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FUTURES THE CONCEPT A futures contract can be defined as a standardized agreement between the buyer and the seller in terms of which the seller is obligated to deliver a specified asset to the buyer on a specified date and the buyer is obligated to pay to the seller the then prevailing futures price in exchange of the delivery of the asset. The futures contracts represent an improvement in the forward contract in terms of standardization, performance guarantee and liquidity. Whereas forward contracts are not standardized, the futures contract are standardized ones, so that 1. The quantity of the commodity or the other asset which could be transferred or would form the basis of gain loss on maturity of the contract, !. The quality of the commodity " if a certain commodity is involved " and the place where delivery of the commodity would be made, #. The date and month of delivery, $. The units of price quotation, %. The minimum amount by which the price would change and the price limits of the day&s operations, and other relevant details are all specified in a futures contract. Thus, in a way, it becomes a standard asset, li'e any other asset to be traded. (utures contracts are traded on commodity exchanges or on other futures exchanges. )eople can buy of sell futures li'e other commodities. When an investor buys a futures contract *so that he ta'es a long position+ on an organized futures exchange, he is, in fact, assuming the right and obligation of ta'ing delivery of the specified underlying item *say 1, quintals of wheat of a specified grade+ on a specified date. -imilarly, when an investor sells a contract, to ta'e a short position, one assumes the right and obligation to ma'e delivery of the underlying asset. While there is a ris' of non.performance of a forward contract, it is not so in case of a futures contract. This is because of the existence of a clearing house or clearing corporation associated with the futures exchange, which plays a pivotal role in the trading of futures. /nli'e a forward contract, it is not necessary to hold on to a futures contract until maturity " one can easily close out a position in the futures contract. -omething. RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE The price of a commodity *here we are not restricting ourselves to equity stoc' as the underlying asset+ is, among other things, a function of0 1emand and supply position of the commodity -torability " depending on whether the commodity is perishable or not -easonality of the commodity
To understand the lin'age between spot and futures price, let us consider an example. Example 2f 3ohn is certain that the demand.supply position of wheat is such that # months from now, the price of wheat is li'ely to go up, he should be tempted to buy wheat now and sell the stoc' after # months at a higher price. (or this purpose, he will hire a godown, stoc' the inventory, pay interest on the money invested 2 the stoc' as well as pay incidental charges in holding the inventory, li'e, handling charges, insurance charges, etc., collectively called the 4carrying costs&. 5et us assume that he buys a unit of wheat at 6s. 1,, and the carrying costs aggregates 6s. 7 per unit. 5ogically, to earn profit, he would have to be sure that spot price of wheat8 # months from now should be more than 6s. 1,7. 9ow if others also have the same information that the wheat prices are li'ely to
,al!atio$ o- -!t!res 5et us ta'e a simple example of a fixed deposit in a ban'. 6s. 1,, deposited in the ban' at a rate of interest of 1,: would become 6s. 11, after 1 yr. ;ased on annual compounding8 the amount will become 6s. 1!1 after ! yrs. Thus, we can say that the forward price of the fixed deposit of 6s. 1,, is 6s. 11, after 1 yr. and 6s. 1!1 after ! yrs. As against the usual annual, semi.annual and quarterly compounding, continuous compounding are used in derivative securities. 2n terms of annual compounding, the forward price can be computed through the following formula0 A = P &. " r / .00+t ttg Where A is the terminal value of an amount ) invested at the rate of interest of r : p.a. for t years. 9ow, if compounding was done twice a year, the amount at the end of ! years can be calculated as follows0 Be%i$$i$% o- perio' I Hal-#ear II Hal-2#ear III Hal-2#ear I, Hal-2#ear Pri$ iple 1,,, 1,%, 11,!.%, 11%B.7!% I$terest 1,,, x ,.,% @ %, 1,%, x ,.,% @ %!.%, 11,!.% x ,.,% @ %%.1!% 11%B.7!% x ,.,% @ %B.CC1 Amt* at t1e e$' 1,%, 11,!.%, 11%B.7!%$ 1!1%.%1
2t is observed that with all the inputs being the same, the amount is a little higher when the frequency of compounding is increased from one to two in each year. With the still greater compounding frequency, the amount at the end of the ! yr period would increase. (or instance, for different compounding period at the end of ! yrs are given below0 Compo!$'i$% 3!arterl# 4o$t1l# Wee5l# Dail# Amo!$t &Rs*+ 1!1C.$, 1!!,.#D 1!!1.1B 1!!1.#B
2n general terms, A = P &. " r / m+ m $ where r is the per annum rate of interest, m is the number of compounding per annum and n is the number of yrs. (or quarterly compounding, for eg. m @ $, while for daily compounding, m @ #7%.
F!t!re6s mar5et As in any other trade, the futures trade has to have a mar'et to facilitate buying and selling. As the futures mar'ets involve the operation and execution of financial deals of an enormous magnitude, their efficiency has to be of the highest quantity. 9ot only the size of the monetary operation that a futures mar'et handles but also the critical significance it has on the equilibrium of the commodities stoc's is what ma'es the operation of the mar'et so crucial. PURPOSE OF A FUTURES 4AR7ET (utures mar'ets provide flexibility to an otherwise rigid spot mar'et because of their very concept, which allows a wholistic approach to the price mechanism involved in futures contracts. The future price of a commodity is a function of various commodities related and mar'et related factors and their inter.play determines the existence of a futures contract and its price. (utures mar'ets are relevant because of various reasons, some of which are as follows0 .* 3!i 5 a$' Lo8 Cost Tra$sa tio$s9 (utures contracts can be created quic'ly at low cost to facilitate exchange of money for goods to be delivered at future date. -ince these low cost instruments lead to a specified delivery of goods at a specified price on a specified date, it becomes easy for the finance managers to ta'e optimal decisions in regard to protection, consumption and inventory. The costs involved in entering into futures contracts is insignificant as compared to the value of commodities being traded underlying these contracts.
Thus, the buyer and the seller do not get into the contract directly8 in other words, there is no counter party ris'. The idea is to secure the interest of both. 2n order to achieve this, the clearing house has to be solvent enough. This solvency is achieved through imposing on its members, cash margins and or ban' guarantees or other collaterals, which are encashable fast. The clearing house monitors the solvency of its members by specifying solvency norms. The solvency requirements normally imposed by the clearing house on their members are broadly as follows. .* Capital A'e?!a # =apital adequacy norms are imposed on the clearing members to ensure that only financially sound firms could become members. The extent of capital adequacy has to be mar'et specific and would vary accordingly. :* Net Positio$ Limits -uch limits are imposed to contain the exposure threshold of each member. The sum total of these limits, in effect, is the exposure limit of the clearing association as a whole and the net position limits are meant to diversify the association&s ris'. ;* Dail# Pri e Limits These limits set up the upper and the lower limits for the futures price on a particular day and incase these limits are touched the trading in those futures is stopped for the day. <* C!stomer 4ar%i$s 2n order to avoid unhealthy competition among clearing members in reducing margins to attract customers, a mandatory minimum margin is obtained by the members from the customers. -uch a step insures the mar'et against serious liquidity crisis arising out of possible defaults by the clearing members owing to insufficient margin retention. 2n order to secure their own interest as well as that of the entire system responsible for the smooth functioning of the mar'et, comprising the stoc' exchanges, clearing houses and the ban's involved, the members collect margins from their clients as may be stipulated by the stoc' exchanges from time to time. The members pass on the margins to the clearing house on the net basis i.e. at a stipulated percentage of the net purchases and sale position while they collect the margins from clients on gross basis, i.e. separately on purchases and sales. The stoc' exchanges impose margins as follows0 a+ 2nitial margins on both the buyer as well as the seller. b+ 1aily maintenance margins on both. c+ The accounts of the buyer and the seller are mar'ed to the mar'et daily. 4AR>INS The concept of margin here is the same as that for any other trade, i.e. to introduce a financial sta'e of the client, to ensure performance of the contract and to cover day to day adverse fluctuations in the prices of the securities bought. The margin paid by the investor is 'ept at the disposal of the clearing house through the bro'erage firms. The clearing house gets the protection against po,ssible business ris's through the margins placed with it in this manner and by the process of 4mar'ing to mar'et& *it means, debiting or crediting the clients& equity accounts with the loss or gains of the day, based on which, margins are sought or released+. The margin for futures contract has two components 2nitial margin, and >aintenance margin.
Ot1er -!t!re o$tra t STOC7 INDE@ FUTURES -toc' index futures are drawn on stoc' mar'et indices and each of these contracts are characterized by payment of cash on the delivery date of an amount equal to a multiplier times the difference between0 a+ The value of the index at the close of the last trading day of the contract, and b+ The purchase price of the futures contract. INTEREST RATES FUTURES (utures written on fixed income instruments as the underlying securities are 'nown as interest rate futures. )redetermined periodical income through the life of such instruments and principle maturity amount at the end of the instrument&s life are the usually the features of such securities. These instruments have become an integral part of all balance portfolios and accordingly the growth of these securities has grown substantially. ;ut ever since, interest rates on fixed income instruments have become highly volatile, the need for suitable hedge against this volatility has risen. Thus, two prime.movers for the growth of interest rate futures are0 1. the tremendous growth in the fixed income securities, and !. increased volatility in the interest rates in the mar'et.
WHAT IS AN OPTIONA ?ption is a legal contract in which the writer of the contract grants to the buyer, the right to purchase from or to sell to the writer a designated instrument or a scrip at a specified price within a specified period of time. The right to purchase a specified stoc' is called the call option, while the right to sell a specified stoc' is called a put option. Example -uppose a writer of an option writes a contract, which conveys or grants to the buyer the right to bur 1,, shares of 2T= from him, i.e. from the writer at the rate of 6s. 7%, per share. This option is called a call option and is designated as 1,, 2T= 7%, call. -imilarly, if a writer writes an option which grants to the buyer the right to sell to the writer 1,, shares of 2T= at 6s. 7%, per share, such an option is called a put option and is designated as 1,, 2T= 7%, put. 2t should be noted that in a call option transaction, there is not put option involved. The writer is writing or selling a call option and the buyer is buying a call option. -imilarly, in the case of a put option transaction there is no call option involved. The writer is writing or selling a put option and the buyer is buying a put option.
WHO CAN WRITE AN OPTIONA Anyone eligible to enter into contract as per the 5aw of =ontract can write an option irrespective of the fact whether one owns the underlying stoc' or not. 2f the writer of a call option owns the stoc' that he is obliged to deliver upon exercise of the call he has written, he is called a covered call writer. ?n the other, if the writer of the call option does not own the stoc' he has written the option for, he is called an uncovered or na'ed call writer and the option is called an uncovered or na'ed call option. OBLI>ATION OF THE OPTION WRITER AND BU=ER The writer is legally obligated to perform according to the terms of the option. ?n the other hand, the buyer of the option has bought a write to exercise the option and is under no obligation to exercise the option. <e can conveniently let the option lapse on the date of expiration of the option. The significance of this feature of an option is explained through the following example. Example -uppose you buy a 1,, 2T= 7%, =all option contract. 1uring the expiration period, the stoc' price does not appreciate enough to cover even the premium paid, i.e., you do not gain anything by exercising the option. The options contract confers on you the right to either invo'e the contract or let it lapse. 2nvo'ing the contract means " calling upon the writer to deliver the stoc' at the
An option buyer starts with a loss equivalent to the premium paid. <e has to carry on with the loss till the stoc'Is mar'et price equals the exercise price as shown in *a+. The intrinsic value of the option up to this point remains zero and thus, runs along the J.axis. As the stoc' price increases further, the loss starts reducing and gets wiped out as soon as the increase equals the premium, represented on the graph by point 4b&, also called the brea' even point. The profitability line starts climbing up at an inclination of $% degrees after crossing the J.axis at 4b& and from thereon moves into the positive side of the graph. The inclined line beyond the point 4b& indicates that the option acquires intrinsic value and is, thus referred to as the intrinsic value line. The position graph in *b+ represents the profitability status of the writer who does not own the stoc', i.e., a na'ed or an uncovered writer. The graph is logically the inverse of that for the option buyer. RATIONALE OF BU=IN> CALL OPTIONS There are broadly three reasons why an investor could buy a call option instead of buying the stoc' outright. These are as follows0
Positio$ >rap1s RATIONALE OF BU=IN> A PUT OPTION A$ i$(estor) i- 1e a$ti ipates -all i$ t1e pri e o- some sto 5) 1as t1e -ollo8i$% alter$ati(es9 1. -ell the stoc' short, i.e. enter a sales transaction without owning the stoc'. 2n the event of a fall in the stoc' price, he can buy the stoc' at a lower price and can deliver the stoc' sold to the buyer, thus ma'ing profit equal to the fall in the price. <owever, in case the stoc' price appreciates instead of declining, the investor would be exposed to unlimited loss.
1,
A4ERICAN (/s EUROPEAN OPTIONS The definitions of options, both call and put, given above apply to the American-st le options. An American option can be exercised by its owner at an time on or !e"ore the expiration date. ;esides the American type there are Huropean.style options as well. 2n case of Huropean options, the owner can exercise his right only on the expiration date and not before it. 2t may be pointed out however, that most of the options traded in the world, including those in Hurope, are of the American style.
Termi$olo%#6s
;efore into the concepts and mechanics of options trading, we need to be familiar with the basic terminology as they are repeatedly used in case of options and also the factors that influence the option price. E@ERCISE PRICE The exercise price *also called the stri'e price+ is the price at which the buyer of a call option can purchase the stoc' during the life of the option, or the buyer of the put option can sell during the life of the option. Hxercise price is that price at which the writer has to deliver the stoc' to the call option buyer and buy from the put buyer irrespective of the prevailing mar'et price in case the latter decides to exercise the option. E@PIRATION DATE Hxpiration 1ate is the date on which the option contract expires, i.e. the last date on which options contract can be exercised. ?ptions usually have either a monthly and or quarterly expiration cycle. The maturity period for an option does not normally exceed nine months. PRE4IU4
11
AT2THE24ONE= 2n case the call&s mar'et price is the same as its exercise price, it would bee called at-themone or at-the-market. OUT2OF2THE24ONE= -imilarly, if the mar'et price of the stoc' is less than the exercise price, it shall be called out-o"the-mone .
These concepts are tabulated below, wherein - indicates the present value of the stoc' and H is the exercise price. Co$'itio$ -MH -NH -@H Call Optio$ 2n.the.>oney ?ut.of.the.>oney At.the.>oney P!t Optio$ ?ut.of.the.>oney 2n.the.>oney At. the.>oney
INTRINSIC ,ALUE The premium or the price of an option is made up of two components, namely, intrinsic value and time value. 2ntrinsic value is termed as parit value. (or an option, the intrinsic value refers to the amount by which it is in money if it is in.the. money. Therefore, an option, which is out.of.the.money or at.the.money, has zero intrinsic value. (or a call option, which is in.the.money, then, the intrinsic value is the excess of stoc' price *-+ over the exercise price *H+, while it is zero if the option is other than in.the.money. -ymbolically, 2ntrinsic Falue of a call option @ max *,, - " H+ 2n case, of an in.the.money put option, however, the intrinsic value is the amount by which the exercise price exceeds the stoc' price, and zero otherwise. Thus, 2ntrinsic Falue of a put option @ max *,, H . -+ TI4E ,ALUE
1!
the.money option time value may or may not exist. 2n case, of a call which is in.the.money, the time value exists if the call price, =, is greater than the intrinsic value, - " H. Lenerally, other things being equal, the longer the time of a call to maturity, the greater will be the time value. This is also true for the put options. An in.the.money put option has a time value if its premium exceeds the intrinsic value, H " -. 5i'e for call options, put options, which are at.the.money or out. of.the.money, have their entire premium as the time value. Accordingly, Time value of a call @ = " Omax *,, - . H+K Time value of a put @ = " Omax *,, H . -+K Example9 =onsider the following data calls on a hypothetical stoc'. Optio $ .* :* Exer ise Pri e &Rs+ C, C% Sto 5s Pri e &Rs+ C#.%, C#.%, Call Optio$ Pri e &Rs+ 7.B% !.%, Classi-i atio$ 2n.the.money ?ut.the.money
We may show how the mar'et price of the two calls can be divided between intrinsic and time values.
CO,ERED AND UNCO,ERED OPTIONS An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position. 2n the absence of one of these conditions, the writer is exposed to the ris' of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price. The call writer may have to purchase the underlying asset at a price that is higher than he stri'e price. The put writer may have to buy the asset from the holder at a price that creates a loss. When they face such a ris' writers are said to be uncovered *or na'ed+. Co(ere' Call Optio$s / Co(ere' Calls =all writers are consider to be covered if they have any of the following positions0 Along position in the underlying asset. An escrow.receipt from a ban'. A security that is convertible into requisite number of shares of the underlying security.
1#
1$
The profit profile for this contract is indicated below. (igure *a+ shows the profit loss function for the investor #$ the writer of the call, while (igure *b+ gives the same for the other investor Y$ the buyer of the option.
1%
2t is evident that the call writerIs profit is limited to the amount of call premium but, theoretically, there is no limit to the losses if the stoc' price continues to increase and the writer does not ma'e a closing transaction by purchasing an identical call. The situation is exactly opposite for the call buyer for whom the loss is limited to the amount of premium paid. <owever, depending on the stoc' price, there is no limit on the amount of profit which can result for the buyer. ;eing a Izero.sumI game, a loss *gain+ to one party implies an equal amount of gain *loss+ to the other party. PUT OPTIONS 2n a put option, since the investor with a long position has a right to sell the stoc' and the writer is obliged to buy it at the will of the buyer, the profit profile is different from the one in a call option where the rights and obligations are different. =onsider a put option contract on a certain share, )Q), -uppose, two investors J and P enter into a contract and ta'e short and long positions respectively. The other details are given below0 Hxercise price @ 6s 2 1, Hxpiration month @ >arch, !,,1
17
The brea'.even share price would be 6s 1,!.%, *@ 6s 11, 6s B.%,+. 2f the price of the share happens to be lower than this, the writer would ma'e a loss.and the buyer ma'es a gain. (or instance, when the price of the share is 6s 1,,, the gain loss for each of the investors may be calculated as shown below. I$(estor @ ?ption premium received @ B.% x 1,, @ 6s. B%, Amount to be paid for shares @ 11, x 1,, @ 6s. 11,,, >ar'et value of the shares @ 1,, x 1,, @ 6s. 1,,,, 9et )rofit*5oss+ @ B%, . 11,,, A 1,,,, @ *6s. !%,+
Profit
I$(estor = 1500 ?ption premium paid @ B.% x 1,, @ 6s. B%, received for shares @ 11, x 1,, @ Amount 1000 to be 6s. 11,,, >ar'et value of the shares @ 1,, x 1,, @ 6s. 1,,,, Stock Price 500 9et profit*loss+ @ .B%, A 11,,, . 1,,,, @ 6s. !%, The profile of profit loss for each of the investors is given in (igures below. (ig. *a+ shows the profit loss function for the investor J the writer of the put, while the (ig. *b+ gives the same for the 500 other investor P, the buyer of the option. As indicated earlier, the profiles of the two investors other. replicate1000 each
1500 2000 2500 3000 0 90 100 110 120 130 140 150 160
1B
Loss
Profit 2500 2000 1500 1000 500 0 500 1000 Loss 90 100 110 120 130 140 150 Stock Price
1C
He'%i$% a Lo$% Positio$ i$ Sto 5 An investor buying a common stoc' expects that its price would increase. <owever, there is a ris' that the price may in fact fall. 2n such a case, a hedge could be formed by buying a put i.e., buying the right to sell. =onsider an investor who buys a share for 6s. 1,,. To guard against the ris' of loss from a fall in its price, he buys a put for 6s. 17 for an exercise price of, say, 6s. 11,. <e would, obviously, exercise the option only if the price of the share were to be less than 6s. 11,. Table below gives the profit loss for some selected values of the share price on maturity of the option. (or instance, at a share price of 6s. B,, the put will be exercised and the resulting profit
1D
The profits resulting from the strategy of holding a long position in stoc' and long put are shown in the figure below. He'%i$%9 Lo$% Sto 5 Lo$% P!t
Profit 50 40 30 20 10 0 10 20 30 40 Loss
Profit on Exercise of Put Profit / Loss on Hedging
E
Stock Price
He'%i$% a S1ort Positio$ i$ Sto 5 /nli'e an investor with a long position in stoc', a short seller of stoc' anticipates a decline in stoc' price. ;y shorting the stoc' now and buying it at a lower price in the future, the investor intends to ma'e a profit. Any price increase can bring losses because of an obligation to purchase at a later date. To minimize the ris' involved, the investor can buy a call option with an exercise price equal to or close to the selling price of the stoc'. 5et us suppose, an investor shorts a share at 6s. 1,, and buys a call option for 6s. $ with a stri'e price of 6s. 1,%. The conditional payoffs resulting from some selected prices of the share are shown in a table below.
!,
The payoff function associated with this policy is shown below. He'%i$% 9 S1ort Sto 5 Lo$% Call
Profit 50 40 30 20 10 0 10 20 30 40 Loss
Profit / Loss on S ort Stock Profit / Loss on !"## $%tion
E
Stock Price Profit / Loss on Hedging
HED>IN> WITH WRITIN> CALL AND PUT OPTIONS ;oth the strategies discussed above aim at limiting the ris' of an underlying position in an equity stoc'. ?ptions may also be used for enhancing returns from the positions in stoc'. 2f the common stoc' is not expected to experience significant price variations in the short run, then the strategies of writing calls and puts may be usefully employed for the purpose. As an example, suppose that you hold shares of a stoc' which you expect will experience small changes in the short term, then you may write a call on these. This is 'nown as writing covered calls. ;y writing covered call options, you tend to raise the short.term returns. ?f course, you will not derive any benefit if large price changes occur because then the option will be exercised or, else, you would have to ma'e a reversing transaction. The writing of covered calls, i.e., agreeing to sell the stoc' you have, is a very conservative strategy. To illustrate the strategy of writing a covered call, consider an investor who has bought a share for 6s 1,,, and who writes a call with an exercise price of 6s. 1,%, and receives a premium of 6s. #. The profit loss occurring at some prices of the underlying share is indicated in table below.
!1
(igure depicts the payoff function for the strategy of writing covered calls. He'%i$% 9 Lo$% Sto 5 S1ort Call
Profit 50 40 30 20 10 0 10 20 30 40 Loss
Profit / Loss on !"## $%tion Profit / Loss on Long Stock
2n a similar way, an investor who shorts stoc' can hedge by writing a put option. ;y underta'ing to 4be the buyer&, the investor hopes to reduce the magnitude of loss that would be occurring from an increase in the stoc' price, by limiting the profit that could be made when the stoc' price declines. As an example, suppose that you short a share at 6s. 1,, and write a put option for 6s. #, having an exercise price of 6s. 1,,. =learly, the buyer of the put will exercise the option only if the share price does not exceed the exercise price. The conditional payoffs resulting from some selected values of the share price are contained in table below. S1are Pri e D, D% 1,, 1,% 11, Pro-it / Loss -or Sele te' S1are ,al!es9 S1ort Sto 5 S1ort P!t Exer ise Pro-it o$ Pro-it / Loss o$ Pri e Exer ise &i+ S1are Hel' &ii+ 1,, 1,, 1,, 1,, 1,, .B .! # # # 1, % , .% .1, Net Pro-it &i+ " &ii+ # # # .! .B
!!
The figure below gives a general view of the profit function associated with the policy of writing a protected put. He'%i$% 9 S1ort Sto 5 S1ort P!t
Profit 50 40 30 20 10 0 10 20 30 40 Loss
Profit / Loss on S ort Stock
!#
H! " H1 -1 " H1 ,
Stock Price E1 E2
Loss
!$
Pri e o- Sto 5 -1 N@ H! H1 N -1 N H! -1 M@ H!
Profit
Example9
!%
&a+ Call With price of long call, H1 @ 7, and price of a short call, H! % B%, the profit loss would be as follows0 Sto 5 Pri e -1 M @ H! H1 N -1 N H! -1 N @ H1 Pa#o-- -rom Lo$% Call -1 " 7, -1 " 7, , Pa#o-- -rom S1ort Call B% " -1 , , Total Pa#o-1% -1 " 7, , Net Pro-it / Loss = Pa#o-- Cost 1% " 7 @ D -1 " 7, " 7 @ -1 . %$ , " 7 @ .7
The brea'.even stoc' price would be one where net profit is equal to zero. Accordingly, -1 . %$ @ , or -1% %$. Thus, a stoc' price greater than 6s. %$ would yield profit. &B+ P!t ;uying a put option with exercise price equal to 6s. %, and selling a put option with a greater exercise price of 6s. 7% represents a !ull spread. This would result in a positive cash flow of 6s. 11 " 6s. $ @ 6s. B to the investor up front.
The profit loss position is as given below. Pa#o-- -rom Pa#o-- -rom Sto 5 Pri e Lo$% Call S1ort Call -1 M @ H! H1 N -1 N H! -1 N @ H1 , , %, " -1 , -1 " 7% -1 " 7%
To obtain the brea'.even price, we set -1 . %C @ ,, so that, - 1 @ %C, implying that a profit would result when the stoc' price exceeded 6s. %C and a loss would be incurred when it fell short of 6s %C. Bear Sprea's 2n contrast to the bull spreads, bear spreads are used as a strategy when one is bearish of the mar'et, believing that it is more li'ely to go down than up. 5i'e a bull spread, a bear spread may be created by buying a call with one exercise price and selling another one with a different exercise price. /nli'e in a bull spread, however, the exercise price of the call option purchased is higher than that of the call option sold. A bear spread would involve an initial cash inflow since the premium for the call sold would be greater than for the call bought. Assuming that the exercise prices are H1 and H! with H1 E H!, the payoffs realizable from a bear spread in different circumstances are given in the table below. The profit profile is shown in figure.
!7
E1
E2
Stock Price
Loss
-uppose that the exercise prices of two call options are 6s. %, and 6s. 7,. 2f the stoc' price, - 1, were lower than 6s. %,, then none of the calls will be exercised and, therefore, no payoffs are involved. 2f the price were between the two exercise prices, say 6s. %B, then the call written for 6s. %, would be exercised and the investor loses 6s. B, and if the price of the stoc' exceeded 6s. 7,, both the calls would be exercised and an outward payoff of 6s. 1, would result. 2n each of the cases, the net profit would be obtained by adGusting for the initial cash inflow. ;ear spreads can also be created by using put options instead of call options. 2n such a case, the investor buys a put with a high exercise price and sells one with a low exercise price. This would require an initial investment because the premium for the put with a higher exercise price would be greater than the premium receivable for the put with the lower exercise price, written by the investor. 2n this spread, the investor buys a put with a certain exercise price and chooses to give up some of the profit potential by selling a put with a lower exercise price. 2n return for the profit given up, the investor gets the price of the option sold. The payoffs from a bear spread created with put options are given in the table below, wherein H1 and H! are the exercise prices of the option sold and purchased respectively. The profit function is given in figure below. 2t may be observed that, li'e bull spreads, bear spread limit both the upside profit potential and the downside ris'. Pa#o--s -rom a Bear Sprea' &Usi$% P!ts+ Pa#o-- -rom Pa#o-- -rom Lo$% P!t S1ort P!t , H! . - 1 H! . - 1 , , -1 " H1
Pri e o- Sto 5 -1 M@ H! H1 N -1 N H! -1 M@ H!
!B
Stock Price
E1
E2
Loss
Example9
&a+ Call <ere Hl is the price of call sold and H ! is the price of the call purchased. Thus, H l @ B, and H! @ C,. 9et premium obtained @ 11 . % @ 6s. 7. The profit loss would be as shown below0 Sto 5 Pri e -1 M @ H! H1 N -1 N H! -1 N @ H1 Pa#o-- -rom Lo$% Call -1 " C, B, " -1 , Pa#o-- -rom S1ort Call 7, " -1 , , Total Pa#o-. !, B, " -1 , Net Pro-it / Loss = Pa#o-- Cost . !, A 7 @ . 1$ B, " -1 A 7 @ B7 " -1 ,A7@7
To determine brea'.even stoc' price, we set B7 & -1 % ,. Thus, -1 @ B7. Therefore, a stoc' price below 6s. B7 would yield profit, while for stoc' prices above this level losses would result. &B+ P!t With Hl @ 7, and H! @ B,, and a net cost of 6s. $ *@ 6s. D " 6s. %+, the profit loss profile is as given below. Sto 5 Pri e -1 M @ H! H1 N -1 N H! -1 N @ H1 Pa#o-- -rom Lo$% Call , , B, " -1 Pa#o-- -rom S1ort Call , 7, " -1 -1 . 7, Total Pa#o-, 7, " -1 1, Net Pro-it / Loss = Pa#o-- Cost f, . $ @ . $ 7, " -1 . $ @ %7 " -1 1, . $ @ 7
!C
Pri e o- Sto 5 -1 N H1 H1 N@ -1 N H! H! N@ -1 N H# -1 M@ H!
-1 . H1 A !H! . !-1 @ !H! " H1 " -1, or H# " -1 -ince !H! @ H# A H1 B!tter-l# Sprea'
Profit Profit / Loss fro& S ort !"##s Profit / Loss fro& Long !"## Profit / Loss fro& Long !"##
E2 E1
E 3
Stock Price
Loss
3 3
!D
Example9
The investor decides to go long in two callsSone each with exercise price 6s. 7% and 6s. B%S and writes two calls with an exercise price of 6s. B,. 5ets see the payoff function for different levels of stoc' prices. *i+ 6s. 7# *ii+ 6s. 7C *iii+ 6s. B# 'iv( 6s. C, The decision of the investor leads to a !utter"l spread. ;uying two calls involves a payment of 6s. 11A 6s. 7 % 6s. 1B, and writing two calls yields 6s. C x ! @ 6s.17. Thus, cost involved with the pac'age of options @ 6s. 1B " 6s. 17 6e. 1. The payoffs associated with this plan are given below. Pa#o--s -rom a B!tter-l# Sprea' Pa#o-- -rom Pa#o-- -rom Pa#o-- -rom Total Pri e o- Sto 5 First Lo$% Call Se o$' Lo$% Call T8o S1ort Calls Pa#o-&E. = FC+ &E; = GC+ &E: = G0+ -1 N 7% 7% N@ -1 N B, B, N@ -1 N B% -1 M@ B% , -1 " 7% -1 " 7% -1 " 7% , , , -1 " B% , , !*B, . -1+ !*B, . -1+ , -1 " 7% B% " -1 ,
(rom the table, it is clear that when the stoc' price is less than 6s. 7% or 6s. B% and above, the payoff will be nil, while if the price varied between 6s. 7% and 6s. B,, the payoff equal to the price in excess of 6s. 7% and if it is in the range of 6s. B, to 6s. B%, then the payoff is 6s. B% minus the stoc' price. Accordingly, profit loss can be calculated for various given prices as follows. Pri e 7# 7C B# C, Total pa#o-- -rom Calls , # ! , Cost o- Strate%# *1+ *1+ *1+ *1+ Net Pro-it / Loss *1+ ! 1 *1+
CO4BINATIONS While spreads involve ta'ing positions in call or put options only, combinations represent option trading strategies which involve ta'ing positions in both calls and puts on the same stoc'. 2mportant combination strategies include straddles, strips, straps and strangles. Stra''le A straddle involves buying a call and a put option with the same exercise price and date of expiration. -ince a call and a put are both purchased, it costs to buy a straddle and, to that extent, a loss is incurred if the price does not move away from the exercise price since none of them will be exercised. The payoff and profit function is respect of a straddle are shown below.
#,
H . -1 ,
Stock Price
Loss
(rom the profit function depicted in the figure, it is evident that buying a straddle is an appropriate strategy to adopt when large price changes are expected in the stoc' . for lower prices of the stoc', the put option will be exercised and for higher prices, the call option will be exercised. -uppose an investor feels that the price of a certain stoc', currently valued at 6s. C% in the mar'et, is li'ely to move significantly, upward or downward, in the next three months. The investor can create a straddle by buying a call and a put option both with an exercise price of 6s. C% and an expiration date in three months. -uppose that the call costs 6s. $ and the put 6s. !. 9ow, if the stoc' price at expiration is 6s. C%, then none of the options will be exercised and a loss of 6s. 7 would occur. 2f the stoc' price Gumps to 6s 1,,, then the call will be exercised resulting in a net profit of *6s. 1,, " 6s. C%+ " 6s 7 @ 6s. D while if the price falls to, say, 6s. %B then the put option will be exercised and a net profit of 6s. C% " 6s. %B " 6s. 7 @ 6s. !! will result * This 'ind of strategy is an obvious one to employ in respect of the stoc' of a company, which is subGected to a ta'eover bid. The straddle shown above is an example of a straddle purchase. This is also referred as a !ottom straddle. A straddle write$ or a top straddle represents the reverse position so that it may be created by selling a call and a put with the same expiration date and exercise price. 2n a straddle write, a significant profit is made if stoc' price is equal to, or close to exercise price, but large deviations of stoc' price from this on either side would cause large losses, which are potentially unlimited. <ence, a straddle write is a very ris'y strategy to adopt. Strips A strip results when a long position in one call is coupled with a long position in two puts, all with the same exercise price and expiration date. <ere the investor is expecting that a big price movement in the stoc' price will ta'e place but a decrease in the stoc' price is more li'ely than an increase. -ince a put option is profitable when the price decreases, two puts are bought in this strategy. Accordingly, the profit function for the strategy, shown in the figure below is steeper in the lower than exercise price range and less steep in region of higher prices.
Strip
#1
Profit
E Stock Price
Loss
Straps ?n the other hand, if the investor is expecting that a big price change would occur in the stoc' price, but feels that there is a greater li'elihood of the price increasing rather than decreasing, the investor will consider the strategy of a strap. A strap consists of a long position in two calls and one put with same exercise price and expiry date. The profit function of a strap are shown below. Strap
Profit
E Stock Price
Loss
Stra$%les 2n a strangle, an investor buys a put and a call option with the same expiration date but with different exercise prices. The exercise price of the put is lower than the exercise price of the call, so that a profit would result if the stoc' price is lower than the exercise price of the put or if the stoc' price exceeds the call exercise price. ;etween the two exercise prices, none of the options is exercised and hence, a net loss, equal to the sum of the premia paid for buying the two options, results. 2t follows, then, that a strangle is an appropriate strategy for adoption when the price is expected to move sharply. The profit function, for exercise prices H l and H!of put and call respectively, is shown below and payoffs for different ranges of the stoc' price are given in the table.
Profit
H1 " E2 -1 , ,
, ,
Stra$%le
#!
Hvidently, a strangle is a similar strategy to a straddle, because here as well the investor is betting that a large price change would ta'e place but is not sure as to the direction in which the change would occur. <owever, in a strangle, the stoc' price has to move farther, than in a straddle, in order that the investor ma'es a profit. Also, if the stoc' price happens to be between the two exercise prices, the downside ris' is smaller with a strangle than it is with a straddle if the price is close to the exercise price. The strangle described above is also called the !ottom vertical com!ination or strangle !ought or long strangle. -imilarly, a strangle may be sold. A short strangle is the choice of an investor who believes that large variations in stoc' price are unli'ely. <owever, if they do occur, then larger amounts of losses are imminent. CONDORS A condor is an investment strategy which involves four call options or four put options. 2t may be long condor or a short condor. Lo$% Co$'or A long condor involving call options is created by buying callsSone with a very low exercise price H1, and another with a comparatively high exercise price H $, . and selling two call optionsS one with a price H! higher than, and closer to, H 1, and the other with a price H # which is lower than and closer to H$, H1, H!, H# and H$ are chosen in such a way that H ! " H1 @ H$ " H# and H# " H1 @ !*H! " H1+. The profit function of a long condor is shown below0 Lo$% Co$'or
Profit Profit / Loss fro& Long !"## Profit / Loss fro& Long !"##
E4
Stock Price
Loss
E 1
E2
E3
A long condor using put options can be created similarly, by buying one put with exercise price H1 and another one with an exercise price of H $, and selling two putsSwith exercise prices of H ! and H#. The prices H1, H!, H# and H$ are related to each other as in the case of a long condor with call
##
E2
E3 E4
Stock Price
Loss
E 1
An examination of the profit functions for condors and strangles reveals that while profit loss potential resulting from large deviations in stoc' price is very high for a strangle, it is not so in the case of a condor. 2n the latter case, profit loss is limited. BO@ SPREADS 2n a box spread strategy, the profit or loss made is independent of the stoc' price. With the obGective of ma'ing a profit regardless of the stoc' price, a box spread may be created in many ways. (or instance, it may be decided to buy one call and write one put, with an exercise price equal to H1, and write one call and buy one put, with an exercise price of H! *H! M Hl+. The table shows that the payoff in respect of this strategy will be the same irrespective of the price of the stoc'. Pa#o--s -rom Box Sprea's Sto 5 Pri e Ra$%e -1 N @H1 H1 N -1 N H! -1 M @ H! Exer ise Pri e = E. Call Bo!%1t , -1.H1 -1.H1 P!t Sol' -1.H1 , , Exer ise Pri e = E: Call Sol' H!.-1 , H!.-1 P!t Bo!%1t , H!.-1 , Total H!.H1 H!.H1 H!.H1
When the stoc' price does not exceed the lower exercise price of H 1, none of the call options is exercised and both the puts are exercised. This results in a total payoff of H ! . Hl because the stoc' bought for H1 is sold for H!. -imilarly, when the stoc' price is H ! or more, none of the puts is exercised. With a right to buy the stoc' at H l and the obligation to sell at H!, the two call options result in a payoff of H! " H1. (or the price range between H 1 and H!, stoc' will be bought at Hl, using the right under long call to buy at this price, and sold for H !, by exercising the right to sell the stoc' by virtue of the put option. A box spread can also be constructed by buying a put and writing a call, with an exercise price Hl, and buying a call and writing a put with an exercise price of H ! *H! being greater than Hl+.
#$
There are certain fundamental differences between a futures and an option contract. OPTIONS ?nly the seller is obligated to perform )remium is paid by the buyer to the seller 5oss is restricted while there is unlimited gain potential for the option buyer ?ptions prices are affected not only by prices of the underlying asset but also the time remaining for expiry of the contract and volatility of the underlying asset ?ption contract can be exercised any time till the maturity by the buyer FUTURES ;oth the parties are obligated to perform 9o premium is paid by any party There is potential ris' for unlimited gain loss for the futures buyer (uture prices affected mainly by the underlying asset
(uture contract can be honoured by both the parties only on the date specified
The 2ndian =apital >ar'et has witnessed impressive growth and qualitative changes, especially over the last two decades. 1erivatives are playing a crucial role in the =apital >ar'ets world.wide. Their introduction in the 2ndian =apital >ar'et is, the beginning of a new eraT.. 1erivatives are for emerging mar'ets li'e 2ndia. They wor' as instruments for ris' management and tools for mar'et development and serve to enhance mar'et efficiency in areas of ris' transfer. -ecurities and Hxchange ;oard of 2ndia *-H;2+ after considering the suggestions of the =ommittee on 1erivatives, chaired by >r. 5. =. Lupta U of >r. 3. 6. Farma in their reports stipulated the regulatory framewor' and ris' containment measures for derivatives trading in 2ndia. 2n line with -H;2 directives, the 9ational -toc' Hxchange of 2ndia 5imited *9-H+ commenced trading in index futures on 3une 1!, !,,,. Trading in 2ndex ?ptions commenced on 3une $, !,,1. (utures U ?ptions contracts on 2ndex are based on the popular benchmar' -U) =9J 9ifty. 9-H also became the first Hxchange to launch trading in options on individual securities from 3uly !, !,,1. ;ombay -toc' Hxchange *;-H+ too began trading in index futures in 3une last year and soon after 9-H started its trading in stoc' options ;-H also began its option trading. ?ptions on individual securities are available on %# securities stipulated by -H;2. As the derivatives mar'et is in its nascent stage in 2ndia as compared to other countries. The volume being traded in futures and options used to be very low, however it has pic'ed up significantly in last one year since the bull run began and now daily derivatives volumes is more then ! times the daily cash volume. ;oth ;-H and 9-H have been ta'ing measures to spread awareness through investor education programs. They have seminars and wor'shops on a regular basis where they teach people about futures and options, how to deal in them and try and clear their myths regarding them. And finally these results are being reflected in the mar'et. The 9ational -toc' Hxchange is emerging the most.preferred exchange for investors in the newly.launched derivatives products . futures and options trading. Folumes in futures and options trading on 9-H have been #,.#% times higher than that on its arch. rival, the ;ombay -toc' Hxchange.
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