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An Introduction to Derivatives. A presentation by Derivative Research. Why learn or talk about Derivatives. Important Financial instrument – In fact the most widely traded or used financial instrument in currency, commodity and equities market.
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An Introduction to Derivatives A presentation by Derivative Research UNICON
Why learn or talk about Derivatives. • Important Financial instrument – In fact the most widely traded or used financial instrument in currency, commodity and equities market. • Why are they used : - Risk control or hedge against any unforeseen event and leverage. • Good liquidity and ease of entry and exit. UNICON
What are derivatives • Derivatives are financial instruments whose value depend on the value of other, more basic underlying assets. • Underlying asset can be a commodity, currency, equity, interest rate, exchange rate etc. UNICON
Futures Forwards Options Derivative Products UNICON
Futures Contract Futures contracts: • Are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. • Are of standard quantity, standard quality. • Have standard delivery time and place. UNICON
Introduction to futures Choice of initial product: • Index futures • Options on index • Stock futures • Options on stocks UNICON
Introduction to futures • Trading mechanism Contract design: • Price • Lot size • Tick size • Expiration month and date • Open interest, volume position UNICON
Futures – definition • A futures is a legally binding agreement to buy or sell something in the future at a price which is determined today. • Pricing Futures = Spot+Cost of carry –dividend (if any) UNICON
Operational Mechanism • Cash settled • Initial Margin (upfront) • Mark-to-Market margin (daily) UNICON
Option - definition • Option is the right given by the option seller to the option buyer to buy or sell specific asset at a specific price on or before a specific date. UNICON
How much does an option cost? • The premium is the price you pay for the option. For buyer of an option • Risk : limited to the amount of premium paid • Profit potential: unlimited For a seller of an option • Risk – Unlimited. • Profit Potential – limited to the premium recd. UNICON
Option Terminology • Call Option • Option to buy • Put Option • Option to sell • Option Buyer • has the right but not the obligation • Option Writer/Seller • has the obligation but not the right UNICON
Option Terminology • Option Premium • Price paid by the buyer to acquire the right • Strike Price OR Exercise Price • Price at which the underlying may be purchased • Expiration Date • Last date for exercising the option • Exercise Date • Date on which the option is actually exercised UNICON
Strike Prices • In-the-money • Option with intrinsic value • At-the-money • Exercise Price = Market Price • Out-of-the-money • No intrinsic value • some time value possible UNICON
Types of Options • American Option (options on stocks) • can be exercised any time on or before the expiration date • European Option (options on index) • can be exercised only on the expiration date (options on index) UNICON
Call option • A buyer of call option has the right but not the obligation to buy the underlying at the set price by paying the premium upfront. • He can exercise his option on or before expiry. UNICON
Break-even (Call option) • Call= strike +premium +fees There are two ways you can liquidate your position. • exercise your option • sell back the same option contract you purchased. UNICON
Nifty 4000 Call @ 105.20 CMP = Rs. 3935/- Lot Size = 50 UNICON
Call Buyer V/s Seller • Call Buyer • Pays premium • Has right to exercise resulting in a long position in the underlying • Time works against buyer • Call Seller • Collects premium • Has obligation if assigned resulting in a short position in the underlying • Time works in favor of seller UNICON
Put option • A buyer of Put option has the right but not the obligation to sell the underlying at the set price by paying the premium upfront. • He can exercise his option on or before expiry. UNICON
Break-even (Put option) • Put= strike -premium –fees There are two ways you can liquidate your position. • exercise your option • sell back the same option contract you purchased. UNICON
Put Buyer V/s Seller • Put Buyer • Pays premium • Has right to exercise resulting in a short position in the underlying • Time works against buyer • Put Seller • Collects premium • Has obligation if assigned resulting in a long position in the underlying • Time works in favor of seller UNICON
Assignment • When holder of an option exercises the right, a randomly selected option seller is obligated to be assigned into the underlying contract. UNICON
Option Valuation • Option Premium = Intrinsic Value + Time Value Option Premium >= 0 Intrinsic Value >= 0 Time Value >= 0 UNICON
Option Valuation • Intrinsic Value • Difference between Exercise Price and Spot Price • Cannot be negative • For a Call Option • St - K • For a Put Option • K - St St = Spot price at time t K = Strike Price of Option. UNICON
Time Value • Amount buyers are willing to pay for the possibility that, at some time prior to expiration, the option may become profitable • Cannot be negative • An at-the-money option has the maximum time value of any strike price, i.e. more time value than either an in or out-of-the-money option. UNICON
Factors affecting option values • Current Price of the underlying asset (S) • Exercise Price of the option(K) • Interest Rates (Rf) • Time to Expiry (T) • Volatility of prices of the underlying asset (s) UNICON
Key Points • Options can be a very effective tool to take advantage of a rising or falling underlying. The following points may be kept in mind while purchasing options: • The time value of option premiums decay towards expiration, so market timing is very important. • Choose an option month that allows enough time for the anticipated move in the underlying. • In-the-money calls are initially more responsive to underlying price changes than out-of-the-money calls. • Choose a strike price level that offers a good risk/reward ratio given the expected price movement. UNICON
Option Greeks • Delta • Gamma • Vega • Theta • Rho UNICON
Open Interest • Open Interest is an important indicator that can help one in ascertaining the flow of funds. • If the open interest rises with rise in price it is a bullish indication. • If open interest rises and prices fall it is a bearish indication. • If open interest falls and prices rise it is a sign of short covering by bears. • If open interest falls and prices also fall it is a sign of profit booking by bulls or liquidation of positions. UNICON
Put Call Ratio • Put call ratio is an important indicator that can help one in gauging the future direction of the market. • If the Put call ratio rises then there is hope of higher prices in the near future. • If the Put call ratio falls it is a sign of weakness in the market. • Generally put call ratio is read along with volatility. • PCR can be calculated for Open Interest/positions or no of puts and calls traded. • Historically – 1.06 -2.00 is bullish. Above 2 and below 1.06 one may expect a sharp fall. UNICON
VOLATILITY • There are two types of volatility – historic volatility and implied volatility. • Historic volatility is based on historic prices of the futures and implied volatility is based on the volatility calculated from options i.e. volatility implied by premiums in options. • If volatility rises and PCR falls, it has bearish implications. • If volatility falls and PCR rises, it has bullish implications. UNICON
Trading Strategies UNICON
STRATEGIES USING FUTURES • PUT HEDGE • CALL HEDGE • COVERED Call • ARBITRAGE/REVERSE ARBITRAGE UNICON
PUT HEDGE WHEN • Put hedge is used when we are bullish on some stock. • And want to hedge our position if the prices move downwards. HOW • In this strategy we first buy a future and then hedge our position by buying a put immediately. UNICON
Tata Steel Put Hedge Buy Future @ 461 Buy 460 PA @ 16 CMP = Rs. 461/- Lot Size = 675 UNICON
PUT HEDGE • PROBLEMS • Which strike price. • What time. • Premium value. • Reversal of positions • If any important support level is breached (a) We can reduce losses by squaring off the position. (b) Squaring off the future an persisting with the put. UNICON
CALL HEDGE WHEN • Call hedge is used when we are bearish on some stock. • And want to hedge our position if the prices move up. HOW • In this strategy we first sell a future and then hedge our position by buying a call immediately. UNICON
Tata Steel Call Hedge Sell Future @ 450 Buy 460 CA @ 20 CMP = Rs. 449.60/- Lot Size = 600 UNICON
CALL HEDGE • PROBLEMS • Which strike price. • What time. • Premium value. • Reversal of positions • If any important resistance level is breached (a) We can reduce losses by squaring off the position. (b) Squaring off the future an persisting with the call. UNICON
COVERED CALL WHEN • This strategy is used when we are bullish on a stock. • And want to reduce the cost of the future but it limits the profit to the strike price of the call. HOW • In this strategy we first buy a future and sell a call of strike price higher than the future price. UNICON
IFCI Covered Call Buy Future @ 51 Sell 55 CA @ 2.50 CMP = Rs. 51/- Lot Size = 2150 UNICON
Option Spreads • Buying a call (put) and selling a call (put) with different strike prices but the same expiration month. • Two types of spreads • Bull Spreads • Bear Spreads UNICON
Bull Call Spreads • Maximum loss occurs below lower strike price • Maximum profit occurs above upper strike price • Breakeven level equals: • Lower strike plus Premium UNICON
Tata Steel Bull Call Spread Buy 450 CA @ 18.00 Sell 460 CA @ 15.00 CMP = Rs. 382.45/- Lot Size = 400 UNICON
Bear Put Spreads • Maximum loss occurs above upper strike price • Maximum profit occurs below lower strike price • Breakeven level equals: • Upper strike minus Premium UNICON
Reliance Bear Put Spread Buy 1080 PA @ 50.00 Sell 1050 PA @ 40.00 CMP = Rs. 863.35/- Lot Size = 600 UNICON
Option Straddles • Consist of buying a put and buying a call (Long Straddle). Both legs have the same strike price and same expiration; OR • Consist of selling a put and selling a call (Short Straddle). Both legs have the same strike price and same expiration. UNICON
Long Straddles • Maximum loss is equal to net debit, or total premium paid • Maximum profit is unlimited • Breakeven levels are equal to: • common strike price plus or minus total premium paid UNICON