Basics of Derivative Trading

FINANCIAL MARKETS

SPOT/ CASH MARKET DERIVATIVES

FUTURES OPTIONS

1
 Derivatives Defined

• It is a product whose value is derived from the value of

one or more variables –bases \underlying asset which
could be equity,commodity,forex,other
equity commodity forex other asset
asset.

2
 Derivative Products

The most commonlyy used derivative p

products are
Forwards, Futures and Options.

F
Forwards
d -
Is a customized contract between two parties to buy or sell
an asset on a specified date in the future for a specified
price.
They are traded outside the exchanges
p
Are exposed to counter p
party
y risk.

3
 Derivative Products

Futures
– These are agreements between two parties to buy or sell an asset at a
certain time in the future at a certain price.
– Futures contracts are standardized and exchange traded. This makes them
highly liquid unlike the forward contracts
contracts.
– Supply and demand on the secondary market determines the futures
price.
– Index futures are all futures contracts where the underlying
y g is the stock
index (Nifty or Sensex) and helps a trader to take a view on the market as a
whole.
– In India we have index futures contracts based on S&P CNX Nifty and the
BSE Sensex and near 3 months duration contracts are available at all
times.
– Each contract expires on the last Thursday of the expiry month and
simultaneously a new contract is introduced for trading after expiry of a
contract
contract.

4
 Example of a futures trade
• Buy 1 contract of Nifty Futures @ 5400
• Total contract value is 5400 x 50 lot size
• = Rs.2,70,000.
• Margin is approximately 15%
• Means that trader pays only Rs.40,500 to control Rs.2,70,000.
 Example of a futures trade

– If Nift
Nifty moves tto 5700
5700.

– Profit is 5700-5400 = 300

– Total profit is 300 x lot size of 50 = 15000

– (15000/40500) x 100 = 37% return

– Nifty
Nift moved
d only
l 55.55%.
55% (5400 tto 5700)
 Types of future contracts

• In terms of underlying asset

– Index Fut
– Stock Fut
• In terms of expiry
– Near Month
– Next Month
– Far Month
 Futures Terminology

• Basis – Futures price minus spot price. In a normal market

basis is positive as futures prices normally exceed spot prices.
• Cost of carry – Relationship between futures prices and spot
prices. It measures the storage cost plus the interest paid to
finance the asset less the income earned on the asset.
• Initial margin – Amount deposited in the margin a/c at the time
a futures contract is first entered into.
• Marking-to-market – At the end of each day, margin a/c is
adjusted to reflect the investor’s gain or loss.
• Maintenance margin – lower than initial margin.
margin Set to ensure
that balance in margin a/c never becomes negative. If balance
in a/c falls below maintenance margin, investor receives a
g call.
margin
 Open interest (OI)
Open interest indicates the total gross outstanding open positions in
the market for that particular series.

The most useful measure of market activity y is Open

p interest,, which
is also published by exchanges and used for technical analysis.
Open interest indicates the liquidity of a market and is the total
number of contracts, which are still outstanding in a futures market
for a specified futures contract.

p interest is therefore a measure of contracts that have not been

Open
matched and closed out. The number of open long contracts must
equal exactly the number of open short contracts.
 Open interest (OI) - continued
Action Resulting open interest
New buyer (long) and new seller (short) Trade to form Rise
a new contract.
Existing buyer sells and existing seller buys –The old Fall
contract is closed.
New buyer buys from existing buyer. The Existing No change – there is no increase in long
buyer closes his position by selling to new buyer. contracts being held

Existing seller buys from new seller. The Existing No change – there is no increase in short
seller
se e ccloses
oses his
s pos
position
t o by buy
buying
g from
o new
e seseller.
e contracts
co t acts being
be g held
ed

Price Open interest Market

Strong
Warning signal
Weak
Warning signal
 Daily margining
Daily margining is of two types:

1. Initial margins : The initial margin amount is large enough to cover a one-day loss that can be
encountered on 99% of the days.

2. Mark-to-market p profit/loss : The daily

y settlement process
p called "mark-to-market" p provides for
collection of losses that have already occurred (historic losses) whereas initial margin seeks to
safeguard against potential losses on outstanding positions. The mark-to-market settlement is done
in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to

demonstrate the margins payments that would occur.
• A client purchases 4 contract of FUTIDX NIFTY 29JUN2001 at Rs 1500. (Lot size 50)
• The initial margin payable as calculated by VaR is 15%.
Total long position = Rs 3,00,000 (4*1500*50)
(4 1500 50)
Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as
follows:
 Daily margining - continued
Position on Day 1
Close Price Loss Margin released Net cash outflow

1400*50*4 20,000 (3,00,000-2,80,000) 3,000 (45,000-42,000) 17,000

=2,80,000 (20,000-3000)
Payment to be (17 000)
(17,000)
made

New position on Day 2

Value of new position = 1,400*50*4= 2,80,000 Margin = 42,000

Close Price Gain Addn Margin Net cash inflow

1510*50*4 22,000 (3,02,000- 3,300 (45,300-42,000) 18,700 (22,000-3300)

=3,02,000 2,80,000)
Payment to be 18,700
recd
 Daily margining - continued
Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 45,300

Close Price Gain Net cash inflow

1600*50*4 =3,20,000 18,000 (3,20,000-3,02,000) 18,000 + 45,300* = 63,300

Payment to be recd 63,300

 Margin Account
Margin account*
Initial margin = Rs 45
45,000
000
Margin released (Day 1) = (-) Rs 3,000
Position on Day 2 Rs 42,000
Addn margin = ((+)) Rs 3,300
Total margin in a/c Rs 45,300*

Net gain/loss
Day 1 (loss) = (Rs 17,000)
Day 2 Gain = Rs 18,700
Day 3 Gain = Rs 18,000
Total Gain = Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total
cash inflow at the close of trade is Rs 65000
 Derivative Products - Options

• Options
Gives the holder the right to do something, but not the
obligation.
obligation
Purchaser of option has to pay something for this right – in the
form of a premium.
One can also sell/write options and receive an option premium
from the buyer.
y A seller is obliged
g to sell/buyy an asset if the
buyer exercises it on him.

5
 Types of Options

• Index Options – Have the index as the underlying.

underlying
• Stock Options – Options which have stocks as the
underlying asset.
• Call Option – Gives the holder the right but not the
obligation to buy an asset by a certain date for a
certain price.
price
• Put Option – Gives the holder the right but not the
obligation to sell an asset by a certain date for a
certain price.
 Example of call option trade

• Buyy 1 Tata Motors 900 Aug g Call @ Rs.25

• As Lot size is 500, total premium paid is
• Rs.25 x 500 = Rs.12500.
• CMP in cash mkt is Rs.900

• Now iff Tata Motors moves to Rs.1000 option

premium would roughly increase to Rs.125.
• A 400% return compared to 11% in cash mkt
 Options Terminology

• Option price – Price which option buyer pays to option seller.

Al kknown as premium
Also i
• Expiration date – The date specified in the options contract is
known as the expiration date, the exercise date, the strike date
or the
th maturity.
t it
• Strike Price – Price specified in the options contract. Also
called exercise price.
• American Options – Options that can be exercised at any time
upto the expiration date. Most exchange traded options are
American.
• European Options – Options that can be exercised only on the
expiration date itself.
 Options Terminology
• In-the-money option – An option that brings a positive cash
fl
flow tto th
the h
holder
ld if exercised
i d iimmediately.
di t l A callll option
ti iis iin-
the-money if CMP of underlying asset is higher than strike price.

• At-the-money option – An option that brings zero cash flow if

exercised immediately. A call option is at-the-money if CMP of
underlying asset is equal to strike price.

• Out-of-the-money option – An option that brings negative cash

flow if exercised immediately. A call option is out-of-the-money if
CMP of underlying asset is less than strike price.
 Options Terminology
• Option Premium is made up of two components
– Intrinsic Value & Time Value

• Intrinsic Value – is the amount the option is in the money. If the

option is OTM or ATM, its intrinsic value is zero.

• Time Value – Diff between Premium paid and intrinsic value

value.
OTM and ATM options have only time value. Max time value
exist when option is ATM. Longer the time to expiration, greater
is an option’s
option s time value. At expiration, an option should have no
time value.
 Option Pricing
• Factors affecting option price
– Stock Price – Call options become more valuable as stock
price go up.
– Strike Price - Call options become more valuable as strike
price goes down
down.
– Time to expiration – More the time more the value of the
option
– Volatility – More the volatility more the value of the option
– Risk free interest rate – Prices of call options increase as
risk free interest rate increases.
– Dividends – Has a negative effect on call options and
positive effect on put options as dividends have the effect of
reducing the stock price on ex-dividend date.
 Difference between Futures and
Options

• Futures have unlimited profit and loss potential.

• Options have limited risk and unlimited profit

potential.
 P
Payoff
ff for
f Futures
F t

Profit

2500

Nifty

Loss
 Payoff for Buyer of Call Options

Profit

0
Premium Nifty

Loss
 Payoff for Buyer of Put Options

Profit

Nifty
0
Premium

Loss
 Payoff for Writer of Call Options

Profit

Premium
Nifty
0

Loss
 Using Index Futures

• For
F Speculation
S l ti
1. Bullish outlook – Long Nifty Futures
2 Bearish outlook - Short Nifty Futures
2.
Get the advantage of leverage
 Using Index Futures

• For
F Hedging
H d i
1. Long Security, Short Nifty Futures
2 Short Security,
2. Security Long Nifty Futures
3. Have portfolio, Short Nifty Futures
4. Have funds, Long Nifty Futures
 Using Index Options

• Hedging – By buying puts

• Speculation –
– Bullish – Buy Nifty Calls or Sell Nifty Puts
– Bearish – Sell Nifty Calls or Buy Nifty Puts
– Anticipate Volatility – Buy a call and put at same strike
– Bull Spreads – Buy a call and sell another
– Bear Spreads – Sell a call and buy another
 Using
g Index Options
p

• Hedging – By buying puts

• When index falls your portfolio will lose value and the put
options
p bought
g by y yyou will g
gain.

• Level of protection depends on strike price of options chosen.

• This is largely a function of how safe we want to play
play.

• If Nifty spot is 2500 and you buy puts with a strike of 2400, it will
i
insure your portfolio
tf li against
i t an index
i d fall
f ll lower
l th
than 2400.
2400

• Upside remains potentially unlimited.

 Using Index Options

• Speculation
p – Bullish outlook
• Buy Nifty Call Options or Sell Put Option
• Buying Call Options – Limited risk, Unlimited gain
• Selling Put Options – Limited Upside and Unlimited downside
• Strike Price is chosen depending on the view of the market.

• A Trader is bullish on the index. Spot Nifty is at 1200. He buys a

three month Nifty Call Option contract with a strike price of 1260
at a premium of Rs.15 per call. Three months later, the index
closes
l att 1295
1295. Hi
His total
t t l profit
fit iis

• (1295-1260 – 15) * 200 = 20 * 200 = Rs.4,000.

 Using Index Options

• Speculation
S l ti – Anticipate
A ti i t volatility
l tilit
• If you think that market is going to witness volatile swings but
have no opinion on the direction of the swing, you can
i l
implement tad derivative
i ti strategy
t t called
ll d a straddle.
t ddl
• Can be used around budget time or during times of political
uncertainty.
• Involves buying a call and a put with the same strike price and
maturity.
• Maximum loss is the premium paid for the two options.
• Gains are made only if the underlying asset moves significantly.
 Summary of Call & Put Option
Summary
CALL OPTION BUYER
•Pays premium
•Right to exercise and buy the shares
•Profits from rising prices
•Limited losses, Potentially unlimited
gain
PUT OPTION BUYER
•Pays premium
•Right to exercise and sell shares
•Profits from falling prices
•Limited losses, Potentially unlimited
gain
CALL OPTION WRITER (Seller)
•Receives premium
•Obligation to sell shares if exercised
•Profits from falling prices or remaining neutral
•Potentially unlimited losses, limited gain
PUT OPTION WRITER (Seller)
•Receives premium
•Obligation to buy shares if exercised
•Profits from rising prices or remaining neutral
•Potentially unlimited losses, limited gain
 Concepts / Imp Terms

Strike price

The Strike Price denotes the price at which the buyer of the option has a right to
purchase or sell the underlying.

Five different strike prices will be available at any point of time.

The strike p
price interval will be of 20. If the index is currently
y at 1,410,
, , the strike prices
p
available will be 1,370, 1,390, 1,410, 1,430, 1,450.

The strike price is also called Exercise Price. This price is fixed by the exchange for
the
entire duration of the option depending on the movement of the underlying stock or
index in the cash market.
 Concepts / Imp Terms - continued
In-the-money

A Call Option is said to be "In-the-Money" if the strike price is less than the market
price of the underlying stock.

A Put Option is In-The-Money when the strike price is greater than the market price of
the underlying stock.
eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10

In the above example, the option is "in-the-money", till the market price of SATCOM is
ruling above the strike price of Rs 190, which is the price at which Raj would like to buy
100 shares anytime before the end of August
August.

Similary, if Raj had purchased a Put at the same strike price, the option would have
been "in-the- money",
y , if the market price
p of SATCOM was lower than Rs 190 p per share.
 Concepts / Imp Terms - continued
Out-of-the-Money

A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the
market price of the stock.
A Put option
p is Out-Of-Moneyy if the strike price
p is less than the market p
price.

eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150

In the above example

example, the option is "out
out-of-
of the-
the money
money", if the market price of INFTEC
is
ruling below the strike price of Rs 3500, which is the price at which SAM would like to
buy 100 shares anytime before the end of August.

Similary, if Sam had purchased a Put at the same strike price, the option would have
been "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.
 Concepts / Imp Terms - continued
At-the-Money

The option with strike price equal to that of the market price of the stock is considered as
being "At-the-Money" or Near-the-Money.

eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10

In the above case, if the market price of ACC is ruling at Rs 150, which is equal to the
strike price, then the option is said to be "at-the-money".

If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410,
1 430 1,450.
1,430, 1 450 The strike prices for a call option that are greater than the underlying (Nifty
or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that
the underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390,
which are lower than the underlying
y g of 1,410.
,
 Concepts / Imp Terms - continued
The 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 positive or zero. 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.
 Concepts / Imp Terms - continued

F Call
For C ll options
i – the
h right
i h to b
buy the
h underlying
d l i at a fifixed
d strike
ik :

Price – as the underlying price rises so does its premium. As the underlying
price falls so does the cost of the option premium
premium.

For Put options – the right to sell the underlying at a fixed strike :

Price – as the underlying price rises, the premium falls; as the underlying
price falls the premium cost rises.
 Concepts / Imp Terms - continued

The Time Value of an Option

p

Generally, the longer the time remaining until an option’s 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

option s price remaining the same, the time value
portion of an option’s premium will decrease (or decay) with the passage of time.

Option Time to expiry Premium cost

Call
Put
 Concepts / Imp Terms - continued
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.

O p tio n V o l a t il it y P r e m iu m c o s t
C a ll
Put
Thank you