The concept of Derivatives as a trade able instrument is still in its nascent stages in India.

Moreover, before people actually understand the meaning of derivatives, they have been termed
as Derivatives are weapons of mass destruction- Warren Buffet. Derivatives are still regarded
as complex instruments which are understood only by few people in the industry. However, the
truth is that derivatives are simple contracts and easy to understand. The complexity comes in
deriving a fair price for these derivative instruments. For retail participants, pricing should never
be an issue and therefore they do not need to get into the complexities of fair price. They should
always have a view on the underlying asset price and trade derivatives at the current market
price. With the advent of algorithmic trading, which will trade for risk free arbitrages, the retail
participants can safely assume that the current price is the fair price at this point in time.

Various studies have been done on Derivatives, specifically Options to understand the pricing of
these instruments. However much more needs to be done in this field. Most of the research has
been on the theoretical aspect of modeling and mispricing, and very little research work is done
on practically employing strategies and its implementation for profit from a retail investors point
of view.

Derivatives such as options basically were designed as hedging tools, which eventually have
evolved to become the best speculation tools as the losses are limited in this instrument, whereas
the profits can be potentially unlimited.

An option is a tradable instrument which is a contract in which the buyer of the option has the
control and the right to exercise the contract if it is in his favor, or deny obliging the contract if
the prices are not in his favor.
To get this right, the option buyer pays a cost which is also called the premium. A trader need not
hold his position till the expiry; he can sell the contract at the prevailing premium.

Options traders can take multiple views on the market by trading a combination of options.
These combinations are called strategies. These strategies have a structured payoff at the end of
the expiry and hence it is easy to understand the risks involved before initiating a trade. With
some underlying assumptions or views on the market, one can make profits in the long run.

Any combination of buy or sell of call or put can result i n a structured payoff at the end of the
expiry. Based on this, a trader can take multiple views on the price of the asset. For instance, if a

trader is bullish, he can buy call option or sell put option. The choice of which to choose depends
on further specifying the view. If the trader is bullish in the sense he thinks the price of the asset
will increase above the breakeven point which is arrived at by strike + premium, he will buy a
call option of that strike price. If the trader has a view that the price of the asset will stay
anywhere above a particular strike price, then he can sell the put option of that particular strike
price. Thus, in case a trader sells a put of a lower strike price than the current market price, and
the price of the asset goes d own but still manages to remain above the strike price on the expiry
day, the put option seller will make profit. The decision to buy call or sell put is also dependent
on the risk the trader wishes to take, in case his view goes wrong. In selling a put, there can be
potentially unlimited loss, whereas, in buying a call option, the loss is limited to the premium
paid.

In a similar way, a trader can be bearish by buying a put or selling a call, depending on his
specific view.

An options trader can take few more views. He can take a view such that, he doesnt know in
which direction the price of the asset will go, but he knows that the price will move fast in any
one direction, due to an upcoming event after which the price of the asset will see a big move. Fo
r such a view, the trader can buy a call and buy a put. If the market sees a big move upside, the
call can make potentially unlimited profit, whereas the put will make limited loss to the extent of
the premium paid. If the asset price crashes down, the put will make huge profit and the call will
make limited loss to the extent of the premium paid. Thus, even when a trader cannot take a
directional view he can create a strategy by combining the payoffs of buy call and buy put. This
strategy is called a Straddle (if the strike price of call and put is the same) and Strangle (if strike
prices of both options are different).

Bull Call Spread:

For a bullish view, a trader can make a bull call spread, in which he buys a call at a strike price
near to the current value of the asset, also called the At the Money call, and sells a call of a
higher strike price, also known as Out of Money call. By buying an ATM call, th e trader will
start making profit as the price of the asset goes up. However, he will start losing after the price
of the asset goes above the strike price of the sold option. Thus one cannot achieve unlimited
profits but is sure to get some profit if the price of the asset goes up. The trader has given
premium to buy the ATM call and received premium in selling of the OTM call. Hence his total
outflow of cash becomes less. Now, if the price of the asset goes down, both the call options will

become zero. Hence the trader will lose the initial cash outflow only. Thus this is a strategy in
which there is limited loss and limited profit. This strategy usually gives a very good reward to
risk ratio. This is the best strategy known for retail investors.

Bear Put Spread:

Similarly for bearish view, a trader can make a bear put spread in which he buys an ATM put and
sells a put of the lower strike price which is OTM put. The trader will make limited profit if the
price of the asset goes down and makes a limited loss if the price of the asset goes up.

KEY TERMINOLOGIES
FUTURES: A financial contract obligating the buyer to purchase an asset (or the seller to
sell an asset), such as a physical commodity or a financial instrument, at a predetermined future
date and price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange. Some futures contracts may call for
physical delivery of the asset, while others are settled in cash. The futures markets are
characterized by the ability to use very high leverage relative to stock markets.

OPTIONS: A financial derivative that represents a contract sold by one party (option writer) to
another party (option holder). The contract offers the buyer the right, but not the obligation, to
buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price)
during a certain period of time or on a specific date (exercise date).
CALL OPTION: Call options provide the holder the right (but not the obligation) to purchase an
underlying asset at a specified price (the strike price), for a certain period of time. If the stock
fails to meet the strike price before the expiration date, the option expires and becomes
worthless. Investors buy calls when they think the share price of the underlying security will rise
or sell a call if they think it will fall. Selling an option is also referred to as ''writing'' an option.

PUT OPTION: Put options give the holder the right to sell an underlying asset at a specified
price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the option expires. Investors buy
puts if they think the share price of the underlying stock will fall, or sell one if they think it will
rise.
STRIKE PRICE: The price at which a specific derivative contract can be exercised.
PREMIUM: The income received by an investor who sells or "writes" an option contract to
another party.
IN THE MONEY:
1. For a call option, when the option's strike price is below the market price of the
underlying asset.
2. For a put option, when the strike price is above the market price of the underlying asset.
OUT OF THE MONEY: A call option with a strike price that is higher than the market price of
the underlying asset, or a put option with a strike price that is lower than the market price of the
underlying asset. An out of the money option has no intrinsic value, but only possesses extrinsic
or time value. As a result, the value of an out of the money option erodes quickly with time as it
gets closer to expiry. If it still out of the money at expiry, the option will expire worthless.
IMPLIED VOLATALITY: The implied volatility of an option contract is that value of
the volatility of the underlying instrument. In general, implied volatility increases when the

market is bearish and decreases when the market is bullish. This is due to the common
belief that bearish markets are more risky than bullish markets.
AT THE MONEY: A situation where an option's strike price is identical to the price of the
underlying security. Both call and put options will be simultaneously "at the money." An atthe-money option has no intrinsic value, but may still have time value. Options trading
activity tends to be high when options are at the money.

OBJECTIVES:
Stock markets have always been looked upon as speculators paradise and never as a source of
wealth creation. To add to the agony, Derivatives have only increased the pain of the retail
investors and kept them away from markets. This study is an attempt to prove that wealth
creation can be done with the help of derivatives.

To design an options strategy which when applied in a simple mechanical method, results

in long term wealth creation for retail investors.

To study investors psychology towards this options strategy and towards derivatives as a
whole.

METHODOLOGY:

Designing a direction neutral strategy with the help of options and back testing it
mechanically through secondary data available from NSE website. The strategy will be
executed at the open of every expiry month and close on the expiry date of that month. It
will be mechanically executed in the form of a simple algorithm for 7 years starting from

2008 and ending in 2014 and the cumulative profit will be recorded.
A survey was conducted with a mixed research design, to understand the psychology of
respondents towards investing in derivatives. Investment behavior of the respondents will
be recorded and their response to the option strategy will be assessed. The research will
also explore the reasons why the retail investor distances himself from derivatives and its
strategies. This research will be based on a questionnaire which will have open and
closed ended questions.

DATA ANALYSIS
Back testing of strategies:
Strategies or combination of option trades, which are done once and squared off on expiry are
called static strategies. Strategies begin with a view on the market. Options trading allow a trader
to take multiple views and hence there are various static strategies. Based on a view on all three
factors, a strategy involving combination of options can be formed. The research aims to test at
least 4 basic static strategies starting on a particular fixed day of the expiry and squaring off on
the closing price of the last day of the expiry. The objective of the back testing will be to know if
there is any static strategy which can yield profits in every month. Since the strategies are static,
they can be back tested from the secondary data available from the Bhav copies of past trading
days, available from NSE.

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ANALYSIS AND FINDINGS

This strategy attracts margins since there are short options. However, the margin investments are
not considered as investments as margins are allowed to be in the form of any collateral. Hence
only the cash outflow is considered as the new investment.

Out of the 7 years (84 months) in the back testing experiment, it is observed that

No. of profit months:

58

No. of loss months:

26

Maximum loss months in a year:

05

Maximum absolute loss in a month:

Rs. 139

No. of months with loss more than Rs.100

06

Net amount of only losses:

Rs. 1520

Maximum cumulative loss at any point:

Rs. 0

Initial investment:

Rs. 128.70

Cumulative profit at the end of the period:

Rs. 1375

Looking at the data, one can observe that the market has behaved in quite random manner. In
some months there had been extreme movements and in some there was no movement at all. The
direction of the market has been up in 46 months and down in 38 months from its starting point
of the expiry period. In these 7 years, markets have behaved in all risky scenarios and hence it
can be called an optimum sample for capital markets.

SURVEY:

A survey was conducted to study investors psychology towards derivatives.

It was a qualitative research wherein 30 investors were interviewed.

Investment behavior of the respondents was recorded and their response to the option
strategy was assessed. The research explored the reasons why the retail investor distances

himself from derivatives and its strategies.

From the 30 respondents, majority were reluctant from investing in
derivatives since they assume derivatives to be risky and complicated. It was
found that majority of them associated derivatives with share market without

willing to understand the concept of futures and options.

After studying their risk profile the above strategy named as Iron Butterfly
Spread was introduced and explained to those investors. This strategy was
selected since it was a mechanical strategy with limited risk. This strategy

was able to overcome major fear which retail investors face.

This strategy was able to convince 24 out of 30 respondents (80%) for trial.
The other 6 respondents had inherent phobia for derivatives and hence they
restricted themselves.

FINDINGS AND ANALYSIS

Reasons behind derivative phobia:

Reasons behind not investing in derivatives

3% 3%

share market phobia

risk factor

21%

complicated
24%

lack of knowledge
high margins
past experience/negative
reviews

14%

34%

24 respondents who were ready for trial were asked the percentage of total investment portfolio
they would invest in the above strategy :

% of investment portfolio
8%

4%
21%

less than 10%

10%-20%
20%-30%

17%

30%-40%
40%-50%
more than 50%
25%
25%