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Derivatives have made the international and financial headlines in the past for mostly with their association with spectacular losses or institutional collapses. But market players have traded derivatives successfully for centuries and the daily international turnover in derivatives trading runs into billions of dollars.
Derivatives
What is a derivative?:
A financial product which has been derived from another financial product or commodity.
Without the underlying product or market, the derivative would have no independent existence.
Are derivative instruments that can only be traded by experienced, specialist traders? Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors.
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Derivatives have risen from the need to manage the risk arising from movements in markets beyond our control, which may severely impact the revenues and costs of the firm. Derivatives are used to shift risk and act as a form of insurance
Firms are exposed to several risks in the ordinary course of operations and borrowing funds
For some risks, management can obtain protection from an insurance company (fire, loss of profit , loss of stock, marine insurance)
Similarly, there are capital market products available to protect against certain risks. Such risks include : - Risks associated with a rise in the price of commodity purchased as an input - A decline in a commodity price of a product the firm sells - A rise in the cost of borrowing funds - An adverse exchange rate movement. - The instruments that can be used to provide such protection are called derivative instruments
WHAT IS A DERIVATIVE ?
A Derivatives is any security whose price is determined by the value of another asset.
--- This asset is called the underlying security , or simply , the Underlying
TWO PURPOSES
HEDGING
SPECULATION
Types of derivatvies
FORWARDS
A contract to make or take delivery of product in future , at a price set in present. Not standardised or regulated
FUTURES
Similar to Forwards . Stanardised , regulated and traded on exchanges
OPTIONS
A contract giving the right ,but not the obligation,to buy or sell a security for e.g Movie ticket
SWAPS
A contract to exchange stream of cash flows based on certain events Interest rates ,Currencies , Commodities prices, CREDIT DEFAULT SWAPS
Futures Contracts
Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)
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All the future contracts are dated . For example , Indian futures and option settlement takes place on last Thursday of every month. So the current month futures expire on the months last Thursday. If the trader has to carry his position to the next month , he has to shift his position to the next month future. Futures are generally traded using technical analysis because product facilitates speculation. You can go long or short on futures depending upon the short term view of the market and or a stock
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Futures Price
The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price
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The theoretical price of a future contract is sum of the current spot price and cost of carry. However, the actual price of futures contract very much depends upon the demand and supply of the underlying stock. Generally, the futures prices are higher than the spot prices of the underlying stocks.
Futures Price = Spot Price + Cost of Carry
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Cost of carry is the interest cost of a similar position in cash market and carried to maturity of the futures contract less any dividend expected till the expiry of the contract.
Example:
Spot Price of Stock "A" = 3000, Interest Rate = 12% p.a. Futures Price of 1 month contract = 3000 + 3000*0.12*30/365 = 3000 + 30 = 3030
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Electronic Trading
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange
Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
Terminology
The party that has agreed to buy has a long position The party that has agreed to sell has a short position
Example
January: an investor enters into a long futures contract to buy 100 oz of gold @ $1050 in April
Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.
Forward Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates
3-month forward
6-month forward
51.71
52.19
51.64
52.12
FOREIGN EXCHANGE QUOTES FOR USD/INR EXCHANGE RATE ON NOV 30, 2011
Bid/buy Spot 1-month forward 52.41 52.72 Offer/sell 52.32 52.66
3-month forward
6-month forward
53.08
53.49
53.01
53.43
FOREIGN EXCHANGE QUOTES FOR USD/INR EXCHANGE RATE ON DEC 16, 2011
Bid/buy Spot 1-month forward 52.82 53.17 Offer/sell 52.72 53.11
3-month forward
6-month forward
53.73
54.45
53.68
54.40
Illustration 1:
Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000.
What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.
Illustration 2:
Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then.
In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate.
As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency.
Example
If you agree in April with your Aunt that you will buy five kgs of tomatoes from her garden for Rs 75, to be delivered to you in July, you just entered into a futures contract!
Futures
A future contract is a standardised forward contact between two parties where one of the parties commits to sell and other to buy a stipulated quantity of a security or an index at an agreed price on or before a given date in the future
Seller
A
Buyer
B
CLEARING HOUSE
Future price = spot price +carry cost
Futures in India
Futures exists in various forms
Commodities (MCX, NCDEX)
Interest rate futures (NSE) Stock and Index Futures (NSE)
FUTURES
Futures
Index futures
Nifty Future
Let us take an example of a simple derivative contract: Ram buys a futures contract. He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs 800 he will lose Rs 800.
As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty
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The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex. While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995.
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The Nifty index consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore.
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Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes. Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.
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Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging
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Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times.
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Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract
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Example:
Futures contracts in Nifty in July 2011
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On July 28
Contract month August 2011 September 2011 October 2011 Expiry/settlement August 25 September 29 October 27
The permitted lot size is 50 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 50*5500 (Nifty value)= Rs 2,75,000. In the case of BSE Sensex the market lot is 15. That is you buy one Sensex futures the total value will be 15*18000 (Sensex value)= Rs 2,70,000
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Hedging
Stocks carry two types of risk company specific and market risk. While company risk can be minimized by diversifying your portfolio .Market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta
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Beta measures the relationship between movement of the index to the movement of the stock.
The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1.
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When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses. Hedging involves protecting an existing asset position from future adverse price movements
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In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market.
Every portfolio has a hidden exposure to the index, which is denoted by the beta.
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Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures. Steps: Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.
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Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty. Now let us study the impact on the overall gain/loss that accrues:
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Now let us study the impact on the overall gain/loss that accrues
Index up 10% Gain/(Loss) in Portfolio Gain/(Loss) in Futures Net Effect Rs 120,000 (Rs 120,000) Nil
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As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market.
The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.
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The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market.
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Speculation
Speculators are those who do not have any position on which they enter in futures and options market. 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. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.
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Illustration
Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.
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On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position. Selling Price : 4000*100 = Rs 4,00,000
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Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.
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Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.
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In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market.
In index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market.
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Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070. Sale = 1070
These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.
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If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.
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Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage Sale = 1070
However, one has to remember that the components of holding cost vary with contracts on different assets.
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Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 0.03) Futures price = Rs 107
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If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10.
The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.
Thus, we can arrive at the fair value in the case of dividend yield
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TRADING STRATEGIES
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Speculation
We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these instances.
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Have you ever felt that the market would go down on a particular day and feared that your portfolio value would erode? There are two options available
Option 1: Sell liquid stocks such as Reliance Option 2: Sell the entire index portfolio
The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing to do is to sell index futures.
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Illustration:
Scenario 1:
On July 13, 2001, X feels that the market will rise so he buys 200 Nifties with an expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).
On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.
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Scenario 2:
On July 20, 2001, X feels that the market will fall so he sells 200 Nifties with an expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523). On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456. X makes a profit of Rs 13,400 (200*67).
In the above cases X has profited from speculation i.e. he has wagered in the hope of profiting from an anticipated price change.
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Hedging
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stocks Beta. While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.
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Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a stockpicker and carefully purchased a stock based on a sense that it was worth more than the market price? A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
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1. His understanding can be wrong, and the company is really not worth more than the market price or 2. The entire market moves against him and generates losses even though the underlying idea was correct. Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.
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Let us see how one can hedge positions using index futures: X holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does X have to sell if the index futures is ruling at 1527? To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.
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On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. X closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90). Therefore, the net gain is 59940-46551 = Rs 13,389. Let us take another example when one has a portfolio of stocks:
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Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk If the index is at 1200 * 200 (market lot) = Rs 2,40,000 The number of contracts to be sold is: 1.19*10 crore = 496 contracts 2,40,000
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If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged. Thus, we have seen how one can hedge their portfolio against market risk.
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Margins
The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis. Daily margining is of two types: 1. Initial margins 2. Mark-to-market profit/loss
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The computation of initial margin on the futures market is done using the concept of Value-atRisk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days.
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VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected upfront.
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The daily settlement process called "mark-tomarket" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-tomarket settlement is done in cash. Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.
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Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur. A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500. The initial margin payable as calculated by VaR is 15%.
Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:
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Position on Day 1
Close Price
Loss
Margin released
3,000 (45,00042,000)
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Close Price
Gain
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Position on Day 3
Value of new position = 1510*200 = Rs 3,02,000 Margin = Rs 45,300
Payment to be recd
63,300
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Margin released (Day 1) = (-) Rs 3,000 Position on Day 2 Addn margin Total margin in a/c Net gain/loss Day 1 (loss) = (Rs 20,000) Rs 42,000 = (+) Rs 3,300 Rs 45,300*
Day 2 Gain
Day 3 Gain Total Gain
=
= =
Rs 22,000
Rs 18,000 Rs 20,000
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The client has made a profit of Rs 20,000 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.
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Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-tomarket. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price. The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up.
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The initial buyer liquidates his long position by selling identical futures contract. In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.
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The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices. The following table shows how futures data will be generally displayed in the business papers daily.
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Series
Close
BSXJUN 4755 4820 4740 4783.1 2000 BSXJUL 4900 4900 4800 4830.8 2000 BSXAU 4800 4870 4800 4835 G2000
Total
160
38252
116
54
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Source: BSE
The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract. The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades. One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.
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Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts. The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract.
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A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions not both.
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Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.
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Action
New buyer (long) and new seller (short) Rise Trade to form a new contract.
Existing buyer sells and existing seller buys The old contract is closed.
Fall
New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.
Existing seller buys from new seller. The No change there is no increase in Existing seller closes his position by short contracts being held buying from new seller.
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Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.
Price
Market
Warning signal
Weak
Warning signal
The warning sign indicates that the Open interest is not supporting the price direction.
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Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the
Value of a Futures contract; Value of the portfolio to be Hedged; and
Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).
The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.
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Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day. Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day
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VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence.
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Options
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There are two kinds of options: Call Options and Put Options
A Call Option is an option to buy a stock at a specific price on or before a certain date. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium
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Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.
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If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk. With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.
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If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.
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OPTIONS
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract. Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date
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Illustration 1
Raj purchases 1 Tata motors Aug 150 Call -Premium 8 This contract allows Raj to buy 100 shares of Tata Motors at Rs 150 per share at any time between the current date and the end of August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased the right to buy and for that he pays a premium.
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Now let us see how one can profit from buying an option Sam purchases a December call option at Rs 40 for a premium of Rs 15.
That is he has purchased the right to buy that share for Rs 40 in December.
If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit.
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Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.
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Let us take another example of a call option on the Nifty to understand the concept better.
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Let us take another example of a call option on the Nifty to understand the concept better. Nifty is at 1310. The following are Nifty options traded at following quotes
Option contract Dec Nifty 1325 1345 Strike price Call premium Rs 6,000 Rs 2,000
Jan Nifty
1325 1345
Rs 4500 Rs 5000
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A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.
In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).
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He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000). If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited.
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Put Options
A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time.
eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200 This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.
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Illustration 2
Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 70 on X. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium). So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.
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An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro. Quotes are as under: Spot Rs 1040 Jan Put at 1050 Rs 10 Jan Put at 1070 Rs 30
He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium. His position in following price position is discussed below. Jan Spot price of Wipro = 1020 Jan Spot price of Wipro = 1080
In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000. In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.
When you expect prices to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.
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CALL OPTIONS If you expect a fall in Short price(Bearish) If you expect a rise in price Long (Bullish) Long
PUT OPTIONS
Short
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Option styles
Settlement of options is based on the expiry date. However, there are two basic styles of options you will encounter which affect settlement.
The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:
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European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration.
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eg: Sam purchases 1 NIFTY AUG 1110 Call -Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.
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American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration. Options in stocks in the Indian market are "American Options".
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eg: Sam purchases 1 ACC SEP 145 Call -Premium 12 Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September. American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.
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IMPORTANT CONCEPTS
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STRIKE PRICE
IN THE MONEY
OUT OF THE MONEY AT THE MONEY MARKET LOTS EXPIRATION DATE OPTION VALUE
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STRIKE PRICE
The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. The strikes in options of most Indian shares are in multiples of Rs 5 and Rs 10 . Generally speaking , five to six options prices are available on both sides of the current price of the underlying. for example , the ACC stock trading at Rs 200 might have options listed with strike of Rs 150 , 160 ,170, 180, 190 , 200 ,210 220 230 240 250
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The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.
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Intrinsic value
Time value Intrinsic value is the amount by which the option is in the money. For example , lets suppose the ACC stock is trading at Rs 220 and 200 ACC call option is trading at a premium of Rs 32. of the premium of Rs 32 , the intrinsic value is Rs 20
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Time value is the part of an option premium that exceeds its intrinsic value . In the above example , therefore , the time value is Rs 12. Just to clarify in terms of which options to buy ; if I am bullish on ACC and the share is trading at Rs 200 , I would take quotes of 200, 210 220 ACC call options and compare the intrinsic values with the time values and buy the one with the maximum intrinsic value.
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Out of the money (OTM) options costs less than in the money (ITM) options because the chances of appreciation are higher in ITM options . Personally , I buy in the money options with the least amount of time value in them.
Thus in the above ACC example , if the 200 call is selling for Rs 30 and 210 call is selling for Rs 25., I would buy the 200 call even if this means paying Rs 5 more. This is because the less time value there is in the option, the lower is the value that is lost because of time
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Currently , in India only the near month (current month) options are actually liquid enough to trade. Accordingly , unless there are strong trending moves , the options time value can evaporate in a hurry. Options with more time till expiration cost more than those with less time.
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EXPIRATION DATE
The date when the term of an options contract terminates is called its expiration date. The expiry of Indian options mandated by the stock exchanges is the last Thursday of every month. Technically speaking , options contract are available for the near month ( current ), mid month (next) and far month ( the month after next) . Currently , however ,only the near month options usually have tradable liquidity and only towards the last week of the near month do the options of the mid month gather enough liquidity to be traded comfortably
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MARKET LOTS
The stock exchanges in their wisdom decided to limit the Indian derivatives market to the relatively larger players and thus introduced market lots with a minimum contract size of Rs 2 lakh. As the derivative market was first implemented at a Nifty level of about 1000 ( or Sensex 3,300 )the average contract sizes in some cases rose close to over Rs 10 lakh. When the market rallied.
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There are four major and two minor factors that determine the price of an option : The major factors are : Price of the underlying Volatility of the underlying Strike price of the option
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The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.
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Price of underlying
The premium is affected by the price movements in the underlying instrument. For Call options the right to buy the underlying at a fixed strike price as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium.
For Put options the right to sell the underlying at a fixed strike price as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.
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The following chart summarises the above for Calls and Puts.
Option Call Underlying price Premium cost
Put
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Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally worth only its intrinsic value.
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The following chart summarises the above for Calls and Puts.
Option Call Time to expiry Premium cost
Put
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Volatility
Volatility is the tendency of the underlying securitys market price to fluctuate either up or down. It reflects a price changes magnitude; it does not imply a bias toward price movement in one direction or the other.
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Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa
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The following chart summarises the above for Calls and Puts.
Option Call Volatility Premium cost
Put
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Volatility
Volatility is a measure of the fluctuation in a stock s ( or index s ) price and often plays the most important role in option trading. Knowing the volatility can help you :
Understanding Volatility
Volatility is a measure of the amount by which an asset s price fluctuation in a given time . Mathematically , volatility is the annualized standard deviation of an asset s daily price changes. There are two types of volatility: 1. Historical volatility , and
2. Implied volatility
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Historical volatility is a measure of actual changes in an assets price over a specific period of time. Historical volatility is available in most trading software. Implied volatility is a measure of how much the market expects an option price move. Thus it is the volatility that the market itself is implying , rather than that indicated by the past movements of the stock price.
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The inputs you need to calculate implied volatility are very simple . You need the current date and the date of expiry , the options strike price , the current price of the underlying , risk free rate and historical volatility. Given these , you will automatically get the implied volatility in the option.
Traders should avoid buying options which have lot of volatility premiums or time value in it , instead should sell a high volatility option
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Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa.
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In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated.
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The situation is reversed when interest rates fall premiums rise. This time it is the writer who needs to be compensated
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While the stock price itself usually undergoes a single adjustment by the amount of the dividend, option prices anticipate dividends that will be paid in the weeks and months before they are announced. The dividends paid should be taken into account when calculating the theoretical price of an option and projecting your probable gain and loss when graphing a position. This applies to stock indices as well. The dividends paid by all stocks in that index (adjusted for each stock's weight in the index) should be taken into account when calculating the fair value of an index option.
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The following chart summarises the above for Calls and Puts. Option Call Put Interest rate Premium cost
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DIVIDENDS
It's easier to pinpoint how dividends affect option premium. Cash dividends affect option prices through their effect on the underlying stock price.
Because the stock price is expected to drop by the amount of the dividend on the exdividend date, high cash dividends imply lower call premiums and higher put premiums.
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Greeks
The options premium is determined by the three factors mentioned earlier intrinsic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows:
Delta Gamma Vega
Rho
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Delta
Delta is the measure of an options sensitivity to changes in the price of the underlying asset. Therefore, its is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal.
Change in option premium Delta = -------------------------------Change in underlying price
For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index.
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Illustration:
A trader is considering buying a Call option on a futures contract, which has a price of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 a rise of Re 1 then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.
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Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1.
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305
310 315 320
16.30
19.22 22.39 25.81
+.562
+.614 +.664 +.71
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While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stock price are inversely related. This is because if you buy a put your view is bearish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The put delta equals the call delta minus 1.
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It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price. On the contrary, if delta is negative, you want the underlying assets price to fall.
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290 285 280
17.71
20.57 23.7 27.1
-.548
-.603 -.657 - .71
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Uses:
The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies.
The delta is often called the hedge ratio. e.g. if you have a portfolio of n shares of a stock then n divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a riskless hedge i.e. a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a very small amount.
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Gamma
This is the rate at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument. Change in an option delta Gamma =------------------------------------Change in underlying price
For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of 1 in the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall.
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Gamma
Gamma is rather like the rate of change in the speed of a car its acceleration in moving from a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) and falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill).
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If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the hedge to maintain a delta neutral position.
If gamma is too large a small change in stock price could wreck your hedge.
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Adjusting gamma, however, can be tricky and is generally done using options -- unlike delta, it can't be done by buying or selling the underlying asset as the gamma of the underlying asset is, by definition, always zero so more or less of it won't affect the gamma of the total portfolio.
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Theta
It is a measure of an options sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio. Change in an option premium Theta = -------------------------------------Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases.
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Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter the premium. Theta is only concerned with the time value. Unfortunately, we cannot predict with accuracy the changes in stock markets value, but we can measure exactly the time remaining until expiration.
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Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change typically 1% in the underlying volatility. Change in an option premium Vega = ----------------------------------------Change in volatilityIf for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%.
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As the stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures the sensitivity of the premium to these changes in volatility. What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it is possible to trade options purely in terms of volatility the trader is not exposed to changes in underlying prices.
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Rho
The change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an options price per unit increase typically 1% in the cost of funding the underlying. Change in an option premium Rho = --------------------------------------------------Change in cost of funding underlying
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Example
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the option will move by Rs 0.14109. To put this in another way: if the risk-free interest rate changes by a small amount, then the option value should change by 14.10 times that amount. For example, if the risk-free interest rate increased by 0.01 (from 10% to 11%), the option value would change by 14.10*0.01 = 0.14. For a put option the relationship is inverse. If the interest rate goes up the option value decreases and therefore, Rho for a put option is negative. In general Rho tends to be small except for long-dated options. 192
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There are various option pricing models which traders use to arrive at the right value of the option. Some of the most popular models have been enumerated below
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The original formula for calculating the theoretical option price (OP) is as follows:
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BACK UP SLIDES
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Indicative on Thursday November 17, 2011 IMPORT Spot 0.7426 0.6354 1month 3months 6months 0.7427 0.6356 0.742 0.636 0.7414 0.6364 Currency Euro Pound Sterling Japanese Yen* Swiss Franc Singapore Dollar Hong Kong Dollar Australian Dollar Norwegian Kroner Swedish Kroner Canadian Dollar Indian Rupees Spot 0.7424 0.6353 EXPORT 1month 3months 6months 0.7427 0.6354 0.7426 0.6356 0.7421 0.636
76.9905 76.9392 76.8008 76.5811 0.9214 1.295 7.792 0.9945 5.7909 6.7947 1.0243 50.96 0.9208 1.2949 7.7815 0.9944 5.8009 6.8101 1.0252 51.28 0.9196 1.2944 7.7759 1.0039 5.8166 6.8763 1.0264 51.71 0.9169 1.2915 7.7779 1.0116 5.8313 6.8401 1.0276 52.19
77.0291 76.9959 76.9368 76.8052 0.9217 1.2957 7.7902 0.9943 5.8005 6.8008 1.025 50.8700 0.9214 1.2948 7.7827 0.9946 5.793 6.8008 1.0244 51.21 0.9208 1.2949 7.7888 0.9979 5.8022 6.8037 1.0252 51.64 0.9197 1.2946 7.7791 1.0048 5.817 6.822 1.0266 52.12
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Rolling Settlement
Rolling Settlement is a mechanism of settling trades done on a stock exchange on T i.e. trade day plus "X" trading days, where "X" could be 1,2,3,4 or 5 days. In other words, in T+5 environment, a trade done on T day is settled on the 5th working day excluding the T day. w.e.f. April 1, 2002, the trades in all the scrips listed and traded on the exchange are now settled on T+3 basis.
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Stock Options
F&O Total
1,47,517
46,14,730
3,426.77
1,13,536.82
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The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-tomarket settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below: F = S * e rt
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where : F = theoretical futures price S = value of the underlying index r = rate of interest (MIBOR) t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After daily settlement, all the open positions are reset to the daily settlement price.
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CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.
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On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price.
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The final settlement profit / loss is computed as the difference between trade price or the previous day's settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their expiration day
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Futures Quiz
In India, futures contracts have an expiry period of Choices: One month Two months Three months All of the above
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F=S-C
F=S+C-B None of the above
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In the case of index futures the contract expires on the last ______ of the month Choices: Monday Thursday Friday Saturday
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4. In the case of index futures all positions are daily marked-to-market Choices: True False
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In stock index futures trading, profits are received or losses are paid Choices: In the delivery month On daily settlement On the day of the expiry of the contract On a weekly settlement basis
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The underlying asset for a derivatives instrument can be Choices: Equity Commodities Interest rate intruments All of the above
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The beta of ACC is 0.8. Assuming you have a position of Rs 2,00,000 of ACC which of the following gives a complete hedge? Choices: Sell 2,00,000 of Nifty Buy 2,00,000 of Nifty
Choices:
He is overhedged
He is underhedged He is completely hedged None of the above
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You are bearish on the market and hope that the market will go down so you sell 10 market lots of Nifty Jul Futures at 1150. Your forecast comes true and you close out the position at maturity at 1126. How much profit do you make?
24,000
2,40,000
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10. An increase in the open interest of a contract denotes a ____ trend Choices: Bullish Bearish Neutral None of the above
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Nifty calls can be sold anytime in the market. They cannot be excercised inbetween and excercise is only on last day of the trading cycle. You seem to be confused about excercise and selling of options. All index options are European type options in India and they cannot be excercised in between but they can be sold in the market anytime. All stock options are American options,they can be sold or excercised any time. So try to clear your concpt about selling and excercising of options. Any option,American or European can be sold in the market anytime and one does not have to wait till last Thursday. The restriction is on excercising,which is different from selling..
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Buy position for 200 shares in Fut - ACC- 26 Mar 2002 @ 150 Sell position for 100 shares in Fut - ACC- 29 Apr 2002 @160.
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LOT SIZE
STOCK CODE ACC AIRTEL GRASIM LOT SIZE 250 1000 125 MARGIN 14.0 16.0 14.0
HDFC BANK
ICICI BANK
500
250
14.0
18.0
IDEA
INFOSYS NIFTY RELIANCE
4000
125 50 250
19.0
14.0 11.0 15.0
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