• Accounting Standard 30 defines derivatives as: A derivative is a financial instrument or other contractwithin the scope of this Standard with all three of the followingcharacteristics: • its value changes in response to the change in underlying • it requires no initial investment or an initial net investment and • it is settled at a future date.
Derivatives Markets Exchange traded : Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard there is virtually no credit risk. Over-the-counter (OTC) : A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard and there is some small amount of credit risk
Forward Contracts Contractual Commitment to buy or sell a specified quantity and quality of underlying asset at a future date and for a specified price. Forward contracts are similar to futures except that they trade in the over-the-counter market. Forward contracts are particularly popular on currencies and interest rates
Futures Contracts contract is an agreement to buy or sell a specified quantity and quality of an underlying product at a specified date in the future, for a price agreed Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange
Types of Traders Hedgers Use derivatives to reduce risk that they face from potential future movements in the market variables Speculators – day traders, Position traders and scalpers Use derivatives to bet on the future direction of the market variables Arbitrageurs Take offsetting positions in two or more instruments to lock in a profit
Options An option is a contract that grants a right to the holder or purchaser of the contract to buy or sell an underlying asset at a specific price on a specific date or upto a specified date without a corresponding obligation to perform on the contract. The holder or the purchaser pays a premium for the right.
Types of options Call option- The right to buy a specified amount of currency at a specified rate. Put option- The right to sell a specified amount of currency at a specified rate.
ITM,ATM,OTM Call Option Put Option1.In-the-money Strike Price less than Strike Price greater than Spot Price of underlying Spot Price of underlying asset asset2. At-the-money Strike Price equal to Spot Strike Price equal to Spot Price of underlying asset Price of underlying asset3. Out-of-the-money Strike Price greater than Strike Price less than Spot Price of underlying Spot Price of underlying asset asset
Margin required • Initial Margin : An Initial margin is the deposit required to maintain either a short or long position in a futures contract. • Maintenance Margin : Maintenance margin is the amount of initial margin that must be maintained for that position before a margin call is generated.
Basis & Convergance Basis = Spot price – Future price process of basis moving towards zero is Convergance.
Intrinsic value & Time value Intrinsic value is difference between strike price and the spot price. Time value is the difference between premium and intrinsic value
Volatility Volatility is a measure of the rate and magnitude of the change of prices (up or down) of the underlying. If volatility is high, the premium on the option will be relatively high, and vice versa.
Delta The movement of the option position relative to the movement of the underlying position. It is the probability of option being itm at the expiration. At ATM delta of Call & Put is 0.5 At OTM delta is between 0 to 0.5 At ITM delta is between 0.5 to 1
Gamma Options Gamma is the rate of change of options delta with a small rise in the price of the underlying stock. Just as options delta measures how much the value of an option changes with a change in the price of the underlying stock, Options Gamma describes how much the options delta changes as the price of the underlying stock changes.
Vega Options Vega measures the sensitivity of a stock options price to a change in implied volatility. When implied volatility rises, the price of stock options rises along with it. Options Vega measures how much rise in option value with every 1 percentage rise in implied volatility. Vega is highest for ATM options, and is progressively lower as options are ITM and OTM.
Theta• Theta is that options Greek which tells you how much an options price will diminish over time, which is the rate of time decay of stock options.• Time decay is a well known phenomena in options trading where the value of options reduces over time even though the underlying stock remains stagnant• Positive Theta means that the options value will increase as the time passes & vice-versa.• Negative Theta means that the options value will fall as the time passes & vice-versa.• Theta is highest for ATM options, and is progressively lower as options are ITM and OTM.
Greeks Table Long call Long put Short call Short put Delta Positive Negative Negative Positive Gamma Positive Positive Negative Negative Vega Positive Positive Negative Negative Theta Negative Negative Positive positive
OPTION STRATEGY INCOME STRATEGIES COVERED CALL BULL PUT SPREAD BEAR CALL SPREAD
COVERED CALLDIRECTION Assset legs Max risk Max reward Strategy typeBullish Long stock Uncapped Capped Income Short call (OTM)•Description: It is like collecting rent while you own a stock• Outlook : neutral to bullish (steady rise).• Greeks : 1. Delta : positive and expected to fall to zero 2. Gamma: negative (net seller) 3. Vega: negative (harmful for this position) 4. Theta: positive (time decay is helpful for the position)
BULL PUT SPREADDirection Asset Legs Max Risk Max Strategy Rewards TypesBullish Long Put Capped Capped Income (FOTM) Shot Put (OTM)Oulook: bullish or neutral to bullishRationale: income for a net credit while reducing yourmaximum risk.Greeks : Delta:Positive
Bear call spreadDirection Asset Legs Max Risk Max Strategy Rewards TypeBearish Short Call Capped Capped Income (ITM) Long Call (OTM) Outlook: bearish or neutral to bearish. Greeks: Delta: negative Gamma: negative Vega: positve Theta: negative
STRADDLEDirection Asset Legs Max Risk Max Strategy Rewards TypeNeutral Long Put Capped Uncapped Capital (ATM) Gains Long Call (ATM)Outlook: movement in either directionGreeks: Delta: highest in either direction Gamma: highest Vega: positive (helpful) Theta: negative (harmful)
STRANGLEDirection Asset Legs Max Risk Max Strategy Rewards TypeNeutral Long Put Capped Uncapped Capital Gains (OTM) Long Call (OTM)Outlook: huge movement expected in either direction.Greeks: Delta: is highest Gamma: positive Vega: positive Theta: negative or harmful