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Jan 2020 Derivatives Session (Auro University - KJ) 1

Jan 2020 Derivatives Session (Auro University - KJ) 2


Several factors affect a derivative contract, such as:
− Operating model
− Modelling factors
− System issues

A bad handling of these factors may lead to catastrophic consequences

Operating Model Failure Modelling Factors Failure Internal Systems Failure

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Derivatives Trading
- Simplified Version

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Derivatives are financial weapons of mass destruction. - Warren Buffett

Derivative trading with mark-to-market accounting degenerates into mark-to-model. Two


firms make a big derivative trade and the accountants on both sides show a large profit
from the same trade.
- Charlie Munger

We [at Soros Fund Management] use options and more exotic derivatives sparingly. We
try to catch new trends early and in later stages we try to catch trend reversals. Therefore,
we tend to stabilize rather than destabilize the market. We are not doing this as a public
service. It is our style of making money. - George Soros

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1. Derivatives Introduction

• Definition - Operations

2. Terminologies and Meaning

3. Trading process

4. Money Management

5. Advantages

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Derivatives Definition:

A derivative can be defined as a financial instrument whose value depends on (or derives from) the
value of other basic underlying variables(assets).

Linear Derivatives:

Linear products are instruments that see their value directly related to the market price of the
underlying variable.

— In case of a move in the underlying asset, the value of the derivative will move with a nearly
identical quantity.
— Often called “Delta-One” products because there is a 1:1 relationship between the values of the
underlying and derivative in case of market move.

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A forward contract is a customized contract between two parties, where settlement takes place on a
specific date in the future at today’s pre-agreed price.

The main features of forward contracts are

•They are bilateral contracts and hence exposed to counter party risk
•Each contract is custom designed, and hence is unique in terms of contract size, expiration date and
the asset type and quality
•The contract price is generally not available in public domain
•The contract has to be settled by delivery of the asset on expiration date
•In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party,
which being in a monopoly situation can command the price it wants

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Definition :

A future contract is a standardization agreement between the seller (short position) of the contract
and the buyer (long position), traded on a futures exchange, to buy or sell a certain underlying
instrument at a certain date in future, at a pre-set price. The future date is called the delivery date or
final settlement date. The pre-set price is called the futures price.

Futures price = Spot price * [1+ r*(x/365) – d]

r = Risk free return (Gov. bond)


x = Duration (Expiry Date - T. Date)
d = Dividend

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Bullish / Bearish - Bullish = Teji / Bearish = Mandi.

Exchange - Place where Buyers and Sellers are meeting.

Settlement - The last step of a security transaction where the buyer pays cash and gets the ownership

rights over the security.

Margin - Collateral kept by a trader with a broker to cover the risk of losses on a transaction.

Long / Short - Long means Buy / Short means Short Sell.

Mark to Market - The process of determining the present market value of a security position.

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Spot(cash) Price - Transaction now with standard immediate delivery.

Premium / Discount - Difference between spot(cash) price and future price.

Calendar Spread - The difference between the Expire.

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•Non-linear products are instruments that see their value related to the market price of the underlying
variable, but under a non-linear relationship.

• The payoff of such products varies with the value of the underlying, but also with other
elements (interest rates, volatility, dividends, etc.)

• Non-linear products are often referred to as “options” but this is a global name for a wide
range of different payoffs

•Various underlying assets: stocks, indices, funds, fx rate, interest rates, bonds, etc.

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Option :

•Option may be defined as a contract, between two parties whereby one party obtains the right, but
not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date.
•The person who acquires the right is known as the option buyer or option holder.
•The other person (who confers the right) is known as option seller or option writer.
•The seller of the option for giving such option to the buyer charges an amount which is known as the
option premium.

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Types of Options :

•Call Option : A call option gives the holder a right to buy shares. The option holder will make money if
the spot price is higher than the strike price.
• Buyer is bullish / Seller is bearish or not bullish
•Put Option : The put option gives the right to sell. The option holder will make money if the spot price
is lower than the strike price.
• Buyer is bearish / Seller is bullish or not bearish

The maximum profit that an option writer can make in this case is the premium amount.

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Option Terminology :
•Buyer of an option : The option buyer is the person who acquires the rights .
•Seller / Writter of an option : The writer of an option is the one who receives the option premium and
is thereby obliged to sell/buy the asset if the buyer exercises on him.
•Contract Size of Equity Options : Lot size * Premium
•Contract Size of Index Options : Lot size * Premium
•Strike Price : Also known as the “exercise price,” this is the stated price at which the buyer of a option
has the right to purchase/sell a specific futures contract.
•American options : American options are options that can be exercised at any time up to the
expiration date
•European options : European options are options that can be exercised only on the expiration date
itself.
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Particulars Call Option Put Option Premium

Right to Buy Right to Sell


Buy Pay
Bullish Bearish

Obligation to Sell Obligation to Buy


Sell Receive
Bearish / Flat Bullish / Flat

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Moneyness :

Moneyness is a measure of the degree to which a derivative is likely to have positive monetary value at
its expiration, in the risk-neutral measure. There are three positions in options: In-the-money; At-the-
money; and Out-of-the-money.

Particulars In the Money At the Money Out of the Money

Call Option Spot > Strike Spot = Strike Spot < Strike

Put Option Spot < Strike Spot = Strike Spot > Strike

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Option pricing :

Various factors affect the price of options on index / stocks. We shall look at the impact of changes in
each of these factors on option prices one at a time, assuming that all other factors remain the same.

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Option price = Intrinsic Value + Time value

Intrinsic value is the difference between Strike Price and CMP. Intrinsic value is always found in ITM
options. OTM options have zero Intrinsic Value.

Time value premium decreases at an accelerated rate as the option approaches maturity.

Options Greeks

- Delta : Speed / Probability


- Gamma : Speed of delta
- Theta : Time decay
- Vega : Volatility

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Future Spot
Date 27/12/'19 Contacts Jan 2020
12200 12120
Strike Price CE 11900 12000 12100 12200 12300
Premium 360 285 220 160 115
Intrinsic Value 220 120 20 0 0
Time Value 140 165 200 160 115

Future Spot
Date 27/12/'19 Contacts Jan 2020
12200 12120
Strike Price PE 11900 12000 12100 12200 12300
Premium 70 95 130 170 215
Intrinsic Value 0 0 0 80 180
Time Value 70 95 130 90 35

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LONG CALL OPTION :

When to use : Investor is very bullish on the stock / index.


Risk : Limited to the Premium. (Maximum loss if market expires at or below the option strike price).
Reward : Unlimited
Break-even : Strike Price + Premium

LONG PUT OPTION :

When to use : Investor is bearish about the stock / index.


Risk : Limited to the Premium. (Maximum loss if market expires at or above the option strike price).
Reward : Unlimited
Break-even Point : Strike Price - Premium

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LONG CALL OPTION :

Strategy : Buy Call Option Amount On expiry Nifty Net Payoff from Call
closes at Option (Rs.)

Spot Nifty index 12300 12300 -50


12350 -50
12400 -50
Call Option Strike Price 12500
12450 -50
12500 -50
Client Pay Premium 50 12550 0
12600 50
Break-even point 12550 12650 100
12700 150

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LONG PUT OPTION :

Strategy : Buy Put Option Amount On expiry Nifty Net Payoff from Put
closes at Option (Rs.)

Spot Nifty index 12300 11700 250


11750 200
11800 150
Call Option Strike Price 12000
11850 100
11900 50
Client Pay Premium 50 11950 0
12000 -50
Break-even point 11950 12050 -50
12100 -50

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SYNTHETIC LONG CALL: BUY STOCK, BUY PUT :

When to use : When ownership is desired of stock yet investor is concerned about near-term
downside risk. The outlook is conservatively bullish.

Risk : Losses limited to Stock price + Put Premium – Put Strike price

Reward : Profit potential is unlimited.

Break-even point : Put Strike Price + Put Premium + Stock Price – Put Strike Price

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SYNTHETIC LONG CALL: BUY STOCK, BUY PUT :
On expiry Net Payoff Net Payoff
Strategy : Buy Nifty + Buy Put Option Amount Net Payoff
Nifty closes from Put from Fut
(Rs.)
at Option (Rs.) (Rs.)

Client Buy Nifty Nifty Fut 12300 11900 220 -400 -180
12000 120 -300 -180
12100 20 -200 -180
Put Option Strike Price 12200
12200 -80 -100 -180
12300 -80 0 -80
Client Pay Premium 80 12400 -80 100 20
12500 -80 200 120
BEP = 12200+80+12300-12200 12380 12600 -80 300 220
12700 -80 400 320

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LONG STRADDLE : AT THE MONEY OPTION

When to Use : The investor thinks that the underlying stock / index will experience significant volatility
in the near term.

Risk : Limited to the initial premium paid.

Reward : Unlimited

Break-even point :

Upper Break-even Point = Strike Price of Long Call + Net Premium Paid

Lower Break-even Point = Strike Price of Long Put - Net Premium Paid

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LONG STRADDLE : AT THE MONEY OPTION

Strategy : Buy Call + Put Option Amount Net Payoff Net Payoff
On expiry Net Payoff
from Put from Call
Nifty closes at (Rs.)
Option (Rs.) Option (Rs.)
Nifty Spot CMP 12300
11900 300 -100 200
Call & Put Strike Price 12300 12000 200 -100 100
12100 100 -100 0
Client Pay C= 100 + P= 100 200 12200 -100 -100 -200
12300 -100 -100 -200
12400 -100 -100 -200
BEP = 12300 + 200 (U) 12500
12500 -100 100 0
12600 -100 200 100
BEP = 12300 - 200 (L) 12100
12700 -100 300 200

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LONG STRANGLE : OUT OF THE MONEY OPTION

When to use : The investor thinks that the underlying stock / index will experience very high levels of
volatility in the near term.

Risk : Limited to the initial premium paid

Reward : Unlimited

Break-even point :

Upper Break-even Point = Strike Price of Long Call + Net Premium Paid

Lower Break-even Point = Strike Price of Long Put - Net Premium Paid

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LONG STRANGLE : OUT OF THE MONEY OPTION
Strategy : Buy Call + Put Option Amount Net Payoff Net Payoff
On expiry Net Payoff
from Put from Call
Nifty Spot CMP 12300 Nifty closes at (Rs.)
Option (Rs.) Option (Rs.)
Call Strike Price 12500 11500 550 -50 500
11700 350 -50 300
Call premium 50
11900 150 -50 100
Put Strike Price 12100 12100 -50 -50 -100
12300 -50 -50 -100
Put premium 50
12500 -50 -50 -100
BEP = 12500 + 50 (U) 12550 12700 -50 150 100
12900 -50 350 300
BEP = 12100 - 50 (L) 12050 13100 -50 550 500

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•Understanding of assets and view if any
• View can developed by
Technical / Fundamental or both

•Risk profile
• High Risk - Derivatives
• Low Risk - Equity

•Tools for analysis


• Data Reading
• Charting

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Open Interest :
Open interest is the total number of option contracts that are still open.
i.e. have not yet been exercised, or have not been closed out by an offsetting transaction or have not
expired.

Volumes :
Derivatives volume is the number of contracts traded during a given period of time. Hence volume
reflects the number of contracts that changed hands from a seller to a buyer, regardless of whether it
is new contract being created of just an existing contracts.

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Trading Days Client Buy/Sell Contracts Volume Open Interest
T-1 A Buy 2
2 2
B Sell 2
T-2 C Buy 7
7 9
D Sell 7
T-3 D Buy 2
2 7
A Sell 2

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Price Open Interest Volume Implication

Rising UP UP Bullish

Weak Bull / Trend


Rising Down Down
reversal

Falling UP UP Bearish

Weak Bear / Trend


Falling Down Down
reversal

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Derivatives and its operation

What is required to do trade ?

•View has to be there


•Either deep understanding of options strategies / Greeks
•Either big capital to trade options

In short : Discretionary trading

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Jan 2020 Derivatives Session (Auro University - KJ) 39
YES,

Requirements :-

Basic understanding of options

Basic understanding of charting

Small capital

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Derivatives Trading Process
- Simplified Version

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Objective System Option trading system on 15 mini time frame.

•When ? = Wednesday and Thursday - near weekly expire

•What ? = ATM Strike or 1 - ATM Strike option premium chart

•How ? = 15 mini option premium candle's RSI closed above 60 and prices also above its
20 EMA (Previous Candle)
• Buy = Above previous candle's high
• SL = (-1) Previous candle's low or 20 EMA which ever is higher
• Trail SL = After candle closes, move SL to current LOW of candle

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Buy Above 134

SL 112

Candle close & High 136


RSI > 60

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SL triggered
@ 118

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Buy Above 136

SL 112

Candle close & High 136


RSI > 60

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Booked at 240

Buy Above 136

SL 112

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Buy Above 98
Candle close & High 97.80

SL 56

RSI > 60

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Buy Above 98
Booked
at 145

SL 56

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Buy Above 48

SL 28

Candle close & High 48 RSI > 60

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Buy Above 48 Booked
at 58

SL 28

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26 DEC Strike Entry Total Capital = 20,000/-
Exit Price P&L % Chng Total of premium buying = 416
2019 Price Price
Banknifty Lot size = 20
Gross Amount = 20*416 = 8,320
Trade 1 32300 PE 134 118 -16 -11.94% Brk + Other cost = 50rs per lot each side

Gross P&L = 145


Trade 2 32300 PE 136 240 104 76.47% Brk + other cost = 400rs
Net earning = (145*20)-400 = 2500

Trade 3 32200 PE 98 145 47 47.95% ROI = 12.5%

Trade 4 32100 PE 48 58 10 20.83

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26 DEC Strike Entry Exit Total Capital = 20,000/-
P&L % Chng No. Lot G. P&L
2019 Price Price Price Per trade = 4000 investment
Banknifty Lot size = 20
32300 Brk + Other cost = 50rs per lot each side
Trade 1 134 118 -16 -11.94% 2 -640
PE
Gross P&L = 5800
Brk + other cost = 1000rs
32300 Net earning = 5800 - 1000 = 4800
Trade 2 136 240 104 76.47% 2 4160
PE
ROI = 24.00%
32200
Trade 3 98 145 47 47.95% 2 1880
PE

32100
Trade 4 48 58 10 20.83 4 400
PE

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Money management define as budgeting , saving , investing and spending etc.

Money management in investments \ trading deals with the question of what part
of the money put into risk in order to maximize the profit and even survival in
worst case scenario.

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TSL
Price

TSL

Buy

SL

Time

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Strike Rate Reward To Risk
Win trades Loss trades Profit
( For 100 Trade) Ratio

20% 2 to 1 20 80 -40

40% 2 to 1 40 60 +20

60% 2 to 1 60 40 +80

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Thank You
- Kiran Jani

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