date (ST) was greater than the forward price

(F T), the party with the short position will have to pay an amount equivalent to

the net loss to the party at the long position. In our example, A will simply pay

Rs. 5000 to B on the expiry date. The opposite is the case in Scenario (III),

when ST< FT. The long party will be at a loss and have to pay an amount

equivalent to the net loss to the short party. In our example, B will have to pay

Rs. 5000 to A on the expiry date. In case of Scenario (II) where ST = FT, there

is no need for any party to pay anything to the other party. The profit and loss

position in case of physical settlement and cash settlement is the same except

for the transaction costs which is involved in the physical settlement.

3.3:Default Risk in Forward Contract

A drawback of forward contracts is that they are subject to default risk.

Regardless of whether the contract is for physical or cash settlement, there

exists a potential for one party to default, i.e. not honor the contract. It could be

either the buyer or the seller. This results in the other party suffering a loss.

This risk of making losses due to any of the two parties defaulting is known as

counter party risk. The main reason behind such risk is the absence of any

mediator between the parties, who could have undertaken the task of ensuring

that both the parties fulfill their obligations arising out of the contract. Default

risk is also referred to as counter party risk or credit risk

3.4: Difference between Forward & Future Contract

CHAPTER 4: OPTIONS

4.1: Definition of Options

Option is a type contract between two persons where one grants the other the

right to buy a specific asset at a specific price within a specified time period.

Alternatively the contract may grant the other person the right to sell a specific

asset at a specific price within a specific time period. . In order to have this

right, the option buyer has to pay the seller of the option premium.

Options are an important element of investing in markets, serving a function of

managing risk and generating income. Unlike most other types of investment

today, options provide a unique set of benefits. Not only does option trading

provide a cheap and effective means of hedging one’s portfolio against adverse

and unexpected price fluctuations, but it also offers a tremendous speculative

dimension to trading.

One of the primary advantage of option trading is that the option contracts

enable a trade to be leveraged, allowing the trader to control the full value of an

asset for a fraction of the actual cost. And since an options price mirrors that of

the underlying asset at the very least, any favorable return in the asset will be

met with greater percentage return in the option provides limited risk and

unlimited reward.

With options, the buyer can only lose what was paid for the option contract,

which is the fraction of what the actual cost of the asset would be. However the

profit potential is unlimited because the option holder possesses a contract that

performs in sync with the asset itself. If the outlook is positive for the security,

so too will the outlook be for that assets underlying options. Options also

provide their owners with numerous trading alternatives. Options can be

customized and combined with other options and even other investments to take

advantage of any possible price dislocation within the market. They enable the

trader or them investor to acquire a position that is appropriate for any type of

market outlook that he or she may have, be it bullish, bearish, choppy or silent.

A derivative security is any security in whole or in part the value of which is

based upon the performance of another underlying instrument, such as option , a

warrant or any hybrid securities.

Typically, option trading is more cumbersome and complicated than stock

trading because traders consider many variables aside from the direction they

believe market will move. The effects of the passage of time, variables such as

delta and the underlying market volatility on the price of the option are just

some of the many items that prudent in ones investment decision, one could

potentially lose a lot of trading options. Those who disregard careful

consideration and sound money management techniques often find out the hard

way that these factors can quickly and easily erode the value of their option

portfolios.

4.2: Types of Options

Call Option

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

specified quantity of the underlying asset at the strike price on or before

expiration date. The seller (one who is short call) however, has the obligation to

sell the underlying asset if the buyer of the call option decides to exercise his

option to buy.

Example: An investor buys One European call option on Infosys at the strike

price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the

day of expiry is more than Rs. 3500, the option will be exercised

The investor will earn profits once the share price crosses Rs. 3600 (Strike Price

+ Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor

will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in

the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) –

Premium

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say

suppose it touches Rs. 3000, the buyer of the call option will choose not to

exercise his option. In this case the investor loses the premium (Rs 100), paid

which should be the profit earned by the seller of the call option. Premium

Put Option

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

specified quantity of the underlying asset at the strike price on or before an

expiry date.

Example: An investor buys one European Put option on Reliance at the strike

price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on

the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the

money'.

The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e.,

investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys

Reliance share in the market @ Rs. 260/- & exercises his option selling the

Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15

{(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Reliance is Rs 320/

-, the buyer of the Put option will choose not to exercise his option to sell as he

can sell in the market at a higher rate. In this case the investor loses the

premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the

put option.

The Options Game

Call Option Put Option

Option buyer or

option holder

Buys the right to buy the

underlying asset at the

specified price

Buys the right to sell the

underlying asset at the

specified price

Option seller or

option writer

Has the obligation to sell

the underlying asset (to the

option holder) at the

specified price

Has the obligation to buy

the underlying asset (from

the option holder) at the

specified price

4.3: Options are different from Futures

Futures are agreements/contracts to buy or sell specified quantity of the

underlying assets at a price agreed upon by the buyer and seller, on or before a

specified time. Both the buyer and seller are obligated to buy/sell the underlying

asset. Futures Contracts have symmetric risk profile for both buyers as well as

sellers, whereas options have asymmetric risk profile.

In options the buyer enjoys the right and not the obligation, to buy or sell the

underlying asset. In case of Options, for a buyer (or holder of the option), the

downside is limited to the premium (option price) he has paid while the profits

may be unlimited. For a seller or writer of an option, however, the downside is

unlimited while profits are limited to the premium he has received from the

buyer.

The futures contracts prices are affected mainly by the prices of the underlying

asset. Prices of options are however, affected by prices of the underlying asset,

time remaining for expiry of the contract and volatility of the underlying asset.

It costs nothing to enter into a futures contract whereas there is a cost of

entering into an options contract, termed as Premium

4.4:Option Terminology

4.4.1: Underlying - The specific security / asset on which an options contract is

based.

4.4.2: Option Premium - This is the price paid by the buyer to the seller to

acquire the right to buy or sell.

4.4.3: Strike Price or Exercise Price - The strike or exercise price of an option

is the specified/ pre-determined price of the underlying asset at which the same

can be bought or sold if the option buyer exercises his right to buy/ sell on or

before the expiration day.

4.4.4: Expiration date - The date on which the option expires is known as

Expiration Date. On Expiration date, either the option is exercised or it expires

worthless.

4.4.5: Exercise Date - is the date on which the option is actually exercised. In

case of European Options the exercise date is same as the expiration date while

in case of American Options, the options contract may be exercised any day

between the purchase of the contract and its expiration date (see European/

American Option)

4.4.6:Assignment - When the holder of an option exercises his right to buy/ sell,

a randomly selected option seller is assigned the obligation to honor the

underlying contract, and this process is termed as Assignment.

4.4.7: Open Interest - The total number of options contracts outstanding in the

market at any given point of time.

4.4.8: Option Holder - is the one who buys an option which can be a call or a

put option. He enjoys the right to buy or sell the underlying asset at a specified

price on or before specified time. His upside potential is unlimited while losses

are limited to the Premium paid by him to the option writer.

4.4.9: Option seller/ writer - Is the one who is obligated to buy (in case of Put

option) or to sell (in case of call option), the underlying asset in case the buyer

of the option decides to exercise his option. His profits are limited to the

premium received from the buyer while his downside is unlimited.

4.4.10: Option Class - All listed options of a particular type (i.e., call or put) on

a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex

Put Options

4.5: How to start Option Trading?

Before we devote our attention to more sophisticated option applications, it is

important that we introduce a basic option foundation. While this introduction

to options will be descriptive in its scope, its coverage will by no means be

exhaustive. The sheer magnitude of option terminology and strategy could

comprise an entire book on its own, and that is not our primary focus.

Therefore, we will only be addressing the items necessary to understanding

option basics and the techniques we will be presenting throughout the book.

This simple introduction is tailored to those who are unfamiliar with options

Whether they apply to stocks, indices, or futures, all options work in the same

manner. Simply stated, an option is a financial instrument that allows the owner

the right, but not the obligation, to acquire or to sell a predetermined number of

shares of stock or futures contracts in a particular asset at a fixed price on or

before a specified date. With each option contract, the holder can make any of

three possible choices: exercise the option and obtain a position in the

underlying asset; trade option, closing out the trader’s position in the contract

by performing an offsetting trade; or let the option expire if the contract lacks

value at expiration, losing only what was paid for the option..

Option contracts are identified using quantity, asset expiration date, strike price,

type, and premium. With the exception of the option’s premium, each of these

items is standardized upon issuance of a listed option contract. In other words,

once an option contract is created, its rights are static; the price that one would

pay for those rights is not; it is dynamic and determined by market forces.

Seeing as there are many items which make up the definition of an option

contract, it is important that each be addressed before moving on.

The first aspect of an option contract is the option’s quantity. The number of

shares or contracts that can be obtained upon exercising an exchange-listed

option contract is standardized. Each stock option contract allows the holder of

that option to control 100 shares of the underlying security while each futures

option contract can be exercised to obtain one contract in the underlying futures

contract

Another item that identifies the option contract is the asset itself. The asset

refers to the type of investment that can be obtained by the option holder. This

asset could be a futures contract, shares of stock in a company, or a cash

settlement in the case of an index contract

The type of option is critical in determining the trader’s market outlook.

Unlike trading stocks or futures themselves, option trading is not simply being

long a particular market or short a particular market. Rather, there are two types

of options, call options and put options, and two sides to each type, long or

short, allowing the trader to take any of four possible positions. One can buy a

call, sell a call , buy a put , sell a put or any combination thereof.

It is important to understand that trading call options is completely separate

from trading put options. For every call buyer there is a call seller; while for

every put buyer there is a put seller. Also keep in mind that option buyers have

rights, while option sellers have obligations. For this reason, option buyers have

a defined level of risk and option sellers have unlimited risk.

A call option is a standardized contract that gives the buyer the right, but not the

obligation, to purchase a specific number of shares or contracts of an underlying

security at the option’s strike prices, or exercise price, sometime before the

expiration date of the contract. Buying a call contract is similar to taking a long

position in the underlying asset, and one would purchase a call option if one

believed that the market value of the asset was going appreciate before the date

the option expires. The most trader can lose by purchasing a call option is

simply the price that he or she pays for the option; the most the trader can make

is unlimited

On the other side of the transaction, the seller, or writer, of a call options has the

obligation, not the right, to sell a specific number of shares or contracts of an

asset to the option buyer at the strike price, if the option is exercised prior to its

expiration date. Selling a call contract acts as a proxy for a short position in the

underlying asset, and one would sell a call option if one expected that themarket

value of the asset would either decline or move sideways

The most an option seller can make on the trade is the price he or she initially

receives for the option contract; the most the trader can lose is unlimited. In

order to offset a long position in a call option contract, one must sell a call

option of the same quantity, type, expiration date, and strike price. Similarly, in

order to offset a short position in a call option contract, one must buy a call

option of the same quantity, type, expiration date, and strike price

Long

With respect to this booklet’s usage of the word, long describes a position (in

stock and/or options) in which you have purchased and own that security in

your brokerage account. For example, if you have purchased the right to buy

100 shares of a stock, and are holding that right in your account, you are long a

call contract. If you have purchased the right to sell 100 shares of a stock, and

are holding that right in your account, you are long a put contract. If you have

purchased 1,000 shares of stock and are holding that stock in your brokerage

account, or elsewhere, you are long 1,000 shares of stock.

When you are long an equity option contract:

You have the right to exercise that option at any time prior to its expiration.

Your potential loss is limited to the amount you paid for the option contract.

PAYOFF DIAGRAM Profit diagrams for a Long Call and a Long Put

LONG CALL

OUTLOOK = BULLISH

S = STRIKE PRICE

BEP = BREAK-EVEN-POINT = S+DR

DR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSS

MAXIMUM GAIN = UNLIMITED

LONG PUT

OUTLOOK = BEARISH

S = STRIKE PRICE

BEP = BREAK-EVEN-POINT = S-DR

DR= DEBIT = INITIAL OPTION COST = MAXIMUM LOSS

MAXIMUM GAIN= UNLIMITED

Profit

Underlying asset

Loss

With respect to this booklet’s usage of the word, short describes a position in

options in which you have written a contract (sold one that you did not own). In

return, you now have the obligations inherent in the terms of that option

contract. If the owner exercises the option, you have an obligation to meet. If

you have sold the right to buy 100 shares of a stock to someone else, you are

short a call contract. If you have sold the right to sell 100 shares of a stock to

some-one else, you are short a put contract. When you write an option contract

you are, in a sense, creating it. The writer of an option collects and keeps the

premium received from its initial sale.

When you are short (i.e., the writer off) an equity option contract:

- You can be assigned an exercise notice at any time during the life of the

option contract. All option writers should be aware that assignment prior

to expiration is a distinct possibility.

-Your potential loss on a short call is theoretically unlimited. For a put, the risk

of loss is limited by the fact that the stock cannot fall below zero in price.

Although technically limited, this potential loss could still be quite large if the

underlying stock declines significantly in price.

PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short Put

SHORT CALL

OUTLOOK = BEARISH

S = STRIKE PRICE

BEP = BREAK-EVEN-POINT = S+CR

CR = CREDIT =

INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN

MAXIMUM LOSS = UNLIMITED

SHORT PUT

OUTLOOK = BULLISH

S = STRIKE PRICE

BEP = BREAK-EVEN-POINT = S-C

CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM

GAIN

MAXIMUM LOSS = UNLIMITED

A put option is a standardized contract that gives the buyer the right, but not the

obligation, to sell a predetermined number of shares or contracts of an

underlying security at the option’s strike price, or exercise price, sometime

before the expiration date of the contract.

A put contract is similar to taking a short position in the underlying asset, and

one could purchase a put option contract if one believed that the market price of

the asset was going to decline at some point before the date the option expires.

The most a trader can lose by purchasing a put option is simply the price that he

or she pays for the option; the most the trader can make is unlimited (in reality,

it is the full value of the underlying asset which is realized if its price declines to

zero).

Conversely, the seller, or writer, of a put option has the obligation, not the right,

to buy a specific number of shares or contracts of an asset to the option buyer at

the strike price, assuming the option is exercised prior to its expiration date.

Selling a put contract acts as a substitute for a long position in the underlying

asset, and a trader would sell a put contract if he or she expected the market

value of the asset to either increase or move sideways. Again, the most an

option seller can make on the trade is the price he or she initially receives for

the option contract; the most the seller can lose is unlimited (in reality, the most

one can lose is the full value of the underlying asset which is realized if its price

declines to zero.

In order to offset a long position in a put option contract, one must sell a put

option of the same quantity, type, expiration date, and strike price. Similarly, in

order to offset a short position in a put option contract, one must buy a put

option of the same quantity, type, expiration date, and strike price.

Open

An opening transaction is one that adds to, or creates a new trading

position. It can be either a purchase or a sale. With respect to an option

transaction, consider both:

Opening purchase – a transaction in which the purchaser’s intention is to create

or increase a long position in a given series of options.

Opening sale – a transaction in which the seller’s intention is to create or

increase a short position in a given series of options.

Close

A closing transaction is one that reduces or eliminates an existing position

by an appropriate offsetting purchase or sale. With respect to an option

transaction:

Closing purchase – a transaction in which the purchaser’s intention is to reduce

or eliminate a short position in a given series of options. This transaction is

frequently referred to as “covering” a short position.

Closing sale – a transaction in which the seller’s intention is to reduce or

eliminate a long position in a given series of options.

Note: An investor does not close out a long call position by purchasing a put,

or vice versa. A closing transaction for an option involves the purchase or sale

of an option con-tract with the same terms, and on any exchange where the

option may be traded. An investor intending to close out an option position must

do so by the end of trading hours on the option’s last trading day

.Call buyers want the market price of the underlying security to go higher so the

option will gain in value and they can make money; and call writer want the

market to go sideways or lower so the option will expire worthless and they can

make money.

Put buyers want the market price of the underlying security to go lower so the

option can gain in value and they can make money; and put sellers want the

market price to go higher or sideways so the option will expire worthless and

they can make money. Also, option buyers can choose whether they wish to

exercise their options; option sellers cannot.

The strike price or exercise price is simply the price at which the underlying

security can be obtained or sold if one were to exercise the option.

For a call option, the strike price is the price at which the holder can buy the

security from the option writer upon exercising the option. For a put option, the

strike price is the price at which the holder can sell the security to the option

writer upon exercising the option. These option strike prices are standardized,

with the strike increments determined by the asset’s price.

Which of the standardized strike prices the trader chooses depends upon his or

her investment needs and capital outlay. Obviously, depending upon the

prevailing underlying market price, the rights to some option strike prices will

cost more than others.

Strike prices for futures options contracts are different than those for stock

options. Much like options on stock, the trader can choose from any of the

standardized futures option strike prices that are issued. However, the strike

prices that are set for the futures options are more contract-specific, contingent

upon the market price of the underlying contract, how the future is priced, and

how it trades

The expiration date refers to the length of time through which the option

contract and its rights are active. At any time up to and including the expiration

date, the holder of an option is entitled to the contract’s benefits, which include

exercising the option (taking a position in the underlying asset), trading the

option (closing one’s position in the contract by trading it away to another

individual), or letting it expire worthless (if the contract lacks value at

expiration). While the trader can choose from any of the listed option expiration

months he or she wishes to purchase (or sell), the trader cannot choose the

specific date the option will expire. This date is standardized and is determined

when the option is listed on the exchange on which it is traded. For most options

on equity securities, the final trading day occurs on the third Friday of each

month. The actual expiration occurs the following day, the Saturday following

the third Friday of the month.

The expiration date for futures options is more complicated than that for stock

options and depends upon the contract that is being traded. Some futures option

contracts expire the Saturday before the third Wednesday of the expiration

month while others expire the month before the expiration month. Since an

option’s expiration date depends upon the type of asset that is traded, it is

important for a trader to know the specific date the contract will expire before

investing in the option.

American Style of options

An American style option is the one which can be exercised by the buyer

on or before the expiration date, i.e. anytime between the day of purchase of the

option and the day of its expiry.

European Style of Options

The European kind of option is the one which can be exercised by the buyer on

the expiration day only & not anytime before that.

Leverage and Risk

Options can provide leverage. This means an option buyer can pay a relatively

small premium for market exposure in relation to the contract value (usually

100 shares of underlying stock). An investor can see large percentage gains

from comparatively small, favorable percentage moves in the underlying index.

Leverage also has downside implications. If the underlying stock price does not

rise or fall as anticipated during the lifetime of the option, leverage can magnify

the investment’s percentage loss. Options offer their owners a predetermined,

set risk. However, if the owner’s options expire with no value, this loss can be

the entire amount of the premium paid for the option. An uncovered option

writer, on the other hand, may face unlimited risk.

Moneyness of Option

An option is said to be 'at-the-money', when the option's strike price is

equal to the underlying asset price. This is true for both puts and calls A call

option is said to be in-the-money when the strike price of the option is less than

the underlying asset price. For example, a Sensex call option with strike of 3900

is 'in-the-money', when the spot Sensex is at 4100 as the call option has value.

The call holder has the right to buy a Sensex at 3900, no matter how much the

spot market price has risen. And with the current price at 4100, a profit can be

made by selling Sensex at this higher price.

On the other hand, a call option is out-of-the-money when the strike price is

greater than the underlying asset price. Using the earlier example of Sensex call

option, if the Sensex falls to 3700, the call option no longer has positive

exercise value. The call older will not exercise the option to buy Sensex at 3900

when the current price is at 3700.

Striking the Price

Call Option Put Option

In-the-money Strike Price less than Spot

Price of underlying asset

Strike Price greater

than Spot Price of

underlying asset

At-the-money Strike Price equal to Spot

Price of underlying asset

Strike Price equal to

Spot Price of

underlying asset

Out-of-the-

money

Strike Price greater than

Spot Price of underlying

asset

Strike Price less than

Spot Price of

underlying asset

A put option is in-the-money when the strike price of the option is greater than

the spot price of the underlying asset. For example, a Sensex put at strike of

4400 is in-the-money when the Sensex is at 4100. When this is the case, the put

option has value because the put holder can sell the Sensex at 4400, an amount

greater than the current Sensex of 4100.

Likewise, a put option is out-of-the-money when the strike price is less than the

spot price of underlying asset. In the above example, the buyer of Sensex put

option won't exercise the option when the spot is at 4800. The put no longer has

positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if the

exercise price is at significant variance with the underlying asset price.

The amount by which an option, call or put, is in-the-money at any given

moment is called its intrinsic value. Thus, by definition, an at-the-money or out-

of-the-money option has no intrinsic value; the time value is the total option

premium. This does not mean, however, these options can be obtained at no

cost. Any amount by which an option’s total premium exceeds intrinsic value is

called the time value portion of the premium.

It is the time value portion of an option’s premium that is affected by

fluctuations in volatility, interest rates, dividend amounts and the passage of

time. There are other factors that give options value, therefore affecting the

premium at which they are traded. Together, all of these factors determine time

value.

Option Premium = Intrinsic Value + Time Value

4.6: Factors that affect the value of an option premium

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:

Underlying stock price,

The strike price of the option,

The volatility of the underlying stock,

The time to expiration and;

The risk free interest rate.

Non-Quantifiable Factors:

Market participants' varying estimates of the underlying asset's future volatility

Individuals' varying estimates of future performance of the underlying asset,

based on fundamental or technical analysis

The effect of supply & demand- both in the options marketplace and in the

market for the underlying asset

The "depth" of the market for that option - the number of transactions and the

contract's trading volume on any given day.

4.7: Different pricing models for options

The theoretical option pricing models are used by option traders for calculating

the fair value of an option on the basis of the earlier mentioned influencing

factors. An option pricing model assists the trader in keeping the prices of calls

& puts in proper numerical relationship to each other & helping the trader make

bids & offer quickly. The two most popular option pricingmodels are:

1) Black Scholes Model which assumes that percentage change in the price of

underlying follows a normal distribution.

2) Binomial Model which assumes that percentage change in price of the

underlying follows a binomial distribution.

Options Premium is not fixed by the Exchange. The fair value/ theoretical price

of an option can be known with the help of pricing models and then depending

on market conditions the price is determined by competitive bids and offers in

the trading environment.

An option's premium / price is the sum of Intrinsic value and time value

(explained above). If the price of the underlying stock is held constant, the

intrinsic value portion of an option premium will remain constant as well.

Therefore, any change in the price of the option will be entirely due to a change

in the option's time value.

The time value component of the option premium can change in response to a

change in the volatility of the underlying, the time to expiry, interest rate

fluctuations, dividend payments and to the immediate effect of supply and

demand for both the underlying and its option.

Covered and Naked Calls

A call option position that is covered by an opposite position in the underlying

instrument (for example shares, commodities etc), is called a covered call.

Writing covered calls involves writing call options when the shares that might

have to be delivered (if option holder exercises his right to buy), are already

owned.

E.g. A writer writes a call on Reliance and at the same time holds shares of

Reliance so that if the call is exercised by the buyer, he can deliver the stock.

Covered calls are far less risky than naked calls (where there is no opposite

position in the underlying), since the worst that can happen is that the investor is

required to sell shares already owned at below their market value.

When a physical delivery uncovered/ naked call is assigned an exercise, the

writer will have to purchase the underlying asset to meet his call obligation and

his loss will be the excess of the purchase price over the exercise price of the

call reduced by the premium received for writing the call.

Intrinsic Value of an option

The intrinsic value of an option is defined as the amount by which an option is

in-the-money or the immediate exercise value of the option when the underlying

position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be a positive number or 0. It cannot be

negative. For a call option, the strike price must be less than the price of the

underlying asset for the call to have an intrinsic value greater than 0. For a put

option, the strike price must be greater than the underlying asset price for it to

have intrinsic value.

Time Decay

Generally, the longer the time remaining until an options expiration, the higher

its premium will be. This is because the longer an option’s lifetime, greater is

the possibility that the underlying share price might move so as to make the

option in-the-money. All other factors affecting an option’s price remaining the

same, the time value portion of an option’s premium will decrease (or decay)

with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s

life. When an option expires in-the-money, it is generally worth only its

intrinsic value.

Expiration Day

The expiration date is the last day an option exists. For listed stock options, this

is the Saturday following the third Friday of the expiration month. Please note

that this is the deadline by which brokerage firms must submit exercise notices

to Stock Exchange Clearing; however, the exchanges and brokerage firms have

rules and procedures regarding deadlines for an option holder to notify his

brokerage firm of his intention to exercise. This deadline, or expiration cut-off

time, is generally on the third Friday of the month, before expiration Saturday,

at some time after the close of the market. Please contact your brokerage firm

for specific deadlines. The last day expiring equity options generally trade is

also on the third Friday of the month, before expiration Saturday. If that Friday

is an exchange holiday, the last trading day will be one day earlier, Thursday.

Exercise

If the holder of an American-style option decides to exercise his right to buy (in

the case of a call) or to sell (in the case of a put) the underlying shares of stock,

the holder must direct his brokerage firm to submit an exercise notice to Stock

Exchange Clearing. In order to ensure that an option is exercised on a particular

day other than expiration, the holder must notify his broker-age firm before its

exercise cut-off time for accepting exercise instructions on that day.

Note: Various firms may have their own cut-off times for accepting exercise

instructions from customers. These cut-off times may be specific for different

classes of options and different from Stock Exchange Clearing’s requirements.

Cut-off times for exercise at expiration and for exercise at an earlier date may

differ as well.

Once Stock Exchange Clearing has been notified that an option holder wishes to

exercise an option, it will assign the exercise notice to a Clearing Member – for

an investor, this is generally his brokerage firm – with a customer who has

written (and not covered) an option contract with the same terms. Stock

Exchange clearing will choose the firm to notify at random from the total pool

of such firms. When an exercise is assigned to a firm, the firm must then assign

one of its customers who has written (and not covered) that particular option.

Assignment to a customer will be made either randomly or on a “first-in first-

out” basis, depending on the method used by that firm. You can find out from

your brokerage firms.

Assignment

The holder of a long American-style option contract can exercise the option at

any time until the option expires. It follows that an option writer may be

assigned an exercise notice on a short option position at any time until that

option expires. If an option writer is short an option that expires in-the-money,

assignment on that contract should be expected, call or put. In fact, some option

writers are assigned on such short contracts when they expire exactly at-the-

money. This occurrence is generally not predictable.

To avoid assignment on a written option contract on a given day, the position

must be closed out before that day’s market close. Once assignment has been

received, an investor has absolutely no alternative but to fulfill his obligations

from the assignment per the terms of the contract. An option writer cannot

designate a day when assignments are preferable. There is generally no exercise

or assignment activity on options that expire out-of-the-money. Owners

generally let them expire with no value.

What’s the Net?

When an investor exercises a call option, the net price paid for the underlying

stock on a per share basis will be the sum of the call’s strike price plus the

premium paid for the call. Likewise, when an investor who has written a call

contract is assigned an exercise notice on that call, the net price received on a

per share basis will be the sum of the call’s strike price plus the premium

received from the call’s initial sale.

When an investor exercises a put option, the net price received for the

underlying stock on per share basis will be the sum of the put’s strike price less

the premium paid for the put. Likewise, when an investor who has written a put

contract is assigned an exercise notice on that put, the net price paid for the

underlying stock on per share basis will be the sum of the put’s strike price less

the premium received from the put’s initial sale.

Early Exercise/ Assignment

For call contracts, owners might exercise early so that they can take possession

of the underlying stock in order to receive a dividend. Check with your

brokerage firm and/or tax advisor on the advisability of such an early call

exercise. It is therefore extremely important to realize that assignment of

exercise notices can occur early – days or weeks in advance of expiration day.

As expiration nears, with a call considerably in-the-money and a sizeable

dividend payment approaching, this can be expected. Call writers should be

aware of dividend dates, and the possibility of an early assignment.

When puts become deep in-the-money, most professional option traders will

exercise them before expiration. Therefore, investors with short positions in

deep in-the-money puts should be prepared for the possibility of early

assignment on these contracts.

Volatility

Volatility is the tendency of the underlying security’s market price to fluctuate

either up or down. It reflects a price change’s magnitude; it does not imply a

bias toward price movement in one direction or the other. Thus, it is a major

factor in determining an option’s premium. The higher the volatility of the

underlying stock, the higher the premium because there is a greater possibility

that the option will move in-the-money. Generally, as the volatility of an under-

lying stock increases, the premiums of both calls and puts overlying that stock

increase, and vice versa.

4.8: Option Greeks

The price of an Option depends on certain factors like price and volatility of the

underlying, time to expiry etc. The Option Greeks are the tools that measure the

sensitivity of the option price to the above-mentioned factors. They are often

used by professional traders for trading and managing the risk of large positions

in options and stocks. These Option Greeks are:

1) Delta: Is the option Greek that measures the estimated change in option

premium/price for a change in the price of the underlying.

2) Gamma: Measures the estimated change in the Delta of an option for a change

in the price of the underlying

3) Vega: Measures estimated change in the option price for a change in the

volatility of the underlying.

4) Theta: Measures the estimated change in the option price for a change in the

time to option expiry.

5) Rho: Measures the estimated change in the option price for a change in the risk

free interest rates.

How the Greeks help in hedging

Spreading is a risk-management strategy that employs options as the

hedging instrument, rather than stock. Like stock, options have directional risk

(deltas). Unlike stock, options carry gamma, Vega, and theta risks as well.

Therefore, if a position involves any combination of gamma, vega, and/or theta

risk, this can be reduced or eliminated by adding one or more options positions.

Table 1-1 summarizes the possible hedges and their gamma, vega and theta

impact for each of the six building blocks.

Notice that owning option contracts be they puts or calls, means that you are

adding positive gamma, positive vega, and negative theta. Being short either of

these contracts means acquiring negative gamma, negative vega, and positive

theta. This statement points out that as far as these Greeks are concerned, you

get a package deal.

By owning options, our position responds favorably to stock-price movement

(the position gets longer as the stock price increases and gets shorter as the

stock price decreases). The position responds positively to increases in implied

volatility (and negatively to decreases in implied volatility) and will lose value

over time. By being short options, your position responds adversely to stock-

price movement (the position gets shorter as the stock price increases and gets

longer as the stock price decreases). The position also responds negatively to

increases in implied volatility (and positively to decreases in implied volatility)

and will gain value over time as the time premium of the short option decays.

4.9: Benefits of Option Trading

Besides offering flexibility to the buyer in form of right to buy or sell, the major

advantage of options is their versatility. They can be as conservative or as

speculative as one's investment strategy dictates.

Some of the benefits of Options are as under:

1) High leverage as by investing small amount of capital (in form of premium),

one can take exposure in the underlying asset of much greater value.

2) Pre-known maximum risk for an option buyer

3) Large profit potential and limited risk for option buyer

4) One can protect his equity portfolio from a decline in the market by way of

buying a protective put wherein one buys puts against an existing stock

position.

5) This option position can supply the insurance needed to overcome the

uncertainty of the marketplace. Hence, by paying a relatively small premium

(compared to the market value of the stock), an investor knows that no matter

how far the stock drops, it can be sold at the strike price of the Put anytime until

the Put expires.

E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks

that the stock is over-valued and decides to buy a Put option' at a strike price of

Rs. 3800/- by paying a premium of Rs 200/-

If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs

3800/- by exercising his put option. Thus, by paying premium of Rs 200,his

position is insured in the underlying stock.

How can you use options for short-term trading?

If you anticipate a certain directional movement in the price of a stock, the right

to buy or sell that stock at a predetermined price, for a specific duration of

timecanoffer an attractive investment opportunity. The decision as to what type

of option to buy is dependent on whether your outlook for the respective

security is positive (bullish) or negative (bearish).

If your outlook is positive, buying a call option creates the opportunity to share

in the upside potential of a stock without having to risk more than a fraction of

its market value (premium paid).Conversely, if you anticipate downward

movement, buying a put option will enable you to protect against downside risk

without limiting profit potential.

Purchasing options offer you the ability to position yourself accordingly with

your market expectations in a manner such that you can both profit and protect

with limited risk.

Risks of an options buyer

The risk/ loss of an option buyer is limited to the premium that he has

paid.

Risks for an Option writer

The risk of an Options Writer is unlimited where his gains are limited to

the Premiums earned. When a physical delivery uncovered call is exercised

upon, the writer will have to purchase the underlying asset and his loss will be

the excess of the purchase price over the exercise price of the call reduced by

the premium received for writing the call.

The writer of a put option bears a risk of loss if the value of the

underlying asset declines below the exercise price. The writer of a put bears the

risk of a decline in the price of the underlying asset potentially to zero.

Option writing is a specialized job which is suitable only for the knowledgeable

investor who understands the risks, has the financial capacity and has sufficient

liquid assets to meet applicable margin requirements. The risk of being an

option writer may be reduced by the purchase of other options on the same

underlying asset thereby assuming a spread position or by acquiring other types

of hedging positions in the options/ futures and other correlated markets. In the

Indian Derivatives market, SEBI has not created any particular category of

options writers. Any market participant can write options. However, margin

requirements are stringent for options writers.

CHAPTER 5: CONCLUSION

This project concludes that derivatives are powerful and innovative product

which transfer the risk from those who do not want to take it at a price to those

who are capable of and expert in managing risk. Hedger, Speculator and

Arbitrageurs are the people who are prepared to deal with the risk.

Financial institution are very sensitive to the risk exposer measures so they look

Forward to derivatives market and use various innovative products like

Forward, Future, Options and Swaps.

Indian derivatives market is strongly routed through the stock exchanges and

commodities market derivatives. Future traders deal through the stock

exchanges in a standardize manner. NSE India is the Pioneer of derivatives

product in India.

Derivatives are important tools which help in growth of Indian Capital Markets.

SEBI on time to time issue various guidelines to all the dealers of derivatives to

bring transparency in the working.

.1 Analysis

Survey Questions

1} Education and qualification of investor who investing in derivative market?

Under Graduate 6

Graduate 10

Post graduate 23

Professional 11

2} Income range of investor who invest in derivative market ?

Income range Number Of Result

Below 1,50,000 01

1,50,000 - 3,00,000 09

3,00,000 – 5,00,000 14

Above 5,00,000 16

3} Why people do not invest in derivative market ?

Results Number of result

Lack of knowledge and understanding 27

Increase speculation 02

Risky and highly leveraged 17

Counter party risk 04

4] What is the purpose of investing in derivative market ?

Purpose of investment Number of result

Hedge their fund 27

Risk control 9

More stable 1

Direct investment without holding & buying asset

13

5} You participate in derivative market as?

Participation as Number of result

Investor 23

Speculator 02

Broker / Dealer 08

Hedger 17

6} From where you prefer to take advice before investing in derivative market ?

Advice from

Number of result

Brokers 15

Research analyst 7

Websites 2

News network 23

Others 3

7} In which of the following would you like to participate ?

Participate in Number of result

Stock index future 19

Stock index option 13

Future on individual stock 06

Currency future 09

Options on individual stock 03

ANNEXURE

1) How are derivatives settled in India?

Derivative transactions are currently settled in cash.

2) Are the risks involved in derivative trading more than trading in the spot

market?

Yes, sometimes the investors can lose huge amounts within a short span of time

in derivatives much more than possible losses in the cash market given similar

invested amounts.

3) When one make profits will in Future contracts?

If you have bought Futures and the price goes up, you will make profits.

If you have sold Futures and the price goes down, you will make profits.

4) What is the derivatives scenario in India?

Derivative instruments are highly traded in India since its inception in June

2000 on NSE. If you see the amount of contracts traded in the exchanges it is

continuously on a uproll from the past.

5) What are the things which are important while trading in derivatives

It is very important for individuals to know that derivatives are highly

leveraged instruments, it can also prove highly risky instrument as the losses are

also high in derivatives. So proper research and risk management strategy must

be adopted before trading in derivative instruments.