Derivatives

Jignesh Shah Dhiren Prajapati Kaustubh Parkar Akash Jadhav Deepali Jain Rahul Gavali

What will we look at?

Basic concepts of Derivatives Futures

Options

Derivatives

What is Derivatives? Classification of Derivatives Risk Associated with Derivatives Participants of Derivatives

What is Derivatives?

A Derivative is a financial instrument which derives its value from its underlying assets. It does not have any value of its own The underlying assets can be Futures, Equities, Index and Currency

Classification of Derivatives

Futures Options Forward Contracts

Definition

Futures :

Its a standardized agreement between buyer and seller, where the seller is obligated to deliver a specific assets to a buyer on the specified date and buyer is obligated to pay the future price prevailing in the exchange on the delivery of the asset.

Options :

An option is the right, but not the obligation to buy or sell the underlying assets and other financial instrument at an agreed price, on or before a given expiry date.

Forward Contracts :

Its an agreement between two persons for purchase and sale of commodity or financial asset at specified price to be delivered at specified future date.

Risk Associated With Derivatives

Market Risk : It is price sensitive to fluctuation in interest rate and foreign exchange rate. Liquidity Risk : Most derivatives are customized instrument hence they have substantial liquidity risk. Credit Risk : Derivatives are traded in over the counter market which are subject to counter party default. Hedging Risk : Hedge are used to reduce specific risk, it the anticipated risk do not develop it may limit the total return. Regulatory Risk : The regulatory controls are some time too oppressive for market participants.

Participants of Derivatives

Hedgers

Those who are interested in the underlying and want to hedge out their risk of price changes. For eg. farmers who sell future contracts for the crops that guarantee a certain price. Also, hedging against an existing equity position with a view to earn on short term fluctuation while keeping the original position as intact.

Speculators
Those who seek to make profit by predicting market movements and have no interest in the underlying equity / commodity.

Strategist / Traders With the help of cash and derivative products, large number of strategies are being formulated and traded.

Futures

What is Futures? Futures Vs Forwards Characteristics of Futures Types of Futures Example Margin Components Advantages

What is futures ?

Definition:
A future contract is a standardised contract traded on an exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price.

Futures vs. Forwards

Standardized Standard Lot size Exchange Traded

Not Standardized Odd lot size Over the Counter (OTC)

Some of the Exchanges

Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) New York Board of Trade (NYBOT) New York Mercantile Exchange (NYMEX) National Stock Exchange (NSE)

Characteristics

Standardisation

Pricing
Margin

Always traded on an Exchange

Settlement

Standardisation

The contract usually specifies the following:

i.
ii. iii. iv.

v.
vi.

The underlying instrument Whether the settlement would be in cash or physical The amount and number of units of the underlying assets. Currency in which the future contract is quoted. Date of delivery & month. Last date of delivery This varies from exchange to exchange.

Types of Futures

Equity

Commodity
Index

Foreign Currency

Mark to Market
Example: Spot price of Gold is $ 400. Futures Price of Gold is $ 415 at the beginning of the day.

The movements over 3 days as shown below explains the concept of Mark to Market:
Time period Gold Future Buyer's Cash Flow 1 $420.00 $5.00 2 $430.00 $10.00 3 $425.00 - $5.00 Net Cash Flow $10.00

Margin Components

Initial margin VAR technique Maintenance margin minimum requirement Margin Call -Variation margin Additional margin market trends / volatility

Any credit balance in a margin account can be withdrawn.

Simple Illustration
Reliance Future having lot size of 600 @ Rs. 1000/= Rs. 600,000/Margin fixed by Exchange = 15% = Initial Margin Amount deposited with Broker = Rs. 600,000/- * 15% = Rs. 90,000/Maintenance margin = 50% of initial margin = 90,000/- * 50% = 45,000/-

2nd day : Next day, the rate of Reliance future is Rs. 950/Mark to market: 600 lots @ Rs. 950/- = Rs. 570,000/Current Margin Less : Notional loss 3rd day: Next day, the rate of Reliance future is Rs. 900/Mark to market: 600 lots @ Rs. 900/- = Rs. 540,000/Calculation : Current Margin Less : Notional loss 60,000.00 30,000.00 (570,000 540,000) 30,000.00 < 45,000 Required margin 90,000.00 Variation Margin required (60,000.00) margin call 90,000.00 30,000.00 60,000.00 15% (600,000 570,000) > 45,000

Calculation: Future Contract: Date 16th June 30th June B / S Lot Sell Buy 10 * 2 * Multiplier Price 10 10 Mark-to-market Comm. Fees 25.00 109.19

* 3,514.60 = 351,460.00/* 3,639.505 = 72,790.10/-

Cash Flow: On 16th June: Commission fees: 25.00 is the cash flow generated on this day. On 30th June: 72,790.10 - 70,292.00/- (2 lots * 10 * 3,514.60) = 2,498.10 + Commission Fees 109.10 = 2,607.2

Options

What is Options? Kinds of Options. Types of Options. Characteristics of Options. Call Options Put Options In / At / Out the Money Options Benefits of Options Trading

What is an options ?

Definition: An option contract is a standardised contract traded on an exchange, offering the right, but not the obligation, to buy or sell a certain underlying instrument at a pre-set price called the strike price.

Kinds of Options
European Options:
These are exercised only on the maturity date. On the expiry date, the option buyer's right to exercise the option (and the seller's obligation to perform) ends.

American Options:
These can be exercised at any time prior to or up to the maturity date. This presentation presumes European options for ease of calculation.

Types of Options

Equity

Commodity
Index

Foreign Currency
Future Contracts

Characteristics

Standardisation Premium Call / Put option Always traded on an Exchange Settlement

Standardisation

The contract usually specifies the following:

i.
ii. iii. iv.

v.
vi.

The underlying instrument Whether the settlement would be in cash or physical The amount and number of units of the underlying assets. Currency in which the option contract is quoted. Date of delivery & month. Last date of delivery This varies from exchange to exchange.

Call / Put Options

CALL OPTIONS

Buyer gets a RIGHT, To BUY underlying shares at a price. On or before a determined date.

PUT OPTIONS

Buyer gets a RIGHT, To SELL underlying shares at a price.

On or before a determined date.

Options-Positions

BUY CALL: Buyer gets right to BUY underlying at the strike price

BUY PUT: Buyer gets right to SELL underlying at the strike price

SELL CALL: Seller has an obligation to SELL the underlying at strike price

SELL PUT:
Seller has an obligation to BUY the underlying at strike price

Options- Spot & Strike price Relationship

In The Money Concepts from the buyers perspective. Option is said to be in the money when the option has intrinsic value. Call option is in the money when the Strike price is < Spot price Put option is in the money when the strike price is > spot price Eg. Strike Price 250 Call option of Satyam Computers when the Spot price is 300. The difference of Rs. 50 is said to be the intrinsic value of the option.

Options- Spot & Strike price

Relationship

Out of The Money

Option is said to be out of money when it does not have any intrinsic value Call option is out of the money when the Strike price is > CMP Put option is out of the money when the strike price is < CMP

Eg. Strike Price 350 Call option of Satyam Computers when the Spot price is 300.

At The Money Strike price = Spot Price

Call Option Buyer - Example

Mr. X holds a bullish view on Microsoft. Microsoft is trading on NASDAQ in the cash market at $ 100. Call option on Microsoft with 3 months maturity is available at various strikes. Lets takes strike of $ 100. Mr. X Buys one call Options contract with 3 months maturity (Say one contract has 100 underline shares). He Pays a premium, say @ $ 5 per share i.e. $ 500. He waits for 3 months. During this time Microsoft may go up, it may go down or it may remain stable. If Microsoft remains same or goes down i.e. below $ 100, Mr.X will not exercise his option and would loose the premium amount i.e. $ 500. In other words, Mr. X lose is Capped at this value. If the Microsoft rises above $ 105 (Strike Price of $ 100 + Premium of $ 5) Option would generate money for Mr. X The Higher the Microsoft rises, the higher the profit to Mr. X. Hence the maximum profit potential of Mr. X is unlimited, While the maximum lose is limited to premium paid ($ 500).

Call Option Seller - Example

Consider the Option on Microsoft, Which Mr. X had bought, Say for Mr. Y. The Position of Call Option Seller i.e Mr. Y is exactly the opposite of the Option Buyer i.e Mr. X. Mr. Y collects the Premium amount of $ 500 from Mr. X. If Microsoft falls below $ 100, Mr. Y pockets the premium amount, which is the Maximum Profit he can make. However if the Stocks moves up Mr. Ys loss is unlimited which is proportional to Mr. Xs gain.

Benefits of Option Trading

Leverage Limited risk No margin, only premium

Futures - Advantages over Delivery Trading

You can take 4 5 times more than limits Close positions anytime before expiry. On expiry day, exchange automatically closes out positions. Keep your positions open up to 3 months

Profits / losses are paid / recovered on a daily basis

If you feel the market will be bearish, take short positions in futures, which is not possible in delivery based trading without actual shares in demat.

Options- Pricing

Intrinsic Value Difference between the Strike Price and Spot Price Time Value - Theta Time to expiry of the contract As the expiry date comes nearer, the options premium decays Volatility of underlying- Beta Higher volatility of stock would attract higher premium Premium in HINLEV (low beta) would be lesser than SATCOM (high beta) - other factors remaining same

Options-Risk

BUYER of CALL / PUT options

Maximum loss : PREMIUM Maximum Gain : UNLIMITED

SELLER of CALL / PUT options

Maximum loss : UNLIMITED Maximum Gain : PREMIUM

Options-Exercise

Only In the Money (ITM) options are allowed to be exercised Buyer/Holder receives the difference Call Option: Spot price-Strike price Put Option: Strike price-Spot price Writer/Seller pays the difference Call Option : Spot price-Strike price Put option: Strike price-Spot price

All At the Money (ATM) and Out of the Money (OTM) contracts expires worthless
Assigned to seller/writer who is Out of the Money (OTM)

Options - Exercise v/s Square-off

EXERCISE
STRIKE PRICE and CLOSING PRICE of underlying on exercise day

SQUARE-OFF
PREMIUM Amounts at the time of Square-off.

Difference between

Difference between

EXERCISE can be done only by the BUYER. SQUARE-OFF can be made by both BUYER & SELLER

Which strike price to select? Speculator or investor?

Buying an OTM options - very bullish / bearish - very cheap

Same expiry OTM cheaper than ITM Less investment Speculator may look for more leverage with OTM

Your perceptions of the market movement

Your perceptions of the volatility and interest rates in the market.

To sum up
Some of the key uses of options are Leverage Protecting the value of equity positions Limiting risk Alternative to direct investment in equity markets.

How can you get the most out of these instruments?

Adopt the appropriate strategy that suits Your personal circumstances and Your market view

Life is all about Choices, Good or Bad; Right or Wrong; Your Destiny will unfold according to the Choices you make

Thank You