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An Introduction to Derivatives

A presentation by Derivative Research

Why learn or talk about Derivatives.

Important Financial instrument – In fact the most widely traded or used financial instrument in currency, commodity and equities market.

Why are they used : - Risk control or hedge against any unforeseen event and leverage.

Good liquidity and ease of entry and exit.

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What are derivatives

Derivatives are financial instruments whose value depend on the value of other, more basic underlying assets.

Underlying asset can be a commodity, currency, equity, interest rate, exchange rate etc.

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Derivative Products

Futures Forwards Options

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Futures Contract

Futures contracts: Are entered into through exchange, traded on exchange

and clearing corporation/house provides the settlement guarantee for trades.

Are of standard quantity, standard quality.

Have standard delivery time and place.

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Introduction to futures

Choice of initial product: Index futures Options on index Stock futures Options on stocks

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Introduction to futures

Trading mechanismContract design: Price Lot size Tick size Expiration month and date Open interest, volume position

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Futures – definition

A futures is a legally binding agreement to buy or sell something in the future at a price which is determined today.

Pricing Futures = Spot+Cost of carry –dividend (if

any)

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Operational Mechanism

Cash settled

Initial Margin (upfront)

Mark-to-Market margin (daily)

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Option - definition

Option is the right given by the option seller to the option buyer to buy or sell specific asset at a specific price on or before a specific date.

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How much does an option cost?

The premium is the price you pay for the option.

For buyer of an option Risk : limited to the amount of premium paid Profit potential: unlimited

For a seller of an option• Risk – Unlimited.• Profit Potential – limited to the premium recd.

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Option Terminology Call Option

– Option to buy

Put Option– Option to sell

Option Buyer– has the right but not the obligation

Option Writer/Seller– has the obligation but not the right

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Option Terminology

Option Premium– Price paid by the buyer to acquire the right

Strike Price OR Exercise Price– Price at which the underlying may be purchased

Expiration Date– Last date for exercising the option

Exercise Date– Date on which the option is actually exercised

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Strike Prices

In-the-money– Option with intrinsic value

At-the-money– Exercise Price = Market Price

Out-of-the-money– No intrinsic value– some time value possible

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Types of Options

American Option (options on stocks)– can be exercised any time on or before the

expiration date

European Option (options on index)– can be exercised only on the expiration date (options

on index)

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Call option

A buyer of call option has the right but not the obligation to buy the underlying at the set price by paying the premium upfront.

He can exercise his option on or before expiry.

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Break-even (Call option)

Call= strike +premium +fees

There are two ways you can liquidate your position.

exercise your option sell back the same option contract you

purchased.

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Nifty 4000 Call @ 105.20

CMP = Rs. 3935/- Lot Size = 50

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Call Buyer V/s Seller Call Buyer

– Pays premium– Has right to exercise resulting in a long position in

the underlying– Time works against buyer

Call Seller– Collects premium– Has obligation if assigned resulting in a short

position in the underlying– Time works in favor of seller

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Put option

A buyer of Put option has the right but not the obligation to sell the underlying at the set price by paying the premium upfront.

He can exercise his option on or before expiry.

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Break-even (Put option)

Put= strike -premium –fees

There are two ways you can liquidate your position.

exercise your option sell back the same option contract you

purchased.

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Put Buyer V/s Seller

Put Buyer– Pays premium– Has right to exercise resulting in a short

position in the underlying– Time works against buyer

Put Seller– Collects premium– Has obligation if assigned resulting in a long

position in the underlying– Time works in favor of seller

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Assignment

• When holder of an option exercises the right, a

randomly selected option seller is obligated to

be assigned into the underlying contract.

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Option Valuation

Option Premium = Intrinsic Value +

Time Value

Option Premium >= 0Intrinsic Value >= 0Time Value >= 0

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Option Valuation

Intrinsic Value– Difference between Exercise Price and Spot

Price– Cannot be negative– For a Call Option

• St - K– For a Put Option

• K - St

St = Spot price at time t

K = Strike Price of Option.

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Time Value

Amount buyers are willing to pay for the possibility that, at some time prior to expiration, the option may become profitable– Cannot be negative

An at-the-money option has the maximum time value of any strike price, i.e. more time value than either an in or out-of-the-money option.

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Factors affecting option values

Current Price of the underlying asset (S) Exercise Price of the option(K) Interest Rates (Rf) Time to Expiry (T) Volatility of prices of the underlying asset ()

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Key Points

• Options can be a very effective tool to take advantage of a rising or falling underlying. The following points may be kept in mind while purchasing options:• The time value of option premiums decay towards

expiration, so market timing is very important.• Choose an option month that allows enough time for

the anticipated move in the underlying.• In-the-money calls are initially more responsive to

underlying price changes than out-of-the-money calls.

• Choose a strike price level that offers a good risk/reward ratio given the expected price movement.

Option Greeks

Delta Gamma Vega Theta Rho

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Open Interest

Open Interest is an important indicator that can help one in ascertaining the flow of funds.

If the open interest rises with rise in price it is a bullish indication.

If open interest rises and prices fall it is a bearish indication.

If open interest falls and prices rise it is a sign of short covering by bears.

If open interest falls and prices also fall it is a sign of profit booking by bulls or liquidation of positions.

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Put Call Ratio

Put call ratio is an important indicator that can help one in gauging the future direction of the market.

If the Put call ratio rises then there is hope of higher prices in the near future.

If the Put call ratio falls it is a sign of weakness in the market.

Generally put call ratio is read along with volatility. PCR can be calculated for Open Interest/positions or

no of puts and calls traded. Historically – 1.06 -2.00 is bullish. Above 2 and

below 1.06 one may expect a sharp fall.

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VOLATILITY

There are two types of volatility – historic volatility and implied volatility.

Historic volatility is based on historic prices of the futures and implied volatility is based on the volatility calculated from options i.e. volatility implied by premiums in options.

If volatility rises and PCR falls, it has bearish implications.

If volatility falls and PCR rises, it has bullish implications.

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Trading Strategies

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STRATEGIES USING FUTURES

PUT HEDGE

CALL HEDGE

COVERED Call

ARBITRAGE/REVERSE ARBITRAGE

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PUT HEDGE

WHENPut hedge is used when we are bullish on some stock.And want to hedge our position if the prices move

downwards.

HOW In this strategy we first buy a future and then hedge our

position by buying a put immediately.

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Tata Steel Put HedgeBuy Future @ 461

Buy 460 PA @ 16

CMP = Rs. 461/- Lot Size = 675

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PUT HEDGE

PROBLEMS Which strike price. What time. Premium value.

Reversal of positions If any important support level is breached (a) We can reduce losses by squaring off the

position. (b) Squaring off the future an persisting with the

put.

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CALL HEDGE

WHENCall hedge is used when we are bearish on some stock.And want to hedge our position if the prices move up.

HOW In this strategy we first sell a future and then hedge our

position by buying a call immediately.

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Tata Steel Call HedgeSell Future @ 450

Buy 460 CA @ 20

CMP = Rs. 449.60/- Lot Size = 600

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CALL HEDGE

PROBLEMS Which strike price. What time. Premium value.

Reversal of positions If any important resistance level is breached (a) We can reduce losses by squaring off the

position. (b) Squaring off the future an persisting with the

call.

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COVERED CALL

WHEN This strategy is used when we are bullish on a stock. And want to reduce the cost of the future but it limits the profit

to the strike price of the call.

HOW In this strategy we first buy a future and sell a call of strike price

higher than the future price.

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IFCI Covered CallBuy Future @ 51

Sell 55 CA @ 2.50

CMP = Rs. 51/- Lot Size = 2150

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Option Spreads

• Buying a call (put) and selling a call (put) with different strike prices but the same expiration month.

• Two types of spreads• Bull Spreads• Bear Spreads

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Bull Call Spreads

Maximum loss occurs below lower strike price

Maximum profit occurs above upper strike price

Breakeven level equals:– Lower strike plus Premium

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Tata Steel Bull Call SpreadBuy 450 CA @ 18.00

Sell 460 CA @ 15.00

CMP = Rs. 382.45/- Lot Size = 400

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Bear Put Spreads

Maximum loss occurs above upper strike price

Maximum profit occurs below lower strike price

Breakeven level equals:– Upper strike minus Premium

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Reliance Bear Put SpreadBuy 1080 PA @ 50.00

Sell 1050 PA @ 40.00

CMP = Rs. 863.35/- Lot Size = 600

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Option Straddles

Consist of buying a put and buying a call (Long Straddle). Both legs have the same strike price and same expiration;

OR Consist of selling a put and selling a call (Short

Straddle). Both legs have the same strike price and same expiration.

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Long Straddles

Maximum loss is equal to net debit, or total premium paid

Maximum profit is unlimited Breakeven levels are equal to:

– common strike price plus or minus total premium paid

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NIFTY Long StraddleBuy 3900 CA @ 155

Buy 3900 PA @ 124

CMP = 3935 Lot Size = 50

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Short Straddles

Maximum profit is equal to total premium received

Maximum loss is unlimited

Breakeven levels are equal to:– common strike price plus or minus total premium

received

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SYNTHETIC LONG STRADDLE

Sell a future Cover it by buying two calls of same strike

price or of such strike price that the price is in between.

OR Vice versa

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Sell TATASTEEL Fu @ 420buy two 420 CA @ 15.00

-40

-30

-20

-10

0

10

20

30

370 380 390 400 410 420 430 440 450 460 470

Spot on Expiry

Pro

fit

& L

oss Strategy Payoff

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Profit When Price Went DownEg: GUJAMBCEM

DATE ACTION PRICE

02/03/2007 SELL FU 115

  BUY 115 CA 5.5

  BUY 115 CA 5.5

DATE ACTION PRICE

05/03/2007 BUY FU 108

  SELL 115 CA 3.75

  SELL 115 CA 3.75

  RESULT

PROFIT IN FU 7 Lot Size -2062.

LOSS IN CA 1.75*2

TOTAL PROFIT 3.5 7217

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Profit When Price Went UpEg: TATASTEEL

DATE ACTION PRICE

07/03/2007 SELL FU 420

  BUY 420 CA 15.70

  BUY 420 CA 15.70

DATE ACTION PRICE

13/03/2007 BUY FU 446

  SELL 420 CA 32.10

  SELL 420 CA 32.10

  RESULT

LOSS IN FU 26.00 Lot Size :675.

PROFIT IN CA 16.40*2

TOTAL PROFIT 6.80 4590

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Questions

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Thank You !!!