DERIVATIVES LESSONS

DERIVATIVES

DERIVATIVES
Derivative Contracts are wasting assets, which derive their values from an underlying asset. These underlying can be :
Stocks (Equity)
Agri Commodities including grains, coffee beans, etc.
Precious metals like gold and silver.
Foreign exchange rate
Bonds
Short-term debt securities such as T-bills

TYPES OF DERIVATIVES
Forwards
Futures
Option

“ A Forward Contract is a transaction wherein the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified date in future. The price may be agreed on in advance or in future.”
Forward Contract

Risk in Forward Contract
Liquidity Risk:
Ability of the parties to buy or sell the asset whenever he wants to do so without any significant price movement.
Other Risks
Counter party Risk.
Standardisation Risk

It involves an obligation on both the parties i.e the buyer and the seller to fulfill the terms of the contract (i.e. these are pre-determined contracts entered today for a date in the future)
Obligation to buy or sell
Stated quantity
At a specific price
Stated date (Expiration Date)
Marked to Market on a daily basis
FUTURES CONTRACT

Very high Liquidity as contracts are standardized contracts. Poor Liquidity as contracts are tailor made contracts Liquidation Better; as fragmented markets are brought to the common platform. Poor; as markets are fragmented. Profile Price Discovery Exists, but assumed by Clearing Corporation/ house Exists. Counterparty Risk Contracts are standardized contracts. Differs from trade to trade. Contract Specifications Traded on exchange. Not traded on exchange Operational Mechanism Futures Forward Features

OPTIONS
“ An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. ”
The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.
Types of option:
Call Option
Put option

Classification of Option
According to exercise of option
European option : Index : NIFTY, CNXIT
American option : Stocks : TATA MOTORS, ONGC
According to type of option
Call Option
Put Option

Option Jargons S = Spot price K = Strike price S > K 2800 > 2700 S = K 2800 = 2800 S < K 2800 < 2900 PUT S < K 2800 < 2900 S = K 2800 = 2800 S > K 2800 > 2700 CALL Out -the-Money (OTM) At-the-Money (ATM) In-the-Money (ITM) Infosys (2800)

INTRINSIC VALUE TIME VALUE
Intrinsic Value :
When option is in-the-money we have maximum Intrinsic Value. If the option is out of the money or at the money its Intrinsic Value is zero.
For a call option intrinsic value : Max (0, (St – K) )
and
For a put option intrinsic value : Max (0, (K - St ) )
OPTION PREMIUM

Time Value.
- Time value of option is difference between Premium and Intrinsic value.
- ATM and OTM option only have time value and no Intrinsic value.
- The time value decreases as time remaining to maturity reduces and.
becomes zero on maturity.
ATM ITM OTM Time value Reduces Time value Reduces

Eg. Stock ONGC (-30) or 0 11 (1200-1230) = 11 OTM 1200 1230 CA 25/01/2006 OPTSTK 0 24 (1200-1200) = 24 ATM 1200 1200 CA 25/01/2006 OPTSTK 7 (1200-1170) = 30 37 ITM 1200 1170 CA 25/01/2006 OPTSTK TIME VALUE INTRINSIC VALUE PREMIUM TYPE OF OPTION SPOT STRIKE CALL / PUT EXPIRY TYPE

PARTICIPANTS
Speculators - willing to take on risk in pursuit of profit.
Hedgers - transfer risk by taking a position in the Derivatives Market.
Arbitrageurs - aim to make a risk less profit by taking advantage of price differentials and thus bring about an alignment in prices by participating in two markets simultaneously.

FUTURES STRATEGIES
TECHNICAL INDICATORS
FUTURES ARBITRAGE
HEDGING STRATEGIES

1) OPEN INTEREST
Open Interest means the total number of contracts of an underlying asset that have not been offset and closed by an opposite transaction or delivery of the underlying commodity or by cash settlement.
Sum of all positions taken by different traders are reflected in the Open
Interest.
TECHNICAL INDICATORS

Predicting the F&O markets based on Open Interest movements
Increasing OI with increase in price trend is considered positive.
Increasing OI with decrease in price is considered negative.
Decreasing OI with increase in price trend is considered positive.
Decreasing OI with decrease in price trend is considered negative.

2) PUT CALL RATIO
The Put/Call Ratio is the number of put options contracts traded divided by the number of call options contracts traded.
If put call ratio is high, it means more put options are trading in the market which is an indicator of bearishness.
Whereas if the put call ratio is low then it indicates bullishness.
Put call ratio of options shows an inverse relationship with market.

Volatility
It is a statistical measure of a market or a security's price movements over a period of time.
Mathematically volatility is often expressed as standard deviation.
There are two types of volatility:
- Historical Volatility.
- Implied Volatility.

Historical Volatility
Historical volatility is a measure of actual price changes during a specific time period in the past.
It is the annualized standard deviation of daily returns during a specific period.
Historical volatility is also referred to as actual volatility or realized volatility.
For short-term volatility, generally 5 days, 10 days, 20 days or 30 days time frame is considered. Whereas for long term volatility, normally 60 day, 180 day or 360 day time period is considered.

Derivatives’ Strategies Calculation of Historical Volatility 1. Measure the day-to-day price changes in the market: Calculate the natural log of the ratio (R t ) of a stock’s price (S) from the current day (t) to the previous day (t-1): 2. Calculate the Average daily price change (R m ) for a period of time (n) 3. “Average Variance” from the mean is calculated which is the historical volatility

Derivatives’ Strategies
4. Historical volatility is then annualized by multiplying it by the square root of the average number of trading days in a year (252 days).
Annualized H.V. = H.V x
Hence historical volatility is an indication of past volatility of the stock in the market. But, in practice, traders usually work with what is known as implied volatility .
In contrast to historical volatility, implied volatility reflects expectations regarding the stock or index’s future volatility.

Implied Volatility
Implied volatility of a stock or an index is computed using an option pricing model such as the Black-Scholes or Binomial.
Rising implied volatility causes option prices to rise while falling implied volatility results in lower option premiums.
The value of an option consists of several components like - strike price, spot price, expiration date, implied volatility of the stock and prevailing interest rates.

Derivatives’ Strategies
On a given stock, there would generally be a number of calls outstanding,
which may have different exercise prices and expiration dates.
From each of these we can make an estimate about the standard deviation of
the stock’s rate of return.
The various standard deviations are then combined on a simple or weighted
average basis and an estimate about the volatility can be made.
Therefore implied volatility is that level of volatility which is calculated from
the current trading option price.

FUTURES ARBITRAGE
Arbitrage is the act of simultaneously buying and selling assets or commodities in an attempt to exploit a profitable opportunity.
Arbitrage is done between two related instruments which are temporarily mis-priced. For example, the futures price and spot price are related by the interest rate, time to maturity and corporate benefit, if any, in the interregnum.
If the two prices do not move in tandem, then it throws up arbitrage opportunity. An arbitrageur will buy what is cheap and sell what is costly and lock in profits without any risk.

1) Cash and Carry Arbitrage Expiry Date Act. Yield (%)* Fut. Price Cash Price Scrip Reversal Date 31-08-2006 14.87 1128.75 1128.61 Reliance 28-08-2006 31-08-2006 13.01 1002.45 992.61 Reliance 07-08-2006 Expiry Date Exp. Yield (%) * Fut. Price Cash Price Scrip Execution Date

2) Reverse Cash and Carry Arbitrage Expiry Date Exp. Yield (%) * Fut. Price Cash Price Scrip Reversal Date 31-08-2006 529.84 528.23 Wipro 30-08-2006 31-08-2006 477.17 483.43 Wipro 25-07-2006 Expiry Date Exp. Yield (%) * Fut. Price Cash Price Scrip Execution Date

Index Arbitrage is the basis between the Index (Nifty) futures and its constituents (Basket).
Nifty future is in discount to Nifty spot – Buy Nifty Futures and Sell Basket.
Nifty future is in premium to Nifty spot – Buy Basket and Sell Nifty Futures.
As we can’t trade in Nifty spot, we have to create Basket of Nifty components either with underlying stock or stock futures.
INDEX ARBITRAGE

If Nifty is in discount (as quite often), then you have to sell basket.
As you cannot short sell in cash, we will be creating basket using stock futures.
Advantage of using stock futures is – only margin money will be deployed.
We will be creating Basket based on the weight of the constituents in the Nifty.(Market Capitalization Method)
We have to make portfolio - “Perfect Hedge”.
PROCESS

Contd…
Minimum exposure of 242 contracts in Nifty (12,100 units) as it will be best hedge. All the stocks will participate according to their actual weights on the exposure of 242 contracts in Nifty.
Once good returns have been observed we will execute the strategy. Execution requires highly skilled arbitrageurs.

121 NIFTY CONTRACTS : DEPLOYMENT Rs. 16,940,000 Rs. 96,800,000 Total 48,400,000*20% = Rs. 9,680,000 Rs. 48,400,000 Due to Perfect Hedge strategy. Stock Futures 48,400,000*15% = Rs. 7,260,000 4,000*12,100 = Rs. 48,400,000 Nifty Futures (currently @ 4,000) Margin Deployment Contract Value Instrument

RETURNS
We will observe maximum returns when,
Nifty is in discount and stocks are at premium.
Or
Nifty is in premium and stocks are at discount.
10%-12% Low Risk Index Arbitrage Expected Returns Risk Category Strategy

RISKS
Lot size constraint : As we have to buy/sell stocks in lot size in futures, so weights of stocks may differ from actual weights which may lead to some loss.
Execution risk : As both trades have to be executed simultaneously, there can be slippage costs. As we have to execute trades at Market Price and due to low liquidity in some of the stocks Bid/Ask spread can be high which may lead to some loss.

MANAGING RISKS
Lot size risk can be minimized by making the portfolio close to “Perfect Hedge”. If we execute the strategy for 242 contracts then the problem will be solved as most of the stocks will participate in their actual weights.
These transactions are very execution intensive and hence require highly skilled dealers and researchers who can explore all the opportunities available in the market and exploit them in the best possible manner.

HEDGING
Protecting the value of an asset against risk arising out of fluctuations in price is known as hedging. Technically hedging means transfer of risk from the asset holder to another person who is willing to carry risk.
When an investor is bearish on market, he can hedge his position by taking countervailing position against his portfolio, say, selling Nifty futures.
If the market falls, the fall in portfolio value will be compensated by the gains on the Nifty futures. But if the market rises, the rise in the portfolio value would be offset against the futures loss.
The same concept can be applied to any stocks which have a presence in futures market. The result of any Perfect Hedge contract is – “No Profit and No Loss”

PORTFOLIO HEDGING
To hedge portfolio, we need to calculate the Beta of the Portfolio and then hedge the Portfolio against the price risk.
Beta measures the sensitivity of the stock to the broad market index. So if the beta of the stocks Portfolio is 1.05, and if the markets rises by 1%, then the Portfolio is likely to go up 1.05% and same goes for negative movement too.
Calculate the number of Nifty contracts needed for Hedging. We can use the formula (Portfolio Beta x Portfolio Value) / Futures Value.
e.g.:- Portfolio value = Rs. 1,00,00,000, Nifty value = 3,50,000(3500*100) and Beta of Portfolio = 1.05
No. of contracts = (1,00,00,000*1.05)/3,50,000
= 30 contracts
So we need to sell 30 contracts of Nifty to hedge the Long Portfolio.

OPTIONS STRATEGIES
HEDGING STRATEGIES
DIRECTIONAL SPREADS
VOLATILITY SPREADS

HEDGING STRATEGIES
Covered Call
Buying a Stock & Writing a higher strike call option.
E.g.: Reliance
Strategy:
18 1200 Call Reliance Sell - - Stock @ 1150 Reliance Buy Premium Strike Price Type Stock Buy/Sells

Payoff Diagram: 1150 1200 Short Call Long Stock Hedge position 1142 1218

2) Protective Put
Buying a stock & Buying a Put option.
E.g. Century Textile
Strategy:
22 500 Put Century Text Buy - - Stock @ 505 Century Text Buy Premium Strike Price Type Stock Buy/Sell

Payoff Diagram: Long Put Long Stock Hedged Position 505 500 555

DIRECTIONAL SPREADS
Bull Call Spread
Buying a lower strike Call and Selling a higher strike Call.
E.g. Tata Steel
Strategy:
11 540 Call (OTM) Tata Steel Sell 17 520 Call (ATM) Tata Steel Buy Premium Strike Price Type Stock Buy/Sell

Payoff Diagram: 520 540 551 537 Long call Short call Hedged position Stock price Profit Loss 0 14 -6

2) Bear Put Spread:
Buying a higher strike Put and Selling a lower strike Put.
E.g. ONGC
Strategy:
18 1110 Put (OTM) ONGC Sell 28 1140 Put (ATM) ONGC Buy Premium Strike Price Type Stock Buy/Sell

Payoff Diagram: Long put Short put Hedged position Stock price 1128 1168 1140 1110 Profit Loss 0 20 -10

VOLATILITY SPREAD
STRADDLE
Buy Call and Put at same strike price.
E.g.: Infosys
Strategy:
58 1800 Put (ATM) Infosys Buy 70 1800 Call (ATM) Infosys Buy Premium Strike Price Type Stock Buy/Sell

Payoff Diagram: 1672 Hedged position Long Call Long put Profit Loss 1800 1928

2) STRANGLE
Buying an OTM Call and an OTM Put
Strategy is similar as Straddle, but it is used when an investor has is bias towards one direction, but he is not so sure of the direction.
E.g.: Satyam
Strategy:
19 780 Put (OTM) Satyam Buy 29 820 Call (OTM) Satyam Buy Premium Strike Price Type Stock Buy/Sell

Payoff Diagram: 780 820 868 732 Long Put Long Call Hedged position Profit Loss

DERIVATIVES’ GREEKS
GREEKS:
Greeks are statistical values that
show the sensitivity of the price of an
option to the factors that determine
the value of an option.
They can be used as indicators to
help monitor and analyze the risks
associated with portfolios which
include options.
Greeks include:
· Delta
· Gamma
· Vega
· Theta
· Rho

DELTA:
Delta is the rate of change in the price of the stock option to a change in
the price of the underlying.
A delta of 0.5 means that a Re. 1 increase in the price of the underlying
asset will increase the price of the option by approximately Re. 0.50.
GAMMA:
Gamma is the rate of change of delta with respect to the underlying asset
price.
For example:
Spot Price Delta Gamma
XYZ Aug 50 call Rs. 48.0 +0.45 0.07
Rs. 49.0 +0.52
Rs. 47.0 +0.35
If gamma is small, delta changes slowly whereas if gamma is large delta
is very sensitive to the price of the underlying

THETA:
Theta is the rate of change of the value of the portfolio with respect to the passage of time.
The theta of an option measures the unit change in the option price for a 1- day decrease in the days remaining to option.
Theta is also referred to as time decay of an option. For a buyer of the option, this decay works against him while for a seller of the option it works in his favour.
VEGA :
Vega is also known as kappa or lambda.
Vega is the rate of change of the value of the portfolio with respect to the
change in volatility.
A Vega of 0.12 indicates that an option’s value will increase/decrease by Re. 0.12 with every 1% increase/decrease in volatility
RHO:
Rho is the rate of change of the value of the portfolio with respect to the interest rate.

DERIVATIVES REPORT
DERISMART
DERISTRAT
DERIWATCH
PAIR STARTEGY
ROLLOVER ANALYSIS

MIB (Smart Net)
Open Interest
Put Call Ratio
Implied Volatility
Cash & Carry Arbitrage Opportunity
Reverse Cash & Carry
Bulletin Board

Thank You

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DERIVATIVES LESSONS

by Augustin Amaldas

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