Introduction to derivatives Part Derivatives: it is non-spot market.

The spot market or cash market is a public financial market, in which financial instruments are traded and delivered immediately. The spot market is also called the "cash market" or "physical market", because prices are settled in cash on the spot at current market prices, as opposed to forward prices.

The most important tool in derivatives market is options contract. Options contract: it is contract between two parties or more, one is called buyer (to the contract) and the other party is called the writer (seller). This contract gives the buyer the right to buy or sell number of stocks always in hundreds but from one company, the execution is later on and the price is pre-determined now "at strike price" "spot price" "option price" "exercise price". The buyer has the right to execute or not to execute the contract at execution date or exercise date. The buyer must pay premium to the writer which is not part of the contract and this premium must pay now and this premium should be kept at the writer's broker. Definition: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option contract has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the gain is unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff pattern "premium". For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. Option contracts are most frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time. Risk is limited to the option premium (except when writing options for a security that is not already owned). However, the costs of trading options (including both commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In addition, options are very complex and require a great deal of observation and maintenance. also called option.

Types of option contract: 1Option to buy (call option). 2Option to sell (put option). 1Option to buy "call option": *the buyer would like to buy at lowest price.

What Does Call Option Mean? An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date). also called call.

Example: If exercise price=$50

Exercise date Jan2011 And premium per share=$3

At Jan 2011 the execution date: The market price may be $20 $40 $48 $51 $60 $100 or $150 At market price $20: I have the right to buy from X at price $50 but I dont want to buy at loss, so I will not execute the contract so the contract value will be zero and the buyer will lose $3 premium and the writer will gain $3 premium. At market price $40: I have the right to buy from X at price $50 but I dont want to buy at loss, so I will not execute the contract so the contract value will be zero and the buyer will lose $3 premium and the writer will gain $3 premium. At market price $48: I have the right to buy from X at price $50 but I dont want to buy at loss, so I will not execute the contract so the contract value will be zero and the buyer will lose $3 premium and the writer will gain $3 premium. At market price $51: I have the right to buy from X at price $50 so I will execute the contract and the contract value will be one and the buyer will lose $2 and the writer will gain $2 per share. At market price $60: I have the right to buy from X at price $50 so I will execute the contract and the contract value will be 10 and the buyer will gain $7 and the writer will lose $7 per share. At market price $100: I have the right to buy from X at price $50 so I will execute the contract and the contract value will be 50 and the buyer will gain $47 and the writer will lose $47 per share. At market price $150: I have the right to buy from X at price $50 so I will execute the contract and the contract value will be 100 and the buyer will gain $97 and the writer will lose $97 per share.

Market price $20 $40 $48 $51 $60 $100 $150

Value of contract Zero Zero Zero 1 10 50 100

Buyer -3 -3 -3 -2 +7 +47 +97

Writer +3 +3 +3 +2 -7 -47 -97

Notes: *the call option where the buyer has the right to buy. *"the premium must be paid either executed the contract or NOT". *the buyer will never execute the contract unless the market price is greater than the exercise price. *the higher the exercise price the lower the premium. *the longer the maturity the higher the premium. *American option: any time before the execution date. What Does American Option Mean? An option that can be exercised anytime during its life. The majority of exchange-traded options are American. *European option sticks to a certain date. What Does European Option Mean? An option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes trade at a discount to its comparable American option. This is because American options allow investors more opportunities to exercise the contract. *the value of the call option contract=market price-exercise price or zero. (Because the contract will not be executed except if the market price higher than the exercise price) *the maximum gains of the buyer are not limited. *the maximum losses of the buyer are limited up to the premium. *the maximum gains of writer are limited up to premium. *the maximum losses of the writer are unlimited. *there is a negative relationship between the exercise price and the premium. *there is a positive relationship between the premium and the maturity date. *The concept of a zero-sum game//gain was developed first in game theory: what one side gains the other loses. When applied to economics it is often contrasted with a win-win situation in which both sides can make gains without anyone losing. People who are unaware of the phrases origins often mistakenly substitute gain for game. 2put option//option to sell:

The buyer (the holder) would like to sell at the highest price.
What Does Put Option Mean? An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. An option contract that gives the holder the right to sell a certain quantity of an underlying security to the writer of the option, at a specified price (strike price) up to a specified date (expiration date); here also called put.

Example: If exercise price=$50 Exercise date Jan2011 And premium per share=$3 From the buyer point of view: Market price $20 $30 $40 $48 $51 $100 $150 Value of the contract $30 $20 $10 $2 $0 $0 $0 Buyer $27 $17 $+7 $-1 $-3 $-3 $-3 Writer $-27 $-17 $-7 $+1 $+3 $+3 $+3

Notes: *put option contract where the buyer has the right to sell. *the buyer will never execute the put option unless the market price is lower than the exercise price. *the value of the put option contract = exercise price-market price or zero. *the longer the maturity, the higher the premium. *the maximum gains to the buyer are limited up to the exercise price. *the maximum losses to the buyer are limited up to the premium. *the maximum losses to the writer are limited up to the exercise price. *the maximum gains to the writer are limited up to the premium. Part Using option contracts to hedge your position: Example: assume X through spot market paid cash and bought with $100 stock and Y warned X that there will be a recession so X chose to hedge his position through the non-spot market. What is the best type of option in this case? Ans: put option "right to sell"(X be a buyer in a put option contract and his maximum losses limited up to the premium) So, X signed put option contract as buyer at the same price $100 and premium $2. Exercise price $100 Premium per share $2 Exercise date May 2011 1-So now X took two positions in two different markets--- non-spot market and spot market "cash market". If the expectations went right and the price decline to: 1-$20

Cash market: X losses $80 Option market: X "as a buyer in a put option" gains $80-$2 premium=$78 Net loss: $2 instead of $80 2-$80 Cash market: X losses $20 Option market: X "as a buyer in a put option" gains $20-$2 premium=$18 Net loss: $2 instead of $20 3-$50 Cash market: X losses $50 Option market: X "as a buyer in a put option" gains $50-$2 premium=$48 Net loss: $2 instead of $50 If his expectations went wrong and the price increases to: 1-$101 Cash market: X gains $1 Option market: X "as a buyer in a put option" will never execute losing $2 premium Net loss: $1 2-$200 Cash market: X gains $100 Option market: X "as a buyer in a put option" will never execute losing $2 premium Net gain: $98 3-$120 Cash market: X gains $20 Option market: X "as a buyer in a put option" will never execute losing $2 premium Net gain: $18 Note: in this case the buyer instead of gaining $20 he gains $18 but he protected himself on the other hand incase of his expectations goes right and that is called "cost of insurance" as "hedging risk is costing". 2-Assume X chose to be a writer in a call option contract with same terms and conditions, noting that the writer always waiting for the buyer to decide: Incase the expectations went right and the market price declines to: $20

Cash market: X losses $80 Call option: X waits the buyer to decide who will never execute paying to the writer $2 premium. Net loss: X losses $78 Note: of course the first case is better because instead of losing $78, X would lose $2 only. Being a buyer in a put option is much better when prices are expected to fall. If the expectations went wrong and the market price increases to: $200 Cash market: X gains $100 Call option: the buyer will exercise paying to the writer $2 premium so X losses $98 Net gain: $2 as writer gains in this case is limited up to the premium. $120 Cash market: X gains $20 Call option: the buyer will exercise paying to the writer $2 premium so X losses $18 Net gain: $2 writer gains are limited up to the premium. Notes: in call option the writer usually expecting prices to be stable or going down. Buyer and writer are expecting exact the opposite conditions. 3-being a writer and a buyer at the same time: Hedging using call option: Call option Exercise price $30 $35 $40 $45 Exercise date Jan 2011 Premium $3.6 $3.3 $3 $2.8 Exercise date Apr.2011 Premium $4.00 $3.7 $3.2 $3.1

Note: The longer the maturity the higher the premium. The higher the exercise price the lower the premium. A smart X would be: Buyer at low price $30 //Jan2011 And at the same time Writer at higher price $35//Jan2011 The maximum loss would be the difference between the two premiums "30 cents". The maximum gain would be the difference between the two exercises price and the two premiums which is $4.7. At Jan 2011, if market price were: MP $20

As buyer: never exercise losing $3.6 premium As writer: buyer would never exercise gaining $3.3 premium Net loss: $0.3 "hedging the risk is costing"" MP $80 As buyer: will exercise gaining $50 and paying $3.6 premium, net gain $46.4. As writer: buyer will exercise so X losses $45 and gaining premium $3.3, net loss $41.7. Net gain: $4.7 "hedging the risk is costing"" MP $32 As buyer: will exercise gaining $2 and paying $3.6 premium, net loss: $1.6. As writer: buyer will never exercise so X gains $3.3 premium, net gain:$3.3 Net gain: $1.7