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CONTENTS

➢ Derivatives – an overview
➢ Futures contract
➢ Hedging in futures
➢ Speculating in futures
➢ Arbitrage in futures
➢ Options
➢ Options strategies
➢ Derivatives products
➢ Open interest
➢ Futures price = spot price + cost of carry

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DERIVATIVES
The word “DERIVATIVES” is derived from the word itself derived of a underlying asset. It is a
future image or copy of a underlying asset which may be shares, stocks, commodities, stock
indices, etc.
Derivatives is a financial product (shares, bonds) any act which is concerned with lending and
borrowing (bank) does not have its value borrow the value from underlying asset/ basic
variables.
Derivatives is derived from the following products:
A. Shares
B. Debuntures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
Derivatives is a type of market where two parties are entered into a contract one is bullish and
other is bearish in the market having opposite views regarding the market. There cannot be a
derivatives having same views about the market. In short it is like a INSURANCE market where
investors cover their risk for a particular position.
Derivatives are financial contracts of pre-determined fixed duration, whose values are derived
from the value of an underlying primary financial instrument, commodity or index, such as:
interest rates, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes
in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.
Hedging is the most important aspect of derivatives and also its basic economic purpose. There
has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives
as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in
pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are
essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion
and acceptance of market economy, that has really contributed towards the growing awareness of
risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced
derivatives in the local currency Interest Rate markets, which have not really developed, but with
the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product
in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index
futures

BACKGROUND
Consider a hypothetical situation in which ABC trading company has to import a raw material
for manufacturing goods. But this raw material is required only after 3 months. However in 3
months the prices of raw material may go up or go down due to foreign exchange fluctuations
and at this point of time it can not be predicted whether the prices would go up or come down.
Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then
he will incur heavy interest and storage charges. However, the availability of derivatives solves
the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw
material prices would be offset by profits on the futures contract and vice versa. Hence the
company can hedge its risk through the use of derivatives

DEFINATIONS

According to JOHN C. HUL “ A derivatives can be defined as a financial instrument whose


value depends on (or derives from) the values of other, more basic underlying variables.”

According to ROBERT L. MCDONALD “A derivative is simply a financial instrument (or even


more simply an agreement between two people) which has a value determined by the price of
something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the
definition of Securities. The term Derivative has been defined in Securities Contracts
(Regulations) Act, as:-
A Derivative includes: -
a. 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;
b. contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives were developed primarily to manage, offset or hedge against risk but some were
developed primarily to provide the potential for high returns.
INTRODUCTION TO FUTURE MARKET
Futures markets were designed to solvethe problems that exit in forward markets. A futures
con tract is an agreement between two parties to buy or sell an asset at a certain time in the future
at a certain price. There is a multilateral contract between thebuyer and seller for a underlying
asset which may be financial instrument or physical commodities. But unlike forward contracts
the future contracts are standardized and exchange traded.

PURPOSE
The primary purpose of futures market is to provide an efficient and effective mechanism for
management of inherent risks, without counter-party risk.
It is a derivative instrumentand a type of forward contract The future contracts are affected
mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has
to pay the margin to trade in the futures market
It is essential that both the parties compulsorily discharge their respective obligations on the
settlement day only, even though the payoffs are on a daily marking to market basis to avoid
default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts
with a fresh opening value. Here both the parties face an equal amount of risk and are also
required to pay upfront margins to the exchange irrespective of whether they are buyers or
sellers. Index based financial futures are settled in cash unlike futures on individual stocks which
are very rare and yet to be launched even in the US. Most of the financial futures worldwide are
index based and hence the buyer never comes to know who the seller is, both due to the presence
of the clearing corporation of the stock exchange in between and also due to secrecy reasons
EXAMPLE
The current market price of INFOSYS COMPANY is Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is
bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has
purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of
infosys is 300 shares.
Suppose the stock rises to 2200.
Profit

20
2200
10

0
1400 1500 1600 1700 1800 1900
-10

-20

Loss
Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for
the buyer is 500.
Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400


Profit

20
10

0
1400 1500 1600 1700 1800 1900
-10

-20

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is
250.
Unlimited loss for the seller because the seller is bullish in the market.
Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some
date in the future. Futures are often used by mutual funds and large institutions to hedge their
positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or
the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in
proportion to the total value of contract

MARGIN

Margin is money deposited by the buyer and the seller to ensure the integrity of the contract.
Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based
on the value at risk of the stock/index margins are calculated. In general margin ranges between
10-50% of the contract value.

PURPOSE
The purpose of margin is to provide a financial safeguard to ensure that traders will perform on
their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. The initial margin
approximately equals the maximum daily price fluctuation permitted for the contract being
traded. Upon proper completion of all obligations associated with a traders futures position, the
initial margin is returned to the trader.

OBJECTIVE
The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and
seller have to deposit margins. The initial margin is deposited before the opening of the position
in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally the maintenance is lower than
initial margin. This is set to ensure that the balance in the margin account never becomes
negative. If the balance in the margin account falls below the maintenance margin, the investor
receives a margin call to top up the margin account to the initial level before trading
commencing on the next level.

ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty
futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%.
The lot size of nifty futures =200.suppose on MAY 16th
The price of futuressettled at Rs.1950. As the buyer is bullish and the seller is bearish in the
market. The profit for the buyer will be 10,000 [(1350-1300)*200]
Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)
Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)

Suppose on may 17th nifty futures settled at 1400.


Profit of buyer will be 10,000[(1450-1350)*200]
Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)
Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)

As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600
While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.
Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]


Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)
Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)

Therefore in this way each account each account is credited or debited according to the
settlement price on a daily basis. Deficiencies in margin requirements are called for the broker,
through margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN:
In case of sudden higher than expected volatility, additional margin may be called for by the
exchange. This is generally imposed when the exchange fears that the markets have become too
volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by
exchange to prevent breakdown.

CROSS MARGINING:
This is a method of calculating margin after taking into account combined positions in Futures,
options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is
done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly
script of SATYAM fallsthen the investor is required to pay the mark-to-market margin also
called as variation margin for trading in the future contract
HEDGERS :
Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already
exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their
price risk. Hedgers are those persons who don’t want to take the risk therefore they hedge their
risk while taking position in the contract. In short it is a way of reducing risks when the investor
has the underlying security.
PURPOSE:
“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”

Figure 1.1

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize


1) Difficult to 1) No Leverage 1)Fixprice today to buy 1) Additional
offloadholding available risk latter by paying premium. cost is only
duringadverse reward dependant 2)For Long, buy ATM Put premium.
marketconditions on market prices Option. If market goes up,
ascircuit filters long position benefit else
limitto curtail losses. exercise the option.
3)Sell deep OTM call option
with underlying shares, earn
premium + profit with increase prcie
Advantages
• Availability of Leverage
STRATEGY:
The basic hedging strategy is to take an equal and opposite position in the futures market to the
spot market. If the investor buys the scrip in the spot market but suddenly the market drops then
the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification.
Diversification and hedging do not have havecost in cash but have opportunity cost. Hedging is
implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging
eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes
risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk).
Diversification is affected by choosing a group of assets instead of a single asset (technically, by
adding positively and imperfectly correlated assets).

ILLUSTRATION
Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of
manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is
completed.
COST SELLING PRICE PROFIT
400 1000 600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the
contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if
Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.
Shyam defaults Shyam honors
400 (Initial Investment) 600 (Initial profit)
400 (penalty from Shyam (-100) discount given to Shyam
- (No gain/loss) 500 (Net gain)
Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial
investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of
Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and
protected his initial investment.

Now let’s see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short term you expect that the
market would go down due to some news. Then, to minimize your downside risk you could
hedge your position by buying a Put Option. This will hedge your downside risk in the market
and your loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging is the
removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits
than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to
make excess profits for sure; all that can come out of hedging is reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are
not subject to margins as in hedging through futures. Options buyers are however required to pay
premium which are sometimes so high that makes options unattractive.

ILLUSTRATION:
With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Nowthe investor
excepts that price will fall by 100.So he decided to buy the put Option b y paying the premium
of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls
by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered
Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:

 LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of
Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position.
Thus the position LONG SECURITY, SELL NIFTY isa pure play on the performance of the
security, without any extra risk from fluctuations of the market index. Finally the investor has
“HEDGED AWAY” his index exposure.

EXAMPLE:
 LONG SECURITY, SELL FUTURES
Here stock futures can be used as an effective risk –management tool. In this case the
investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the
risk the Hedger enters into a future contract and takes a short position. However the losses
suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390


Market action = 350
Loss = 40
Strategy = BUY SECURITY, SELL FUTURES
Two month Futures= 390
Premium = 12
Short position = 390
Future profit = 40(390-350)
As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures
will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made
on his short futures position.

 HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of
HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price.
Therefore the solution is buy put options on HLL.

The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the
investor has two possible scenarios three months later.

1) IF PRICE RISES

Market action: 215


Loss : 17(232-15)
Strike price : 240
Premium : 08
Profit : 17(240-215-8)

Thus loss he suffers on the stock will be offset by the profit the investor earns on the put
option bought.

2) IF PRICE RISES:

Market share : 250


Loss : 10
Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike price investor chooses) and an
unlimited profit.

 HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and selling nifty futures. In the case
of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a
position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the
LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on
st
1 May, 2001.
Company Beta Amount of Holding ( in Rs)
Infosys 1.55 400,000.00
Global Tele 2.06 200,000.00
Satyam Comp 1.95 175,000.00
HFCL 1.9 125,000.00
Total Value of Portfolio 1,000,000.00
Trading Strategy to be followed
The investor feels that the market will go down in the next two months and wants to protect him
from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY
futures i.e he has to sell June Nifty. This strategy is called Short Hedge.
Formula to calculate the number of futures for hedging purposes is
Beta adjusted Value of Portfolio / Nifty Index level
Beta of the above portfolio
=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000
=1.61075 (round to 1.61)
Applying the formula to calculate the number of futures contracts
Assume NIFTY futures to be 1150 on 1st May 2001
= (1,000,000.00 * 1.61) / 1150
= 1400 Units
Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.
Short Hedge
Stock Market Futures Market
1st May Holds Rs 1,000,000.00 in Sell 7 NIFTY futures
stock portfolio contract at 1150.
25th June Stock portfolio fall by 6% NIFTY futures falls by
to Rs 940,000.00 4.5% to 1098.25
Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00
Net Profit: + Rs 15,450.00

SPECULATORS:
If hedgers are the people who wish to avoid price risk, speculators are those who are willing to
take such risk. speculators are those who do not have any position and simply play with the
others money. They only have a particular view on the market, stock, commodity etc. In short,
speculators put their money at risk in the hope of profiting from an anticipated price change.
Here if speculators view is correct he earns profit. In the event of speculator not being covered,
he will loose the position. They consider variousfactors such as demand supply, market
positions, open interests, economic fundamentals and other data to take their positions.
SPECULATION IN THE FUTURES MARKET
• Speculation is all about taking position in the futures market without having the
underlying. Speculators operate in the market with motive to make money. They take:
• Naked positions - Position in any future contract.
• Spread positions - Opposite positions in two future contracts. This is a conservative
speculative strategy.
Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price
discovery in the market.
Figure 1.2

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize


1) Deliver based 1) Both profit & 1)Buy&Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading& carry price change. 2) Buy Call &Put to premium
forwardtransactions. bypaying paid
2) Buy Index Futures premium
holdtill expiry. Advantages
• Greater Leverage as to pay only the premium.

• Greater variety of strike price options at a given time.

ILLUSTRATION:
Here the Speculator believes that stock market will goingto appreciate.
Current market price of PATNI COMPUTERS = 1500
Strategy: Buy February PATNI futures contract at 1500
Lot size = 100 shares
Contract value = 1,50,000 (1500*100)
Margin = 15000 (10% of 150000)
Market action = rise to 1550
Future Gain:Rs. 5000 [(1550-1500)*100]
Market action = fall to 1400
Future loss: Rs.-10000 [(1400-1500)*100]
Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from
the view. He study the market and play the game with the stock market
TYPES:
 POSITION TRADERS:
These traders have a view on the market an hold positions over a period of as days until their
target is met.
 DAY TRADERS:
. Day traders square off the position during the curse of the trading day and book the profits.
 SCALPERS:
Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS:


A speculator has a definite outlook about future price, therefore he can buy put or call option
depending upon his perception about future price. If speculator has a bullish outlook, he will buy
calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If
speculator’s view is correct he earns profit. In the event of speculator not being covered, he will
loose the position. A Speculator will buy call or put if his price outlook in a particular direction is
very strong but if is either neutral or not so strong. He would prefer writing call or put to earn
premium in the event of price situations.
ILLUSTRATION:
Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of
Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit
otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE
TELEFILMS stock will come down then he will buy put on the stale price until he can write
either call or put.
Finally Speculators provide depth an liquidity to the futures market an in their absence; the price
protection sought the hedger would be very costly.
STRATEGIES:
 BULLISH SECURITY,SELL FUTURES:
Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator
buys the shares of the company an makes the profit. At the same time the Speculator enters into
the future contract i.e. buys futures and makes profit.
Spot Price of RELIANCE = 1000
Value = 1000*100shares = 1,00,000
Market action = 1010
Profit = 1000
Initial margin = 20,000
Market action = 1010
Profit = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000for a period of 2 months the speculator makes a
profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the
Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractive option for speculator.

 BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

 BUY STOCK

ACC spot price : 150


No of shares : 200
Price : 150*200 = 30,000
Market action : 160
Profit : 2,000
Return : 6.6% returns over 2months

 BUY CALL OPTION:

Strike price : 150


Premium : 8
Lotsize : 200 shares
Market action :160
Profit : (160-150-8)*200 = 400
Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a
investment of 2monthsas compared to 6.6% returns over a investment in stocks

 BEARISH SECURITY,SELL FUTURES:


In this case the stock futures is overvalued and is likely to see a fall in price. Here simple
arbitrage ensures that futures on an individual securities more correspondingly with the
underlying security as long as there is sufficient liquidity in the market for the security. If the
security price rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240


Lotsize = 100shares
Margin = 24
Market action = 220
Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit
because the speculator is bearish in the market and all the future stocks need to sell in the market.

 BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can “BUY OR SELL”
the entire index trading on one single security. Once a person is LONG NIFTY using the futures
market, the investor gains if the index rises and loss if the index falls.

1st July = Index will rise


Buy niftyJuly contract = 960
Lot =200
14th July nifty risen= 967.35
Nifty July contract= 980
Short position =980
Profit = 4000(200*20)

ARBITRAGEURS:
Arbitrage is the concept of simultaneous buying of securities in one market
where the price is low and selling in another market where the price is
higher.
Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and
knowledgeable person and ready to take the risk He is basically risk averse.
He enters into those contracts were he can earn risk less profits. When
markets are imperfect, buying in one market and simultaneously selling in
other market gives risk less profit. Arbitrageurs are always in the look out for
such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower
priced market and selling at the higher priced market.
JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where
the investor buys the shares in the cash market and sell the shares in the future market.
ARBITRAGEURS IN FUTURES MARKET
Arbitrageurs facilitate the alignment of prices among different markets through operating in them
simultaneously.

Figure 1.3

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize


1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
oneand selling in whichever way the promising as still game.
anotherexchange. Market moves. inweekly settlement
forwardtransactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price
• Fair Price = Cash Price + Cost of Carry.

Example:
Current market price of ONGC in BSE= 500
Current market price of ONGC in NSE= 510
Lot size = 100 shares
Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:
 BUY SPOT, SELL FUTURES:
In this the investor observing that futures have been overpriced, how can the investor
cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One
month ACC futures = 1025.
This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make
risk less profits entering into the following set f transactions.
• On day one, borrow funds, buy security on the spot market at 1000
• Simultansely, sell the futures on the security at1025
• Take delivery of the security purchased and hold the security for a month
• on the futures expiration date, the spot and futures converge . Now unwind the position
• Sa y the security closes at Rs.1015. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures
position
• Return the Borrow funds.
Finally if thecost of borrowing funds to buy the security is less than the arbitrage profit
possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash – and-
carry arbitrage.

 BUY FUTURES, SELL SPOT:


In this the investor observing that futures have been under priced, how can the
investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and
One month ACC futures = 965.
This shows that futures have been under priced and therefore as an Arbitrageur, investor can
make risk less profits entering into the following set f transactions.
• On day one, sell the security on the spot market at 1000
• Mae delivery of the security
• Simultansely, buy the futures on the security at 965
• On the futures expiration date, the spot and futures converge . Now unwind the position
• Sa y the security closes at Rs.975. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position
Finally if thereturns get investing in risk less instruments is less than the return from the
arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse
cash – and- carry arbitrage.

 ARBITRAGE WITH NIFTY FUTURES:


Arbitrage is the opportunity of taking advantage of the price difference between two markets. An
arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to
arbitraged between NIFTY in the futures market and the cash market. If the futures price is any
of the prices given below other than the equilibrium price then the strategy to be followed is

CASE-1
Spot Price of INFOSEYS = 1650
Future Price Of INFOSEYS = 1675
In this case the arbitrageurwill buy INFOSEYS in the cash market at Rs.1650 and sell in the
futures at Rs.1675 and finally earn risk free profit Of Rs.25.
CASE-2
Future Price Of ACC = 675
Spot Price of ACC = 700
In this case the arbitrageurwill buy ACC in the Future market at Rs.675 and sell in the Spot at
Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract, which gives the buyer
(holder) the right, but not the obligation, to buy or sell specified quantity of the underlying
assets, at a specific (strike) price on or before a specified time (expiration date). The underlying
may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like
equity stocks/ stock index/ bonds etc.

MONTHLY OPTIONS :
The exchange trade option with one month maturity and the contract usually expires on last
Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthly cycle options as the
premium paid for hedging is very high. Also the trader has to pay more money to take a long or
short position which results into iiliquidity in the market.Thus to overcome the problem the BSE
introduced WEEKLY OPTIONS

WEEKLY OPTIONS:
The exchange trade option with one or weak maturityand the contract expires on last Friday of
every weak
ADVANTAGES

 Weekly Options are advantageous to many to investors, hedgers and traders.


 The premium paid for buying options is also much lower as they have shorter time to
maturity.
 The trader will also have to pay lesser money to take a long or short position.
 the trader can take a larger position in the market with limited loss. On account of low
cost, the liquidity will improve, as more participants would come in.
 Weekly Options would lead to better price discovery and improvement in market depth,
resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION:

 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. To acquire this right the buyer pays a premium to the
writer (seller) of the contract.
ILLUSTRATION

Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the
market and other is Rakesh (call seller) who is bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be
excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will
earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has
crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from
the seller at Rs.600 and sell in the market at Rs.660.

Profit

30

20

10

0
590 600 610 620 630 640
-10

-20

-30

Loss
Unlimited profit for the buyer = Rs.35{(spot price – strike price) – premium}
Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock
price fall to Rs.550 the buyer will choose not to exercise the option.

Profit

30

20

10

0
590 600 610 620 630 640
-10

-20

-30

Loss
Profit for the Seller limited to the premium received = Rs.25
Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the
lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

Thus from the above example it shows that option contracts are formed so to avoid the unlimited
losses and have limited losses to the certain extent

Thus call option indicates two positions as follows:


 LONG POSITION
If theinvestor expects price to rise i.e. bullish in the market he takes a long position by buying
call option.
 SHORT POSITION
If the investor expects price to fall i.e. bearish in the market he takes a short positionby selling
call option.

 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 a expiry date. The seller of the put option
(one who is short Put) however, has the obligation to buy the underlying asset at the strike price
if the buyer decides to exercise his option to sell.

ILLUSTRATION
Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the
market and other is Amit(put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0

1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be
excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer’s
breakeven point is Rs.780(Strike price – Premium paid). The buyer will earn profit once the
share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be
exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the
seller at Rs.800

Profit

20

10

0
600 700 800 900 1000 1100
-10

-20

Loss
Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) – premium}
Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. 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.

profit

20

10

0
600 700 800 900 1000 1100
-10

-20
Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for
the seller because the seller is bullish in the market = 780 - 750 = 30
Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

 LONG POSITION
If theinvestor expects price to fall i.e. bearish in the market he takes a long position by buying
Put option.

 SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he takes a short position by selling
Put option

CALL OPTIONS PUT OPTIONS


Option buyer or Buys the right to buy the Buys the right to sell the
option holder underlying asset at the underlying asset at the
specified price specified price

Option seller or Has the obligation to sell Has the obligation to buy
option writer the underlying asset (to the the underlying asset (from
option holder) at the the option holder) at the
specified price specified price.
FACTORS AFFECTING OPTION PREMIUM

 THE PRICE OF THE UNDERLYING ASSET: (S)


Changes in the underlying asset price can increase or decrease the premium of an option. These
price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and the
premium of a put will decrease. A decrease in the price of the underlying asset’s value will
generally have the opposite effect

Premium of the Premium of the


Price of the CALL Price of CALL
Underlying Underlying
asset asset
Premium of the
Premium of the PUT
PUT

 THE SRIKE PRICE: (K)


The strike price determines whether or not an option has any intrinsic value. An option’s
premium generally increases as the option gets further in the money, and decreases as the option
becomes more deeply out of the money.

 Time until expiration: (t)


An expiration approaches, the level of an option’s time value, for puts and calls, decreases.
 Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an option’s underlying.
Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying
price levels. This expectation generally results in higher option premiums for puts and calls alike,
and is most noticeable with at- the- money options.

 Interest rate: (R1)


This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in case
of an option seller or received from alternative investments in the case of an option buyer for the
premium paid.
Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET:


a) Developmental institutions
b) Mutual Funds
c) Domestic & Foreign Institutional Investors
d) Brokers
e) Retail Participants
FUTURES V/S OPTIONS

 RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a
price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller
are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying
asset.

 RISK
Futures Contracts have symmetric risk profile for both the buyer as well as the seller.

While options have asymmetric risk profile. 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.

 PRICES:
The Futures contracts prices are affected mainly by the prices of the underlying asset.
While the prices of options are however, affected by prices of the underlying asset, time
remaining for expiry of the contract & volatility of the underlying asset.

 COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options
contract, termed as Premium.

 STRIKE PRICE:
In the Futures contract the strike price moveswhile in the option contract the strike price
remains constant .

 Liquidity:

As Futures contract are more popular as compared to options. Also the premium charged is high
in the options. So there is a limited Liquidity in the options as compared to Futures. There is no
dedicated trading and investors in the options contract.

 Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of
the underlying only. While trading in option is two-dimensional as the price of the option
depends upon the price and volatility of the underlying.

 PAY OFF:

As options contract are less active as compared to futures which results into non linear pay off.
While futures are more active has linear pay off .

OPTION STRATAGIES:

1. BULL CALL SPREAD:


This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call
Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of
the same month. However, the total investment is usually far less than that required to purchase
the stock.
Current price of PATNI COMPUTERS is Rs. 1500
Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of
1510 and receive 15 ticks per contract.
Premium = 10 ticks per contract(25 paid- 15 received)
Lot size = 600 shares
BREAK- EVEN- POINT= 1490+10=1500
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at
Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will
expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :


If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5
which is less than premium paid result in loss of 5.While 1510 call option sold will not expire
which will reduce the loss through receiving the net premium.
If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of
10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium
receive generate profit .
iii. AT STRIKE:
If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless.
While 1510 call sold result in Rs.10 loss i.e. deep out the money.
If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the
money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the
premium received of Rs. 10
iv. ABOVE HIGHER PRICE:
IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10
while the 1510 option i.e. strike prices-premium paid.
v. BELOW PRICE:
IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in
loss to the premium paid.

The pay-off table:


PATNI COMPUTERS 1485 1490 1495 1500 1510
AT EXPIRATION (below (At the (Between (At BEP)
lower lower lower strike
price) price) &BEP

Intrinsic value of 1490 0 0 5 10 20


long call at expiration (a)
Premium paid (b) 25 25 25 25 25
Intrinsic value of 1510 0 0 0 0 0
short call at expiration
(c)
Premium received (d) 15 15 15 15 15
profit/loss(a-c)-(b- d) -10 -10 -5 0 10

PATNI COMPUTERS 1495 1510 1505 1500 1520


AT EXPIRATION (below (At the (Between (At BEP) (Above BEP
higher higher higher strike
price) price) &BEP

Intrinsic value of 1510 0 0 0 0 10


short call at expiration
(a)
Premium paid (b) 15 15 15 15 15
Intrinsic value of 1490 5 20 15 10 30
long call at expiration (c)
Premium received (d) 25 25 25 25 25
profit/loss(c-a)-( d - b) -5 10 5 0 10

Profit

20

10

0
1490 1500 1510 1520 1530 1540
-10

-20

Loss

2. BEAR PUT SPREAD:


It is implemented in the bearish market with a limited downside. The Bear put Spreadconsists of
the purchase a higher strike price put and sale of a lower strike price put, of the same month. It
provides high leverage over a limited range of stock prices. However, the total investment is
usually far less than that required to buythe stock shares.
Current price of INFOSYS TECHNOLOGIES is Rs. 4500
Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one
month put of 4490 (lower price) and receive 45 ticks per contract.
Premium = 10 ticks per contract(55 paid- 45 received)
Lot size = 200 shares
BREAK- EVEN- POINT= 5510-10 = 5500.
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at
Breakeven. The put purchase of5510 is 10 result in no-profit no loss situation to the premium
paid while the 4490 put option sold will expire worthless and also reduce the premium received.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :
If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5
which is less than premium paid result in loss of 5.While 4490 call option sold will not expire
which will reduce the loss of Rs.10 through receiving the net premium.
If the index is between 5500 and 4490 thenthe 5510 put option will have an intrinsic value of 15
i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium
receive will generate profit .
iii. AT STRIKE:
If the index is at 5510, the 5510 put optionwill have an intrinsic value of 0 and expire
worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as
the premium received
If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While
4490 put sold will have no intrinsic value and expire worthless and profit is the premium
received between the strike price an premium paid.
iv. ABOVE STRIKE PRICE:
IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic
value. whilethe 4490 put option sold result in maximum loss to the premium received.
If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic
value. while the 5510 put option sold result in the maximum profit strike price - premium
v. BELOW STRIKE PRICE:
IF the underlying stock is below 5510, the 5510 option purchase while be in the money and
4490 option sold will be assigned (strike price – premium paid) = profit .

The pay-off table:


INFOSYS AT 5520 5510 5505 5500 4480
EXPIRATION (Above (At the (Between (At BEP)
strike) strike) lower strike
&BEP
Intrinsic value of 5510 0 0 5 10 30
long put at expiration (a)
Premium paid (b) 55 55 55 55 55
Intrinsic value of 4490 0 0 0 0 10
short put at expiration (c)
Premium received (d) 45 45 45 45 45
profit/loss(a-c)-(b- d) -10 -10 -5 0 10
INFOSYS AT 5505 4490 4495 5500 4480
EXPIRATION (Above (At the (Between (At BEP) (below
strike) strike) strike &BEP strike price)

Intrinsic value of 4490 0 0 0 0 10


short put at expiration (a)
Premium received (b) 45 45 45 45 45
Intrinsic value of 5510 5 30 15 10 30
long put at expiration (c)
Premium paid (d) 55 55 55 55 55
profit/loss[(c-a)-( d - b)] -5 20 15 0 10

Profit

20

10

0
3000 3500 4000 4500 5000 5500 6000 6500 7000
-10

-20
Loss

3. BULL PUT SPREAD.


This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market
to provide high leverage over a limited range of stock prices. The investor buys a lower strike put
and selling a higher strike put with the same expiration dates. The strategy has both limited profit
potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290


Here the investor buys one month putof 1300 (lower price) at 25 ticks per contract and sell one
month put of 1310 (higher price) and receive 15 ticks per contract.
Premium = 10 ticks per contract (25 paid- 15 received)
Lot size = 600 shares
BREAK- EVEN- POINT= 1300-10 = 1290
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an
intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:
If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an
intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15
If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no
intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of
5.
iii. AT STRIKE:
If the index is at1300, the 1300 put optionwill have an intrinsic value of 0 and expire worthless.
While 1310 will have an intrinsic value of 10
If the index is at 1310 the 1300 put optionwill have an intrinsic value of 0 (deep out the money
and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t
the premium received
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