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Future & options

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All about futures and options

All about futures and options

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  • 1. FUTURES AND OPTIONS UNIVERSITY OF MUMBAIM.L. DAHANUKAR COLLEGE OF COMMERCE VILE PARLE (EAST), MUMBAI – 400057 A PROJECT ON FUTURES & OPTIONS SUBMITTED BY DEEPALI.N.DALVI SUBMISSION FOR: BACHELOR OF MANAGEMENT STUDIES T.Y.B.M.S SEMESTER V UNDER THE GUIDANCE OF PROF. NACHIKET PATVARDHAN ACADEMIC YEAR 2009-2010 1
  • 2. FUTURES AND OPTIONS 2
  • 3. FUTURES AND OPTIONS DECLARATION I, DEEPALI.N.DALVI, of M.L. Dahanukar College of Commerce,T.Y.B.M.S (Semester Vth), hereby declare that I have completed this project on“FUTURES & OPTIONS” in the academic year 2009-2010The Information Submitted Is True And Original To The Best Of My Knowledge. {DEEPALI DALVI} 3
  • 4. FUTURES AND OPTIONS 4
  • 5. FUTURES AND OPTIONS AcknowledgementIt gives me pleasure to submit this project to the University of Mumbai as a part of curriculum ofBMS course.I take this opportunity to express my sincere gratitude to respected Prof. M.Pethe,The Principal, M.L.Dahanukar College of Commerce and our course coordinator,Prof. ARCHANA ZINGADE.My respect and grateful thanks to Prof.NACHIKET PATVARDHAN, for hisvaluable assistance in completion of this project.Last but not the least; I thank to my Family and Friends who have directly orindirectly helped me in completing my project. 5
  • 6. FUTURES AND OPTIONS PREFACEFutures and Options are the well developed trading instrument in the complexmarkets of today.We will find the futures and options related to almost all types of markets,E.g.-stocks, finance, metals, agriculture produce etc.Futures and options have brought various nations of the world commercially nearerto each other.Futures and Options shield the manufacturers & farmers from risk of loss due tounforeseen circumstances so that they can concentrate on their core business ofmanufacturing and farming. Futures and Options are also important for the national economy since it is a veryeffective risk management tool. 6
  • 7. FUTURES AND OPTIONS TABLE OF CONTENTSr. Topic PageNo. No.1. Introduction 9-10 1.1 History of derivatives 11-12 1.2 Understanding derivatives 13-152. Forward contract 16 2.1 History of forward contract 173. Futures market 18 3.1 History of futures market 19 3.2 Relationship between spot and futures price 20-234. Purpose of futures market 24-255. Advantage of Arbitrage 26-306. Clearing Mechanism 31-327. Types of orders 33-348. Futures Terminology 359. Difference between Forward and Futures contract 3610. Options 37 10.1 History 3811. Option Terminology 39-4512. Call option 46 12.1 Buying a call 47 7
  • 8. FUTURES AND OPTIONS 122 Writing a call 48-49 13. Put option 50 13.1 Buying a put 51 13.2 Writing a put 52 14. Advantages and Disadvantages of Options 53-56 15. Risk & Return with equity options 57-63 16. Option Trading Strategies 64-71 17 Margins 72-73 18. Stock Index Futures 74-80 19. NSE’s derivative market 81-83 20. Futures V/S Options 84-85 21. Conclusion 86 22. Bibliography 87 IntroductionDerivatives are defined as financial instruments whose value derived from the prices of one ormore other assets such as equity securities, fixed-income securities, foreign currencies, orcommodities. Derivatives are also a kind of contract between two counterparties to exchangepayments linked to the prices of underlying assets. 8
  • 9. FUTURES AND OPTIONSThe term Derivative has been defined in Securities Contracts (Regulations) Act, as “A securityderived from a debt instrument, share, loan, whether secured or unsecured, risk instrument orcontract for differences or any other form of security. It is a contract which derives its value fromthe prices, or index of prices, of underlying securitiesThe underlying can be : Stocks (Equity) Agriculture Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate BondsShort-term debt securities such as T-billsDerivative can also be defined as a financial instrument that does not constitute ownership, but apromise to convey ownership.The most common types of derivatives that ordinary investors are likely to come across arefutures, options, warrants and convertible bonds. Beyond this, the derivatives range is onlylimited by the imagination of investment banks. It is likely that any person who has fundsinvested an insurance policy or a pension fund that they are investing in, and exposed to,derivatives-wittingly or unwittingly. 9
  • 10. FUTURES AND OPTIONS 10
  • 11. FUTURES AND OPTIONS HistoryThe history of derivatives is surprisingly longer than what most people think. Some texts evenfind the existence of the characteristics of derivative contracts in incidents of Mahabharata.Traces of derivative contracts can even be found in incidents that date back to the ages beforeJesus Christ.However, the advent of modern day derivative contracts is attributed to the need for farmers toprotect themselves from any decline in the price of their crops due to delayed monsoon, oroverproduction.The first futures contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.These were evidently standardized contracts, which made them much like todays futures.The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, wasestablished in 1848 where forward contracts on various commodities were standardized around1865. From then on, futures contracts have remained more or less in the same form, as we knowthem today.Derivatives have had a long presence in India. The commodity derivative market has beenfunctioning in India since the nineteenth century with organized trading in cotton through theestablishment of Cotton Trade Association in 1875. Since then contracts on various othercommodities have been introduced as well.Exchange traded financial derivatives were introduced in India in June 2000 at the two majorstock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges.The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with thelaunch of index futures on June 12, 2000. The futures contracts are based on the popularbenchmark S&P CNX Nifty Index.The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSEalso became the first exchange to launch trading in options on individual securities from July 2, 11
  • 12. FUTURES AND OPTIONS2001. Futures on individual securities were introduced on November 9, 2001. Futures andOptions on individual securities are available on 227 securities stipulated by SEBI.The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTYJUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing miniderivative (futures and options) contracts on S&P CNX Nifty index in January 1,2008.National Commodity & Derivatives Exchange Limited (NCDEX) started its operations inDecember 2003, to provide a platform for commodities trading. The derivatives market in Indiahas grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts.The size of the derivatives market has become important in the last 15 years or so. In 2007 thetotal world derivatives market expanded to $516 trillion.With the opening of the economy to multinationals and the adoption of the liberalized economicpolicies, the economy is driven more towards the free market economy. The complex nature offinancial structuring itself involves the utilization of multi currency transactions. It exposes theclients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk,economic risk and political risk.. 12
  • 13. FUTURES AND OPTIONS UNDERSTANDING DERIVATIVESThe primary objectives of any investor are to maximize returns and minimize risks. Derivativesare contracts that originated from the need to minimize risk. The word derivative originatesfrom mathematics and refers to a variable, which has been derived from another variable.Derivatives are so called because they have no value of their own. They derive their value fromthe value of some other asset, which is known as the underlying.For example, a derivative of the shares of Infosys (underlying), will derive its value from theshare price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price ofsoybean.Derivatives are specialized contracts which signify an agreement or an option to buy or sell theunderlying asset of the derivate up to a certain time in the future at a prearranged price, theexercise price.The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date ofcommencement of the contract. The value of the contract depends on the expiry period and alsoon the price of the underlying asset.For example, a farmer fears that the price of soybean (underlying), when his crop is ready fordelivery will be lower than his cost of production.Lets say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in theselling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buythe crop at a certain price (exercise price), when the crop is ready in three months time (expiryperiod).In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of thisderivative contract will increase as the price of soybean decreases and vice-a-versa.If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will bemore valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contractbecomes even more valuable. 13
  • 14. FUTURES AND OPTIONSThis is because the farmer can sell the soybean he has produced at Rs .9000 per ton even thoughthe market price is much less. Thus, the value of the derivative is dependent on the value of theunderlying.If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver,precious stone or for that matter even weather, then the derivative is known as a commodityderivative.If the underlying is a financial asset like debt instruments, currency, share price index, equityshares, etc, the derivative is known as a financial derivative.Derivative contracts can be standardized and traded on the stock exchange. Such derivatives arecalled exchange-traded derivatives. Or they can be customized as per the needs of the user bynegotiating with the other party involved.Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example ofthe farmer above, if he thinks that the total production from his land will be around 150 quintals,he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals ofsoybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commoditiesexchange, like the National Commodity and Derivatives Exchange Limited, and buy a standardcontract on soybean.The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives havesome advantages like low transaction costs and no risk of default by the other party, which mayexceed the cost associated with leaving a part of the production uncovered. 14
  • 15. FUTURES AND OPTIONS TYPES OF DERIVATIVES:There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps. Derivatives Forwards Futures Options SwapsThe most commonly used derivatives contracts are Forward, Futures and Options. Here somederivatives contracts that have come to be used are covered. 15
  • 16. FUTURES AND OPTIONS Forward contractA forward contract is an agreement to buy or sell an asset on a specified price. One of theparties to contract assumes a long position and agrees to buy the underlying asset on a certainspecified future date for a specified price. The other party assumes a short position and agrees tosell the asset on the same date for the same price. Other contract details like delivery date, price,and quantity are negotiated bilaterally by the parties to the contracts are normally traded outsidethe exchanges.The salient features of forward contract 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. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the samecounterparty, which often results in high price being charged.However forward contracts in certain markets have become very standardized, as in case of foreignexchange, thereby reducing transaction costs and increasing transactions volume. This process ofstandardization reaches its limit in the organized futures market.The forward price of is commonly contrasted with the spot price, which is the price at which the assetchanges hands on the spot date. The difference between the spot and the forward price is the forwardpremium or forward discount, generally considered in the form of a profit, or loss, by the purchasingparty.Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange raterisk), as a means of speculation, or to allow a party to take advantage of a quality of the underlyinginstrument which is time-sensitive. 16
  • 17. FUTURES AND OPTIONSA closely related contract is a futures contract; they differ in certain respects. Forward contracts are verysimilar to futures contracts, except they are not marked to market, exchange traded, or defined onstandardized assets. Forwards also typically have no interim partial settlements or "true-ups" in marginrequirements like futures - such that the parties do not exchange additional property securing the party atgain and the entire unrealized gain or loss builds up while the contract is open. A forward contractarrangement might call for the loss party to pledge collateral or additional collateral to better secure theparty at gain.The following data relates to ABC Ltd’s share prices:Current price per share Rs. 180Price per share in the futures market-6 months RS. 195It is possible to borrow money in the market for securities transactions at the rate of 12% perannum Q. 1.Calculation of Theoretical Minimum Price of a 6-month Forward contractExplain if any arbitraging opportunities exist.Solution:Calculation of Theoretical Minimum Price of a 6-month Forward contractCurrent share priceInterest rate prevailing in money market for securities transactionsThen,Theoretical Minimum Price = Rs. 180 + (Rs. 180 * 12/100 *6/12) Rs. 190.80Arbitraging opportunities 17
  • 18. FUTURES AND OPTIONSThe current price per share in the futures market-6 months is Rs. 195 and the theoreticalminimum price of 6-months forward is Rs. 190.80. The arbitrage opportunities exist for the ABCLtd’s share. An arbitrageur can invest in ABC Ltd’s share shares at Rs.180 by borrowing at 12%p.a. for 6 months and at same time he can sell the share in the futures market at Rs. 195. On theexpiry date i.e. after 6 months period the arbitrageur can collect Rs. 195 and pay off Rs. 190.80and can record a profit of Rs. 2.20 (i.e. Rs.195-Rs190.80) FUTURE CONTRACTAs the name suggests, futures are derivative contracts that give the holder the opportunity to buyor sell the underlying at a pre-specified price sometime in the future.Futures markets were designed to solve the problems that exist in forward markets. A futurescontract is an agreement between two parties to buy or sell an asset at a certain time in the futureat a certain price. But unlike forwards contract, the futures contracts are standardized andexchange traded. To facilitate liquidity in the futures contract, the exchange specifies certainstandard features of the contract.Futures contract is a standardized form with fixed expiry time, contract size and price. A futurescontract may be defined offset prior to maturity by entering into an equal and oppositetransaction. More than 99% of futures transactions are offset this way.It involves an obligation on both the parties i.e. the buyer and the seller to fulfill the terms of thecontract (i.e. these are pre-determined contracts entered today for a date in the future) 18
  • 19. FUTURES AND OPTIONS HISTORY OF FUTURES CONTRACTMerton Miller, the 1990 Nobel laureate had said that ‘financial future represents the mostsignificant innovation of the last twenty years.’ The first exchange that traded financialderivatives was launched in Chicago in the year 1972. A division of the Chicago MercantileExchange, it was called the International Monetary Market (IMM) and traded currency futures.The brain behind this was a man called Leo Melamed, acknowledged as the “father of financialservices” who was then the chairman of the Chicago Mercantile Exchange. Before IMM openedin 1972, the Chicago Mercantile Exchange sold contracts whose value was counted inmillions. By 1990, the underlying value of all contracts traded at the Chicago MercantileExchange totaled 50 trillion dollars.These currency futures paved the way for the successful marketing of a dizzying array of similarproducts at Chicago Mercantile Exchange, Chicago Board of Trade, and the Chicago BoardOptions Exchange. By the 1990s, these exchanges were trading futures and options oneverything from Asian and American stock indexes to interest-rate swaps, and their successtransformed Chicago almost overnight into the risk-transfer capital of the world. 19
  • 20. FUTURES AND OPTIONS Relationship between Spot and Futures PriceThe price of a commodity (here we are not restricting ourselves to equity stock as the underlyingasset) is, among other things, a function of:Demand and supply position of the commodityStorability – depending on whether the commodity is perishable or notSeasonality of the commodityBasis In the context of financial futures, basis can be defined as the futures price minus the spotprice. There will be a different basis for each delivery month for each contract. In a normalmarket, basis will be positive. This reflects that futures prices normally exceed spot prices.Basis = Futures Price - Spot PriceIn a normal market, the spot price is less than the futures price (which includes the full cost-of-carry) and accordingly the basis would be negative. Such a market, in which the basis is decidedsolely by the cost-of-carry, is known as the Contango Market.Basis can become positive, i.e. the spot price can exceed the futures price only if there are factorsother than the cost-of-carry to influence the futures price. In case this happens, then basisbecome positive and the market under such circumstances is termed as a Backwardation Marketor Inverted Market.Basis will approach zero towards the expiry of the contract, i.e. the spot and futures pricesconverge as the date of expiry of the contract approaches. The process of the basis approachingzero is called Convergence.As already explained above, the relationship between futures price and cash price is determinedby the cost-of-carry. However, there might be factors other than cost-of-carry; especially in case 20
  • 21. FUTURES AND OPTIONSof financial futures there may be carry returns like dividends, in addition to carrying costs, whichmay influence this relationship.The cost-of-carry model in financial futures, thus, isFutures price = Spot price + Carrying costs – Returns (dividends, etc.)The price of ACC stocks on 31st December 2000 was Rs. 220 and the futures price on the samestock on the same date, for March 2001 was Rs. 230. Other features of the contract and relatedinformation are as follows:Time of expiration - 3 months (0.25 year)Borrowing rate - 15% p.a.Annual Dividend on the stock - 25% payable before 31.03.2001Face value of the stock - Rs. 10Based on the above information, the futures price for ACC stock on 31 st December 2000 shouldbe: = 220 + (220 x 0.15 x 0.25) – (0.25 x 10) = Rs. 225.75Thus, as per the ‘cost of carry’ criteria, the futures price is Rs. 225.75, which is less than theactual price of Rs. 230 in February 2001. This would give rise to arbitrage opportunities andconsequently the two prices will tend to converge 21
  • 22. FUTURES AND OPTIONSContract specification: S&P CNX Nifty FuturesUnderlying index S&P CNX NiftyExchange of trading National Stock Exchange of India LimitedSecurity descriptor N FUTIDX NIFTYContract size Permitted lot size shall be 100 (minimum value Rs.2 lakh)Price bands Not applicableTrading cycle The futures contracts will have a maximum of three month trading cycle - the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract. 22
  • 23. FUTURES AND OPTIONSExpiry day The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.Settlement basis Mark to market and final settlement will be cash settled on T+1 basis.Settlement price Daily settlement price will be the closing price of the futures contracts for the trading day and the final settlement price shall be the closing value of the underlying index on the last trading day. 23
  • 24. FUTURES AND OPTIONS PURPOSE OF FUTURES CONTRACTAs in any other trade, the futures trade has to have a market to facilitate buying and selling. Asthe futures markets involve the operation and execution of financial deals of an enormousmagnitude, their efficiency has to be of the highest quantity. Not only the size of the monetaryoperation that a futures market handles but also the critical significance it has on the equilibriumof the commodities / stocks is what makes the operation of the market so crucial.Futures markets provide flexibility to an otherwise rigid spot market because of their veryconcept, which allows a holistic approach to the price mechanism involved in futures contracts.The future price of a commodity is a function of various commodities related and market relatedfactors and their inter-play determines the existence of a futures contract and its price. Futuresmarkets are relevant because of various reasons, some of which are as follows:Quick and Low Cost Transactions:Futures contracts can be created quickly at low cost to facilitate exchange of money for goods tobe delivered at future date. Since these low cost instruments lead to a specified delivery of goodsat a specified price on a specified date, it becomes easy for the finance managers to take optimaldecisions in regard to protection, consumption and inventory. The costs involved in entering intofutures contracts is insignificant as compared to the value of commodities being tradedunderlying these contracts.Price Discovery Function:The pricing of futures contracts incorporates a set of information based on which the producersand the consumers can get a fair idea of the future demand and supply position of the commodityand consequently the future spot price. This is known as the ‘price discovery’ function of future.Advantage to Informed Individuals: 24
  • 25. FUTURES AND OPTIONSIndividuals, who have superior information in regard to factors like commodity demand-supply,market behavior, technology changes, etc., can operate in a futures market and impart efficiencyto the commodity’s price determination process. This, in turn, leads to a more efficient allocationof resources.Hedging Advantage:Adverse price changes, which may lead to losses, can be adequately and efficiently hedgedagainst through futures contract. An individual who is exposed to the risk of an adverse pricechange while holding a position, either long or short, will need to enter into a transaction whichcould protect him in the event of such an adverse change.For e.g., a trader who has imported a consignment of copper and the shipment is to reach withina fortnight, he may sell copper futures if he foresees fall in copper prices. In case copper pricesactually fall, the trader will lose on sale of copper but will recoup through futures. On thecontrary if prices rise, the trader will honors the delivery of the futures contract through theimported copper stocks already available with him.Thus, futures markets provide economic as well as social benefits, through their function of riskmanagement and price discovery. ADVANTAGE OF ARGITRAGE 25
  • 26. FUTURES AND OPTIONS What do you mean by Arbitrage? ….In economics and finance, arbitrage is the practice of taking advantage of a price differentialbetween two or more markets: striking a combination of matching deals that capitalize upon theimbalance, the profit being the difference between the market prices. A person who engages inarbitrage is called an arbitrageur such as a bank or brokerage firm. The term is mainly appliedto trading in financial instruments, such as bonds, stocks, derivatives, commodities andcurrencies.In today’s scenario when markets world over have become highly volatile and choppy because ofSubprime Issue & Credit crises faced by US we very often get to see a gap -up opening or a gapdown opening. However, there is a set of people who enjoy such volatilities. They are waitingfor volatile times in a bull market and are mawkishly waiting for mispricing opportunities to becreated so that they could gain from mispricing in the cash and futures markets. These are thearbitragers. They have been fast gaining currency in the investment market by providing a steadyperformance. Returns from arbitrage funds have been good. These funds are fast gatheringinvestor attention, especially from the retail segment of the market. The attraction of thearbitrage fund comes from the fact that there are near risk-free returns to be made here. By itsvery definition, arbitrage, means getting risk-free returns by seeking price differentials betweenmarkets. So the returns are risk-free. Now, with the markets getting choppy, the returns arestrong. And even better than many other exiting fixed income investment options. Modus operandi!!! 26
  • 27. FUTURES AND OPTIONSBut are arbitrage funds totally risk-free? Before we dwell into this question, knowing how anastute arbitrage works is important. Earlier, the arbitrager would sit across two monitors, onehaving prices of stocks listed on the National Stock Exchange and the other the Bombay StockExchange. The idea was to spot price differences between these markets.Buy in one and simultaneously sell in the other to gain from the difference. However, withmarkets getting sharper and the security transaction tax (STT) coming in, the transaction costshaving risen, the pricing advantage has been nullified to a great extent. The price differential isnow very narrow and one would require huge amounts to really gain, so this type of arbitrage isnot all that attractive now.The game now takes place in the spot (cash) and the futures market. Volatile prices and overallexcitement-led activity often create strong pricing mismatches between the spot and futuresmarket. 27
  • 28. FUTURES AND OPTIONSSuppose the stock price of XYZ company is now is quoting at Rs 100. And the quotation of pricein the futures segment in the derivatives market is Rs 110. In such a case, the arbitrager can makerisk-free profit by selling a futures contract of XYZ at Rs 110 and at the same time buying anequivalent number of shares in the cash market at Rs 100. So this is the first leg of thetransaction which involves selling a futures contract and buying in the cash segment.Now after waiting for a month, or the contract expiration period, on the settlement day, it isobvious that the future and the cash price tend to converge. At this time, the arbitrager willreverse the position. Sell in the cash market and buy a futures contract of the same security. Thisis the second leg of the transaction.There could be two possibilities in such a situation. One, the share price has risen substantially inthe holding period, and has now become Rs 200. In that case, the arbitrager makes money on theprofit on the sale of Rs 100 share at Rs 200 and a loss on the sale of the futures contract. And ifthe price declines to Rs 50, then the arbitrager will gain from the sale of the derivatives contractand take a loss on the sale of the shares in the spot market. Either ways, there is a gain. There areother gains to be made while rolling the contract over and taking advantage of further mispricing 28
  • 29. FUTURES AND OPTIONS Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise!!! Arbitrage - Overpriced futures: buy spot, sell futuresIf you notice that futures on a security that you have been observing seem overpriced, how canyou cash in on this opportunity to earn risk less profits? Say for instance, ACC Ltd. trades atRs.1000. One–month ACC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, youcan make risk less profit by entering into the following set of transactions.On day one, borrow funds; buy the security on the cash/spot market at 1000.Simultaneously, sell the futures on the security at 1025.Take delivery of the security purchased and hold the security for a month.On the futures expiration date, the spot and the futures price converge. Now unwind the position.Say the security closes at Rs.1015. Sell the security.Futures position expires with profit of Rs.10.The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position.Return the borrowed funds.When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy thesecurity is less than the arbitrage profit possible, it makes sense for you to arbitrage. This istermed as cash–and–carry arbitrage. 29
  • 30. FUTURES AND OPTIONS Arbitrage - Underpriced futures: buy futures, sell spotIt could be the case that you notice the futures on a security you hold seem underpriced. How canyou cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades atRs.1000. One–month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, youcan make riskless profit by entering into the following set of transactions.On day one, sell the security in the cash/spot market at 1000.Make delivery of the security.Simultaneously, buy the futures on the security at 965.On the futures expiration date, the spot and the futures price converge. Now unwind the position.Say the security closes at Rs.975. Buy back the security.The futures position expires with a profit of Rs.10.The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.If the returns you get by investing in riskless instruments is more than the return from thearbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carryarbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line withthe cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. Asmore and more players in the market develop the knowledge and skills to do cash–and–carry andreverse cash–and–carry, we will see increased volumes and lower spreads in both the cash aswell as the derivatives market. 30
  • 31. FUTURES AND OPTIONS CLEARING MECHANISMA clearing house is an inseparable part of a futures exchange. This exchange acts as a seller forthe buyer and a buyer for the seller in the process of execution of a futures contract.For example, the moment the buyer and the seller agree to enter into a contract, the clearinghouse steps in and bifurcates the transaction, such that,Buyer buys from the clearing house, andSeller sells to the clearing house.Thus, the buyer and the seller do not get into the contract directly; in other words, there is nocounter party risk. The idea is to secure the interest of both. In order to achieve this, the clearinghouse has to be solvent enough. This solvency is achieved through imposing on its members,cash margins and/or bank guarantees or other collaterals, which are encashable fast. The clearinghouse monitors the solvency of its members by specifying solvency norms.The solvency requirements normally imposed by the clearing house on their members arebroadly as follows.1. Capital AdequacyCapital adequacy norms are imposed on the clearing members to ensure that only financiallysound firms could become members. The extent of capital adequacy has to be market specificand would vary accordingly.2. Net Position LimitsSuch limits are imposed to contain the exposure threshold of each member. The sum total ofthese limits, in effect, is the exposure limit of the clearing association as a whole and the netposition limits are meant to diversify the association’s risk. 31
  • 32. FUTURES AND OPTIONS3. Daily Price LimitsThese limits set up the upper and the lower limits for the futures price on a particular day andincase these limits are touched the trading in those futures is stopped for the day.4. Customer MarginsIn order to avoid unhealthy competition among clearing members in reducing margins to attractcustomers, a mandatory minimum margin is obtained by the members from the customers. Sucha step insures the market against serious liquidity crisis arising out of possible defaults by theclearing members owing to insufficient margin retention.In order to secure their own interest as well as that of the entire system responsible for thesmooth functioning of the market, comprising the stock exchanges, clearing houses and thebanks involved, the members collect margins from their clients as may be stipulated by the stockexchanges from time to time. The members pass on the margins to the clearing house on the netbasis i.e. at a stipulated percentage of the net purchases and sale position while they collect themargins from clients on gross basis, i.e. separately on purchases and sales.The stock exchanges impose margins as follows:Initial margins on both the buyer as well as the seller.Daily maintenance margins on both.The accounts of the buyer and the seller are marked to the market daily. 32
  • 33. FUTURES AND OPTIONS TYPES OF ORDERSThe system allows the trading members to enter orders with various conditions attached to themas per their requirements. These conditions are broadly divided into the following categories: • Time conditions • Price conditions • Other conditionsSeveral combinations of the above are allowed thereby providing enormous flexibility to theusers. The order types and conditions are summarized below.Time conditions– Day order: A day order, as the name suggests is an order which is valid for the day on which itis entered. If the order is not executed during the day, the system cancels the order automaticallyat the end of the day.– Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon asthe order is released into the system, failing which the order is cancelled from the system. Partialmatch is possible for the order, and the unmatched portion of the order is cancelled immediately.Price condition-Stop–loss: This facility allows the user to release an order into the system, after the market priceof the security reaches or crosses a threshold price. 33
  • 34. FUTURES AND OPTIONSE.g. if for stop–loss buy order, the trigger is 1027.00, the limit price is 1030.00 and themarket(last traded) price is 1023.00, then this order is released into the system once themarket price reaches or exceeds 1027.00. This order is added to the regular lot book withtime of triggering as the time stamp, as a limit order of 1030.00. For the stop–loss sellorder, the trigger price has to be greater than the limit price.Other conditions– Market price: Market orders are orders for which no price is specified at the time the order isentered (i.e. price is market price). For such orders, the system determines the price.– Trigger price: Price at which an order gets triggered from the stop–loss book.– Limit price: Price of the orders after triggering from stop–loss book.– Pro: Pro means that the orders are entered on the trading member’s own account.– Cli: Cli means that the trading member enters the orders on behalf of a client.For both the futures and the options market, while entering orders on the trading system,members are required to identify orders as being proprietary or client orders. Proprietary ordersshould be identified as ‘Pro’ and those of clients should be identified as ‘Cli’. Apart from this, inthe case of ‘Cli’ trades, the client account number should also be provided.The futures market is a zero sum game i.e. the total number of long in any contract always equalsthe total number of short in any contract. The total number of outstanding contracts (long/short)at any point in time is called the “Open interest”. This Open interest figure is a good indicatorof the liquidity in every contract. Basedon studies carried out in international exchanges, it is found that open interest is maximum innear month expiry contracts 34
  • 35. FUTURES AND OPTIONS Futures TerminologySpot price:- The price at which an asset trades in the spot market is called spot priceFutures price: - The price at which the futures contract trades in the futures market.Contract cycle: - The period over which a contract trades. The index futures contracts on theNSE have one-month, two months and three –month’s expiry cycles which expire on the lastThursday of the month. Thus a January expiration contract ceases trading on the last Thursday ofFebruary. On the Friday following the last Thursday, a new contract having a three-month expiryis introduced for trading.Expiry date :- It is the date specified in the futures contract. This is the last day on which thecontract will be traded, at the end of which it will cease to exist.Contract size: - The amount of asset that has to be delivered under one contract. For instance,the contract size on NSE’s futures market is 200 Nifties. 35
  • 36. FUTURES AND OPTIONSBasis: - in the context of financial futures, basis can be defined as the futures price minus thespot price. There will be a different basis for each delivery month for each contract. In a normalmarket, basis will be positive. This reflects that futures prices normally exceed spot prices.Cost of carry: - the relationship between futures prices and spot prices can be summarized interms of what is known as the cost of carry. This measures the storage cost plus the interest thatis paid to finance the asset less the income earned on the asset.Differences between Forward and Futures ContractsFEATURE FORWARD CONTRACT FUTURE CONTRACTOperational Traded directly between two parties Traded on the exchanges.Mechanism (not traded on the exchanges).Contract Differ from trade to trade. Contracts are standardized contracts.SpecificationsCounter-party risk Exists. Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally guarantees their settlement.Liquidation Profile Low, as contracts are tailor made High, as contracts are standardized contracts catering to the needs of the exchange traded contracts. 36
  • 37. FUTURES AND OPTIONS needs of the parties.Price discovery Not efficient, as markets are scattered. Efficient, as markets are centralized and all buyers and sellers come to a common platform to discover the price.Examples Currency market in India. Commodities, futures, Index Futures and Individual stock Futures in India. OPTIONS“ An option is a contractual agreement that gives the option buyer the right, but not theobligation, to purchase (in the case of a call option) or to sell( in case of put option) a specifiedinstrument at a specified price at any time of the option buyer’s choosing by or before a fixeddate in the future. Upon exercise of the right by the option holder, an option seller is obliged todeliver the specified instrument at the specified price.”Options are fundamentally different from forward and futures contracts. An option gives theholder of the option the right to do something. The holder does not have to exercise this right. Incontrast, in a forward or futures contract, the two parties have committed themselves in doingsomething. Whereas it costs nothing (except margin requirements) to enter into a futurescontract, the purchase of an option requires an up-front payment.There are two basic types of options, call options and put options. 37
  • 38. FUTURES AND OPTIONS Call option: A call option gives the holder the right but not the obligation to buy an asset by acertain date for a certain price.Put option: A put option gives the holder the right but not the obligation to sell an asset by acertain date for a certain price. HISTORY OF OPTIONS CONTRACT Although options have existed for a long time, they were traded OTC, without muchtechnology of valuation. The first trading in options began in Europe and US as early as theseventeenth century. It was only in the early 1990s that a group of firm’s setup what was knownas the put and call Brokers and Dealers Association with the aim of providing a mechanism forbringing buyers and sellers together. If someone wanted to buy an option, he or she wouldcontact one of the member firms. The firm would then attempt to find a seller or writer of theoption either from its own clients or those of the other member firms. If no seller could be found,the firm would undertake o write the option itself in return for a price.This market however suffered from two deficiencies. First, there was a secondary market andsecond, there was no mechanism to guarantee that the writer of the option would honor thecontract.In 1973, Black, Merton and Scholes invented the framed Back-Scholes formula. In April 1973,CBOE was setup specifically for the purpose of trading options. The market for options 38
  • 39. FUTURES AND OPTIONSdeveloped so rapidly that by early 80’s , the number of shares underline the option contract soldeach day exceeded the daily volume of shares traded on the NYSE. Since then has been nolooking back. Option TerminologyBefore going into the concepts and mechanics of options trading, we need to be familiar with thebasic terminology as they are repeatedly used in case of options.Index options: - These options have the index as the underline. Some options are Europeanwhile other is American. Like index futures contracts, index options are also cash settled.Stock options: - Stock options are options on individual stocks. Options currently trade on over500 stocks in the United States. A contract gives the holder the right to buy or sell shares at thespecific price.Buyer of an option: The buyer of an option is the one who by paying the option premium buysright but not the obligation to exercise his option on the seller / writer. 39
  • 40. FUTURES AND OPTIONSWriter of an option: The writer of a call/per option is the one who receives the option premiumand is thereby obliged to sell/buy the asset if the buyer exercises on him.Option price/premium: Option price is the price which the option buyer pays to the optionseller. It is also referred to as the option premium. - To acquire an option, the speculator mustpay option money, the amount of which depends on the share being dealt in. the more volatilethe share the higher the cost of the option. It may, however, normally be somewhere within therange of 5-10 percent.The premium of the option is a function of variables, such as:Current stock price,Strike price,Time to expiration,Volatility of stock, andInterest rates. The buyer pays the premium to the seller, which belongs to the seller whether the option isexercised, or not. If the owner of an option decided not to exercise the option, the option expiresand becomes worthless. The premium becomes the profit of the option writer, while if the optionis exercised; the premium gets adjusted against the loss that the writer incurs upon such exerciseStriking price: - The fixed price at which the option may be exercised, known as the ‘strikingprice’ is based on the current quoted prices.With a call option the striking price is the higher quoted price plus a further small sum called thecontango to recompense the option dealer.With a put option the striking price is usually the current lower quoted price. There is nocontango money. 40
  • 41. FUTURES AND OPTIONSDeclaration day: - At the end of the period the holder either abandons his/her option or claimsright under it. The time for doing this is the ‘declaration day’ which is the second last day in theaccount before the final account day on which completion of the option may take placeLimiting risk: - Options are expensive and in order to be profitable requires a fairly sharp short-term price movement. The costs to be covered are the jobber’s turn, the option money, thebroker’s commission, and in the case of a call option the contango in the striking price. They dohowever; substantially reduce the speculator’s risk of loss.Traded options: - If the options dealing is introduced in the stock exchanges, they will bepublicly traded like any other quoted stocks. Greater flexibility is available to the holder oftraded options than with the options which are not traded in stock exchanges.Double options: - As well as call and put options it is also possible to obtain a double optionwhich is a combination of both. The holder has the right either to buy or sell the shares subject tothe option at the striking price which in this case will probably be around the middle of thecurrent quoted prices. The option money is exactly twice that of the current quoted prices.Gearing: - Percentage wise the price movements of a traded option are of more than those of theunderlying share. The holder of an option is then exposed to a higher risk but on the other handcould reap greater rewards in relation to the amount of his/her investment.In-the-money option: An in-the-money (ITM) option is an option that would lead to a positivecash flow to the holder if it were exercised immediately. A call option on the index is said to beIn-the-money when the current index stands at a level higher than the strike price (i.e. spot price 41
  • 42. FUTURES AND OPTIONS> strike price). If the index is much higher than the strike price, the call is said to be deep ITM.In the case of a put, the put is ITM if the index is below the strike price.At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the currentindex equals the strike price (i.e. spot price = strike price).Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead tonegative cash flow it were exercised immediately. A call option on the index is out-of-the-moneywhen the current index stands at a level which is less than the strike price (i.e. spot price < strikeprice). If the index is much lower than the strike price, the call is said to be deep OTM. In thecase of a put, the put is OTM if the index is above the strike price.These concepts are tabulated below, wherein S indicates the present value of the stock and E isthe exercise price.Condition Call option Put option S>E In-the-Money Out-of-the-Money S<E Out-of-the-Money In-the-Money S=E At-the-Money At-the-MoneyIntrinsic Value:-The premium or the price of an option is made up of two components, namely,intrinsic value and time value. Intrinsic value is termed as parity value.For an option, the intrinsic value refers to the amount by which it is in money if it is in-the-money. Therefore, an option, which is out-of-the-money or at-the-money, has zero intrinsicvalue. 42
  • 43. FUTURES AND OPTIONSFor a call option, which is in-the-money, then, the intrinsic value is the excess of stock price (S)over the exercise price (E), while it is zero if the option is other than in-the-money.Symbolically,Intrinsic Value of a call option = max (0, S – E)In case, of an in-the-money put option, however, the intrinsic value is the amount by which theexercise price exceeds the stock price, and zero otherwise. Thus,Intrinsic Value of a put option = max (0, E - S)Time Value: - Time value is also termed as premium over parity. The time value of an option isthe difference between the premium of the option and the intrinsic value of the option. For, a callor a put option, which is at-the-money or out-of-the-money, the entire premium about is the timevalue. For an in-the-money option time value may or may not exist. In case, of a call which is in-the-money, the time value exists if the call price, C, is greater than the intrinsic value, S – E.Generally, other things being equal, the longer the time of a call to maturity, the greater will bethe time value.This is also true for the put options. An in-the-money put option has a time value if its premiumexceeds the intrinsic value, E – S. Like for call options, put options, which are at-the-money orout-of-the-money, have their entire premium as the time value. Accordingly, Time value of a call = C – [max (0, S - E)] Time value of a put = C – [max (0, E - S)]Consider the following data calls on a hypothetical stock. 43
  • 44. FUTURES AND OPTIONSOption Exercise Stocks Call Option Classification Price (Rs) Price (Rs) Price (Rs)1. 80 83.50 6.75 In-the-money2. 85 83.50 2.50 Out-the-moneyWe may show how the market price of the two calls can be divided between intrinsic andtime values.Option S E C Intrinsic Value Time Value Max (0, S-E) C-max (0, S-E)1. 83.50 80 6.75 3.50 6.75-3.50=3.252. 83.50 85 2.50 0 2.50-0=2Covered & Uncovered OptionsAn option contract is considered covered if the writer owns the underlying asset or has anotheroffsetting option position. In the absence of one of these conditions, the writer is exposed to therisk of having to fulfill the contractual obligations by buying the asset at the time of delivery atan unfavorable price. 44
  • 45. FUTURES AND OPTIONSThe call writer may have to purchase the underlying asset at a price that is higher than he strikeprice. The put writer may have to buy the asset from the holder at a price that creates a loss.When they face such a risk writers are said to be uncovered (or naked).Covered Call Options / Covered CallsCall writers are considering to be covered if they have any of the following positions:Along position in the underlying asset.An escrow-receipt from a bank.A security that is convertible into requisite number of shares of the underlying security.A warrant exercisable for requisite number of shares of the underlying security.A long position in a call on the same security that has the same or the lower strike price and thatexpires at the same time or later than the option being written.Covered PutThere is only one way for put writer to be covered. They must own a put on the same underlyingasset with the same or later expiration month and the higher strike price than the option beingwritten.We will consider some of the following examples to understand the above discussedconcepts better:-Suppose there is a call option at a strike of Rs.176 and is selling at a premium of Rs.18. At whatprice will it break even for the buyer of the option Mr. Ramesh? 45
  • 46. FUTURES AND OPTIONSFor Mr. Rajesh to recover the option premium of Rs.18, the spot will have to rise to 176 + 18.So answer to this will be Rs 194/-Suppose ACC stock currently sells at Rs.120/-. The put option to sell the stock sells at Rs.134costs Rs.18. The time value of the option in this case will be?????It will be Rs4/-Suppose the spot value of Nifty is 2140. An investor Mr. Murti buys a one month nifty 2157 calloption for a premium of Rs.7. In this case what will such an option be called????It will be called as Out of the moneyEssential Ingredients of an Option ContractAn options contract has four essential ingredients:The name of the company on whose stock the option contract has been derived.The quantity of the stock required to be delivered in the case of exercise of the option.The price, at which the stock would be delivered, or the exercise price or the strike price.The date when the contract expires, called the expiration date. Call optionA call option give the buyer the right but not the obligation to buy a given quantity of aunderlying asset, a given price known as ‘exercise price’ on or given future date called a‘maturity date’ or expiry date’. A call option gives the buyer the rights to buy a fixed number ofshares/commodities in particular securities at the exercised price up to the date of expiration thecontract. The seller of an option is known as the ‘writer’. Unlike the buyer, the writer has no 46
  • 47. FUTURES AND OPTIONS choice regarding the fulfillment of the obligations under the contract. If the buyer wants to exercise his rights, the writer must comply. For this asymmetry of privilege, the buyer must pay the writer the option price which is known as premium. The rights and obligations of the buyer and writer of a call option are explained below CALL OPTION BUYER OR HOLDER SELLER OR WRITER GOING LONG GOING LONG PAYS TOTAL RECEIVES TOTAL PREMIUM PREMIUMHE HAS THE RIGHT BUT NOT THE HE IS OBLIGATED TO SELL ON DEMAND,OBLIGATION TO BUY 100 SHARES OF THE UNDERLYNG STOCK OF 100 SHARESTHE UNDERLYING STOCK AT STRIKE AT SRIKE PRICE WHEN THEPRICE. BUYER/HOLDER EXERCISES CALL OPTION. Buying a call The buyer of a call option pays the premium in return for the right to buy the underlying asset at the exercise price. If at the expiry date of the option, the underlying asset price is above the exercise price, the buyer will exercise the option, pay the exercise price and receives the asset. This may then be sold in the market at spot price and makes profit. Alternatively, the option may be sold immediately prior to expiry to realize a similar profit because at expiry, its value must be sold immediately prior to expiry to realize a similar profit because at expiry, its value must be 47
  • 48. FUTURES AND OPTIONSequal to the difference between the exercise price and market price of the underlying asset. If theasset price is below the exercise price, the option will be abandoned by the buyer and his losswill be equal to the premium paid on the purchase of call option. Intrinsic Value Lines Premium { Stock Price k Writing a callThe call option writer receives the premium as consideration for bearing the risk of having todeliver the underlying asset is return for being paid the exercise price. If at the expiry, the assetprice is above the exercise price, the writer will incur loss because he will have to buy the assetat market price in order to deliver it to the option buyer in exchange for the lower exercise price. 48
  • 49. FUTURES AND OPTIONSIf the asset price is below the exercise price, the call option will not be exercised and the writerwill make the profit equal to the option premium k } Premium b Stock Price Intrinsic Value LinesRationale of Buying Call OptionsThere are broadly three reasons why an investor could buy a call option instead of buying thestock outright. These are as follows:1. Return on InvestmentAn investor anticipates that a stock is shortly going to appreciate from Rs. 300 to Rs. 400 pershare and buying 100 shares of the stock would involve an investment of Rs. 30,000. However,a call option on the stock is available at a premium of Rs. 20. Let us assume that the stocksshare actually goes up to Rs. 400 within the currency of the option. The investor thus makes aprofit of Rs. 80 per share (400 (300+20)]. His investment was only to the extent of premiumpaid, i.e. Rs. 20 per share. Thus, the investor got an appreciation of 400% on his investment.Had he bought the stock outright, the investor would have made Rs. 100 per share on aninvestment of Rs. 300, i.e. 33%. This should be sufficient motivation for the investor to go in f6rcall options on the stock as against outright buying of the stock.2. Hedging 49
  • 50. FUTURES AND OPTIONSTrading with the objective of reducing or controlling risk is called HEDGING. An investor,having short sold a stock, can protect himself by buying a call option. In the event of an increasein the stocks price, he would at least have the commitment of the option writer to deliver thestock at the exercise price, whenever he is to effect delivery for the stock, sold short. Themaximum loss the investor may be exposed to would be limited to the premium paid on the calloption. Options can thus be used as a handy tool for hedging.3. ArbitrageArbitrage involves buying at a lower price and selling- at a higher price, if it so exists. As in anyother trade, options arbitrage provides an opportunity to earn money by exploiting the pricinginefficiencies, which may exist within a market or between two markets or two products and as aresult tends to bring perfection to the market. PUT OPTIONThe put option gives the buyer the right, but not the obligation, to sell a given quantity of theunderlying asset at a given price on or before a given date. The put option gives the right to sellthe underlying asset at exercise price up to date of the contract. The seller of the put option isknown as ‘writer’. He has no choice regarding the fulfillment of the obligation under thecontract. If the buyer wants to exercise his put option, the writer must purchase at exercise price. 50
  • 51. FUTURES AND OPTIONSFor this asymmetry of privilege, the buyer of put option must take the writer, the option pricecalled as ‘premium’. The rights and obligations of the buyer and writer of a put are explained inbelow figure, PUT OPTION BUYER OR HOLDER SELLER OR WRITER GOING LONG GOING LONG PAYS TOTAL RECEIVES TOTAL PREMIUM PREMIUM HE HAS THE RIGHT BUT NOT THE HE IS OBLIGATED TO BUY ON DEMAND, OBLIGATION TO SELL 100 SHARES OF THE UNDERLYNG STOCK OF 100 SHARES THE UNDERLYING STOCK AT STRIKE AT SRIKE PRICE WHEN THE PRICE. BUYER/HOLDER EXERCISES PUT OPTION. Buying a PutThe buyer of the put option pays the option premium for the right to sell underlying asset at theexercised price. If at expiry the asset prices are below the exercised price, the buyer will exercisethe option, gives the asset and receive the exercised price. If the asset is above the exercise price,the put option will be abandoned and the buyer will incur loss equal to the option premium. 51
  • 52. FUTURES AND OPTIONSWRITING A PUTThe put writer receives the premium for bearing the risk of having to take the underlying asset atthe exercised price. If the market price of the asset is below the exercise price at expiry, thewriter will incur a loss because he will have to pay the exercise price but will only be able toresell the asset at the lower market price. If the asset is above the exercise price at expiry, the 52
  • 53. FUTURES AND OPTIONSbuyer will abandon the put option and the writer will make a profit equal to the option premiumreceived.Rationale of Buying a Put OptionAn investor, if he anticipates fall in the price of some stock, has the following alternatives:Sell the stock short, i.e. enter a sales transaction without owning the stock. In the event of a fallin the stock price, he can buy the stock at a lower price and can deliver the stock sold to thebuyer, thus making profit equal to the fall in the price. However, in case the stock priceappreciates instead of declining, the investor would be exposed to unlimited loss.Write a call option without owning the stock, i.e. writing a naked call option. Writing such anoption is similar to selling short, the only difference being that the loss in the event ofappreciation in the stock price would be curtailed to the extent of the premium received onwriting the call option, which may not be sufficient attraction.Purchase a put option. The purchase of a put option is the most desirable policy as compared toeither going short or writing a naked call option. The first reason is that the investment in buyinga put option is restricted to the premium as against a larger sum required for going short. Thus,as in the case of a call option, the return on investment on buying a put option is much higher ascompared to going short on the stock. Secondly, in the event of increase in the stock price, theloss to the put option buyer is restricted to the premium paid. Advantages of options 53
  • 54. FUTURES AND OPTIONS• There is limited risk for many options strategies. The trader can lose the entire premium, but that amount is known when the position is initiated.• There are no margin calls for many strategies.• Options offer a wide range of strategies for a variety of conditions.• Options offer a way to add to futures positions without spending any more money or premiums. Thus, the option trader has more leverage.• With a forward and futures contract, the investor is committed to a future transaction; with an option, he enjoys the right to go ahead but he walk away from the deal if he so desires.• The options have certain favorable characteristics. They limit the downside of risk without limiting the upside. It is quite obvious that there is a price which has to be paid for this one way but which is known as ‘option premium’. Those who sell options must charge a premium high enough to cover their losses when options are exercised at prices that are much better than the existing market price; options have become the fastest growing derivative in the currency markets. 54
  • 55. FUTURES AND OPTIONS Disadvantages of options• The trader pays a premium to enter a market when buying options. When volatility is high, premiums can be very expensive. The trade is paying for time, so premium becomes an eroding asset. On the other side, options sellers can receive price premium, but they have margin requirements.• Currently, there is more liquidity in future contracts than there are in most options contracts. Entry and exit from some markets can be difficult. Even if the positions entered with a limit order, existing can be a problem, unless the option is in the money. Of course, the option buyer can exercise the option, receive a futures position, then liquidate the futures. There are more complex factors affecting premium prices for options, volatility and time to expiration are more important than price movement.• Many options contracts expire weeks before the underlying futures. This can be an occasional often occurs close to the final trading day of futures. However, this should not be construed to mean that commercials cannot use the options to hedge.• Option premiums don’t move tick for tick with the futures (unless they’re deep in the money). Thus can be frustrating to have the market move in your direction, yet lose premium value. 55
  • 56. FUTURES AND OPTIONSIn May beginning Mr. Vicky decide that shares in X Ltd. will rise over the next month or so. Thecurrent price is Rs. 100 and he hopes that the shares will be at Rs.150 by the end of July.When no options are tradedIf Mr. Vicky buys the shares, say 100 shares for Rs 10000 and he is correct in his expectationshis shares will be worth Rs 15000 within three months showing a profit of Rs 5000, 50% of theamount invested less expenses.The risk attached in this investment, is, he need an investment of Rs 10000for purchase of 100shares in X Ltd. And if the amount is invested, there is a risk of price drop on different factorslike collapse of X Ltd. fall of shares market index, slump in the market.etc. then he will loose hismoney, when his expectations go wrong.When options are traded1. When an option is traded, he could buy an option on the share, say at Rs. 10 premium.2. This option would give him the right to buy a share in X Ltd for Rs 100 at any time over thenext three months. 56
  • 57. FUTURES AND OPTIONS3. if X Ltd’s share price remains at Rs. 100 he have no option with no value and so he will loseRs. 10 premium per share that he has paid and his total extent of Rs.1000( 100 shares *Rs. 10).4. If the share price goes up to Rs.150 then his option has value worth exercising. The increase inshare price from Rs.100 to Rs.150 per share amounting to total increase in Rs.5000 on 100shares and his net return is RS. 4000 on an investment of Rs. 1000 and he earns a profit 400% onhis investment by purchasing an option instead of shares in X Ltd.5. If the price rose to over Rs 100. And the option was exercised, then he would be required topart with his shares in X Ltd at Rs. 100 per share or buy them for onward delivery at theprevailing market price. However, he would gets Rs. 10 premium as well. So he would get Rs.10 premium as well, so he would locally be getting Rs. 100 on shares and this Rs. 10 would limitthe paper loss in his portfolio if the X Ltd share price falls. 57
  • 58. FUTURES AND OPTIONS RISK AND RETURN WITH EQUITY OPTIONSWe will now see the risk and return associated with equity stock options.Call OptionsConsider a call option on a certain share; say ABC Suppose the contract is made between twoinvestors X and Y, who take, respectively, the short and long positions. The other details aregiven below:Exercise price = Rs 120Expiration month = March, 2001Size of contract = 100 sharesDate of entering into contract =January 5, 2001Price of share on the date of contract = Rs 124.50Price of option on the date of contract = Rs 10At the time of entering in to the contract, Investor X writes a contract and receives Rs. 1000 (=10 x 100) Investor Y takes a long position and pays Rs 1000 for it.On the date of maturity, the profit or loss to each investor would depend upon the price of theshare ABC prevailing on that day. The buyer would obviously not call upon the call writer tosell shares if the price happens to be lower than Rs 120 per share. Only when the price exceedsRs 120 per share will a call be made. Having paid Rs 10 per share for buying an option, the 58
  • 59. FUTURES AND OPTIONSbuyer can make a profit only in case the share price would be at a point higher than Rs 120 + Rs10 = Rs 130. At a price equal to Rs 130 a break-even point is reached. The profit/loss made byeach of the investors for some selected values of the share price of ABC is indicated below.Profit / Loss Profile for the Investors - Call Option Possible Price of ABC at Investor X Investor Y Call Maturity (Rs.) 90 1000 -1000 100 1000 -1000 110 1000 -1000 120 1000 -1000 130 0 0 140 -1000 1000 150 -2000 2000 160 -3000 3000 59
  • 60. FUTURES AND OPTIONSThe profit profile for this contract is indicated below. Figure (a) shows the profit/loss functionfor the investor X, the writer of the call, while Figure (b) gives the same for the other investor Y,the buyer of the option.(a) For Investor X Profit 1500 – Stock Price 1000 – 90 100 110 120 130 140 150 160 500 – 0 500 –(b) For Investor Y Profit 1000 – 3000 1500 – 2500 2000 – 2000 2500 – Stock Price 90 100 110 120 130 140 150 160 1500 – Loss 1000 – 60 500 –
  • 61. 0– FUTURES AND OPTIONS 500 –It is evident that the call writers profit is limited to the amount of call premium but, theoretically,there is no limit to the losses if the stock price continues to increase and the writer does not make 1000 –a closing transaction by purchasing an identical call. The situation is exactly opposite for the callbuyer for whom the loss is limited to the amount of premium paid. However, depending on thestock1500 – there is no limit on the amount of profit which can result for the buyer. Being a price,zero-sum game, a loss (gain) to one party implies an equal amount of gain (loss) to the otherparty.Loss Put OptionsIn a put option, since the investor with a long position has a right to sell the stock and the writeris obliged to buy it at the will of the buyer, the profit profile is different from the one in a calloption where the rights and obligations are different.Consider a put option contract on a certain share, PQP, Suppose, two investors X and Y enterinto a contract and take short and long positions respectively. The other details are given below:Exercise price = Rs I 10 Expiration month = March, 2001 Size of contract= I 00 shares Date of entering into contract =January 6, 2001 Share price on the date of contract = Rs 1 12 Price of put option on the date of contract = Rs 7.50 61
  • 62. FUTURES AND OPTIONSNow, as the contract is entered into, the writer of the option, X will receive Rs 750 (=7.50 x 100)from the buyer, Y At the time of maturity, the gain/loss to each party depends on the ruling priceof the share. If the price of the share is Rs 110 or greater than that, the option will not beexercised, so that the writer pockets the amount of put premium-the maximum profit which canaccrue to a seller. At the same time, it represents the maximum loss that the buyer is exposed to.If the price of the share falls below the exercise price, a loss would result to the writer and a gainto the buyer. The maximum loss that the writer may theoretically be exposed to is limited by theamount of the exercise price.Thus, if the value of the underlying share falls to zero, the loss to the writer is equal to Rs. 110 –Rs. 7.50 = Rs. 102.50 per share. The profit/loss for some selected values share are given below. Possible Price of PQR at Investor X Investor Y Investor X Investor Y Put Maturity (Rs) 80 -2250 2250 90 -1250 1250 100 -250 250 110 750 -750 120 750 -750 130 750 -750 140 750 -750 150 750 -750The break-even share price would be Rs 102.50 (= Rs 110 Rs 7.50). If the price of the sharehappens to be lower than this, the writer would make a loss-and the buyer makes a gain. For 62
  • 63. FUTURES AND OPTIONSinstance, when the price of the share is Rs 100, the gain/loss for each of the investors may becalculated as shown below.Investor XOption premium received = 7.5 x 100 = Rs. 750Amount to be paid for shares = 110 x 100 = Rs. 11000Market value of the shares = 100 x 100 = Rs. 10000Net Profit (Loss) = 750 - 11000 + 10000 = (Rs. 250)Investor YOption premium paid = 7.5 x 100 = Rs. 750Amount to be received for shares = 110 x 100 = Rs. 11000Market value of the shares = 100 x 100 = Rs. 10000Net profit (loss) = -750 + 11000 - 10000 = Rs. 250 Profit 1500 –The profile of profit/loss for each of the investors is given in Figures below. Fig. (a) shows theprofit/loss function for the investor X the writer of the put, Stock Price Fig. (b) gives the same for while the 1000 –the other investor Y, the buyer of the option. 150 160 90 100 110 120 130 140 As indicated earlier, the profiles of the twoinvestors replicate each other. 500 –(a) For investor X 0 500 – 63 1000 –
  • 64. 1500 – FUTURES AND OPTIONS 2000 – 2500 – 3000 – Loss(b) For Investor Y Profit 2500 – 2000 – Stock Price 90 100 110 120 130 140 150 1500 – 1000 – Option Trading Strategies 500 – 0– 64 500 –
  • 65. 1000 – FUTURES AND OPTIONS LossWe have considered above the profit/loss resulting to the investors with long and short positionsin the call and put options. It is important to note that an investor need not take positions innaked options only or in a single option alone. In fact, a number of trading strategies involvingoptions may be employed by the investors. Options may be used on their own, in conjunctionwith the futures contracts, or in a strategy using the underlying instrument (equity stock, forexample). One of the attractions of options is that they could be used for creating a very widerange of payoff functions. We now discuss some of the commonly used strategies.To begin with, we may consider investment in a single stock option. The payoffs associated witha long or short call, and a long or short put option has already been discussed. A long call isused when one expects that the market would rise. The more bullish market sentiment orperception, the more out-of-the money option should one buy. For the option buyer in thisstrategy, the loss is limited to the premium payable while the profit is potentially unlimited. Onthe other hand, the writer of a call has a mirror image position along the break-even line. Thewriter writes a call with the belief or expectation that the market would not show an upwardtrend.In case of the put option, a long put would gain value as the underlying asset, the equity shareprice or the market index, declines. Accordingly, a put is bought when a decline is expected inthe market. The loss for a put buyer is limited to the amount paid for the option if the marketends above the option exercise price. The writer of a put option would get the maximum profitequal to the premium amount but would be exposed to loss should the market collapse. Themaximum loss to the writer of a put option on an equity hare could be equal to the exercise price(since the stock price cannot be negative).Thus, while selling of options may be used as a legitimate means of generating premium incomeand bought in the expectation of making profit from the likely bullish / bearish marketsentiments, they may or may not be used alone. They may, however, be combined in severalWays without taking positions in the underlying assets or they might be used in conjunction withthe underlying assets for purposes of hedging, which we describe in the next section.Hedging using Call & Put Options 65
  • 66. FUTURES AND OPTIONSHedging represents a strategy by which an attempt is made to limit the losses in one position bysimultaneously taking a second offsetting position. The offsetting position may be in the same ora different security. In most cases, the hedges are not perfect because they cannot eliminate alllosses. Typically, a hedge strategy strives to prevent large losses without significantly reducingthe gains.Very often, options in equities are employed to hedge a long o short position in the underlyingcommon stock. Such options are called covered options in contrast to the uncovered or nakedoptions, discussed earlier.Hedging a Long Position in StockAn investor buying a common stock expects that its price would increase. However, there is arisk that the price may in fact fall. In such a case, a hedge could be formed by buying a put i.e.,buying the right to sell. Consider an investor who buys a share for Rs. 100. To guard against therisk of loss from a fall in its price, he buys a put for Rs. 16 for an exercise price of, say, Rs. 110.He would, obviously, exercise the option only if the price of the share were to be less than Rs.110. Table below gives the profit/loss for some selected values of the share price on maturity ofthe option. For instance, at a share price of Rs. 70, the put will be exercised and the resultingprofit would be Rs. 24, equal to Rs. 110 – Rs. 70, or Rs 40 minus the put premium of Rs. 16.With a loss of Rs. 30 incurred for the reason of holding the share, the net loss equals to Rs. 6. Profit / Loss for Selected Share Values: Long Stock Long Put 66
  • 67. FUTURES AND OPTIONS Share Exercise Profit on Profit / Loss on Net Profit Price Price Exercise (i) Share Held (ii) (i) + (ii) 70 110 24 -30 -6 80 110 14 -20 -6 90 110 4 -10 -6 100 110 -6 0 -6 110 110 -16 10 -6 120 110 -16 20 4 130 110 -16 30 14 140 110 -16 40 24The profits resulting from the strategy of holding a long position in stock and long put are shownin the figure below. Hedging: Long Stock Long Put Profit on Exercise Profit Profit / Loss on Hedging of Put 50 - 40 - 30 - E 20 - 10 - Stock Price 0 10 - 20 - Profit / Loss onHedging a Short30 - Position in Stock Long Stock 40 - Loss 67
  • 68. FUTURES AND OPTIONSUnlike an investor with a long position in stock, a short seller of stock anticipates a decline instock price. By shorting the stock now and buying it at a lower price in the future, the investorintends to make a profit. Any price increase can bring losses because of an obligation to purchaseat a later date. To minimize the risk involved, the investor can buy a call option with an exerciseprice equal to or close to the selling price of the stock.Let us suppose, an investor shorts a share at Rs. 100 and buys a call option for Rs. 4 with a strikeprice of Rs. 105. The conditional payoffs resulting from some selected prices of the share areshown in a table below. Profit / Loss for Selected Share Values: Short Stock Long Call Share Exercise Profit on Profit / Loss on Net Profit Price Price Exercise (i) Share Held (ii) (i) + (ii) 90 105 -4 15 11 95 105 -4 10 6 100 105 -4 5 1 105 105 -4 0 -4 110 105 1 -5 -4 115 105 6 -10 -4 120 105 11 -15 -4 The payoff function associated with this policy is shown below 68