Deriveties in india

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Deriveties in india

  1. 1. A Grand Project On Growth of Derivatives in Indian market SUBMITTED TO: GUJARAT UNIVERSITYIn partial fulfillment of the requirement of MBA program of Gujarat University (Batch: 2006-08) SUBMITTED BY: Dhaval Bachandani (03) Alpesh Parmar (30) Prof.Falguni Pandya AES POST GRADUATE INSTITUTE OF BUSINESS MANAGEMENT, AHMEDABAD 1
  2. 2. PREFACEMBA is a professional course wherein for a student to posses onlytheoretical knowledge alone is not enough but also to improve practical skillwhich is helpful to them in every field of life in their future. Students needsto have a practical implementation in the current scenario.As a part of final semester syllabus of MBA we visited Stock BrokingCompanies for practical training and also studied on the working of itsdifferent services and prepare report on particular topic.This training has expanded our horizon of knowledge in practical as well astheoretical which are vital for any student in management level studies.After completion of this Project we came to know that when we studytheory but practice it is very difficult to understand. Therefore to servedual purpose of practical training has been made compulsory for the studentof MBA.Such training promotes a student to boost his potentials and the innerqualities, and thereby students come to know about their reality that howthe theoretical knowledge works in actual sense in any unit. This has indeedproved to be very useful to us. 2
  3. 3. ACKNOWLEDGEMENT It gives us a great pleasure and personal satisfaction in presenting this report as apart of our Grand Project on “Satisfaction level of Investors with their broking firm”which has helped us to understand the preferences of investors for choosing any stockbroking firm..We are indebted to many individuals who have either directly or indirectly made animportant contribution in the preparation of this report.we are also grateful to Dr.A.H.Kalro, (Director, AES PGIBM), for giving us anopportunity to experience the corporate world, and for his valuable inputs on the project..We are also thankful to our co guide Prof Falguni PandyaWe would like to thank the entire staff of AESPGIBM library, computer lab especiallyHitanshu sir and Anvesha madam for their immense support. We would also like tothank all the respondents, without whom the report would not have been completed.Last but not the least We would like to place special thanks to our parents and friends fortheir help and support. 3
  4. 4. Sr No Title Pg NO1 Introduction to Derivatives 022 Development of Derivatives in 03 India3 Derivative Instrument 044 Derivative User 065 Types of Derivatives 07 a. forward b. futures c. option d. swap6 Uses of Derivatives 217 History of derivatives 238 Recent Development 259 Strategies of Derivatives 27 a. Bull Spread b. Bear Spread c. Butterfly d. Strangle e. Straddle10 Risk involved 3911 FII and Derivatives 4212 Technical analysis 4613 Derivatives system 4914 Derivative product 5115 Derivatives concepts A-Z 5516 Summarization of derivatives 69 market17 Bibliography 79 4
  5. 5. INTRODUCTION TO DERIVATIVESDerivatives are financial instruments whose value is derived from the value of somethingelse. They generally take the form of contracts under which the parties agree to paymentsbetween them based upon the value of an underlying asset or other data at a particularpoint in time. The main types of derivatives are futures, forwards, options, and swaps.The main use of derivatives is to reduce risk for one party while offering the potential fora high return (at increased risk) to another. The diverse range of potential underlyingassets and payoff alternatives leads to a huge range of derivatives contracts available tobe traded in the market. Derivatives can be based on different types of assets such ascommodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as astock market index, consumer price index (CPI) — see inflation derivatives — or even anindex of weather conditions, or other derivatives). Their performance can determine boththe amount and the timing of the payoffs.By far the most significant event in finance during the past decade has been theextraordinary development and expansion of financial derivatives. These instrumentsenhance the ability to differentiate risk and allocate it to those investors most able andwilling to take it - a process that has undoubtedly improved national productivity growthand standards of living. -- Alan Greenspan, Chairman, Board of Governors of the USFederal Reserve System. 5
  6. 6. Development of Derivative Markets in IndiaDerivatives markets have been in existence in India in some form or other for a longtime. In the area of commodities, the Bombay Cotton Trade Association started futurestrading in 1875 and, by the early 1900s India had one of the world’s largest futuresindustry. In 1952 the government banned cash settlement and options trading andderivatives trading shifted to informal forwards markets. In recent years, governmentpolicy has changed, allowing for an increased role for market-based pricing and lesssuspicion of derivatives trading. The ban on futures trading of many commodities waslifted starting in the early 2000s, and national electronic commodity exchanges werecreated.In the equity markets, a system of trading called “badla” involving some elements offorwards trading had been in existence for decades.6 However, the system led to anumber of undesirable practices and it was prohibited off and on till theSecurities and DerivativesExchange Board of India (SEBI) banned it for good in 2001. A series of reforms of thestock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE incollaboration with state-owned financial institutions. NSE improved the efficiency andtransparency of the stock markets by offering a fully automated screen-based tradingsystem and real-time price dissemination. In 1995, a prohibition on trading options waslifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.The report of the L. C. Gupta Committee, set up by SEBI, recommended a phasedintroduction of derivative products, and bi-level regulation (i.e., self-regulation byexchanges with SEBI providing a supervisory and advisory role). Another report, by theJ. R. Varma Committee in 1998, worked out various operational details such as themargining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, orSC(R)A, was amended so that derivatives could be declared “securities.” This allowedthe regulatory framework for trading securities to be extended to derivatives. The Actconsiders derivatives to be legal and valid, but only if they are traded on exchanges.Finally, a 30-year ban on forward trading was also lifted in 1999.The economic liberalization of the early nineties facilitated the introduction of derivativesbased on interest rates and foreign exchange. A system of market-determined exchangerates was adopted by India in March 1993. In August 1994, the rupee was made fullyconvertible on current account. These reforms allowed increased integration betweendomestic and international markets, and created a need to manage currency risk. Figure 1shows how the volatility of the exchange rate between the Indian Rupee and the U.S. 6
  7. 7. dollar has increased since 1991. The easing of various restrictions on the free movementof interest rates resulted in the need to manage interest rate risk. 7
  8. 8. Derivatives Instruments Traded in IndiaIn the exchange-traded market, the biggest success story has been derivatives on equityproducts. Index futures were introduced in June 2000, followed by index options in June2001, and options and futures on individual securities in July 2001 and November 2001,respectively. As of 2005, the NSE trades futures and options on 118 individual stocks andDerivatives.3 stock indices. All these derivative contracts are settled by cash payment and do notinvolve physical delivery of the underlying product (which may be costly).8Derivatives on stock indexes and individual stocks have grown rapidly since inception. Inparticular, single stock futures have become hugely popular, accounting for about half ofNSE’s traded value in October 2005. In fact, NSE has the highest volume (i.e. number ofcontracts traded) in the single stock futures globally, enabling it to rank 16 among worldexchanges in the first half of 2005. Single stock options are less popular than futures.Index futures are increasingly popular, and accounted for close to 40% of traded value inOctober 2005. Figure 2 illustrates the growth in volume of futures and options on theNifty index, and shows that index futures have grown more strongly than index options.9.NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives,there has been little trading in them. One problem with these instruments was faultycontract specifications, resulting in the underlying interest rate deviating erratically fromthe reference rate used by market participants. Institutional investors have preferred totrade in the OTC markets, where instruments such as interest rate swaps and forward rateagreements are thriving. As interest rates in India have fallen, companies have swappedtheir fixed rate borrowings into floating rates to reduce funding costs.10 Activity in OTCmarkets dwarfs that of the entire exchange-traded markets, with daily value of tradingestimated to be Rs. 30 billion in 2004.Foreign exchange derivatives are less active than interest rate derivatives in India, eventhough they have been around for longer. OTC instruments in currency forwards andswaps are the most popular. Importers, exporters and banks use the rupee forward marketDerivatives.To hedge their foreign currency exposure. Turnover and liquidity in this market has beenincreasing, although trading is mainly in shorter maturity contracts of one year or less. Ina currency swap, banks and corporations may swap its rupee denominated debt intoanother currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTCcurrency options is still muted. There are no exchange-traded currency derivatives inIndia. 8
  9. 9. Exchange-traded commodity derivatives have been trading only since 2000, and thegrowth in this market has been uneven. The number of commodities eligible for futurestrading has increased from 8 in 2000 to 80 in 2004, while the value of trading hasincreased almost four times in the same period. However, many contracts barely tradeand, of those that are active, trading is fragmented over multiple market venues, includingcentral and regional exchanges, brokerages, and unregulated forwards markets. Totalvolume of commodity derivatives is still small, less than half the size of equityderivatives. 9
  10. 10. Derivatives Users in IndiaThe use of derivatives varies by type of institution. Financial institutions, such as banks,have assets and liabilities of different maturities and in different currencies, and areexposed to different risks of default from their borrowers. Thus, they are likely to usederivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affectstheir incentives to use derivatives. Indian insurance regulators, for example, are yet toissue guidelines relating to the use of derivatives by insurance companies.In India, financial institutions have not been heavy users of exchange-traded derivativesso far, with their contribution to total value of NSE trades being less than 8% in October2005. However, market insiders feel that this may be changing, as indicated by thegrowing share of index derivatives (which are used more by institutions than by retailinvestors). In contrast to the exchange-traded markets, domestic financial institutions andmutual funds have shown great interest in OTC fixed income instruments. Transactionsbetween banks dominate the market for interest rate derivatives, while state-owned banksremain a small presence (Chitale, 2003). Corporations are active in the currency forwardsand swaps markets, buying these instruments from banks.Why do institutions not participate to a greater extent in derivatives markets? Someinstitutions such as banks and mutual funds are only allowed to use derivatives to hedgetheir existing positions in the spot market, or to rebalance their existing portfolios. Sincebanks have little exposure to equity markets due to banking regulations, they have littleincentive to trade equity derivatives.11 Foreign investors must register as foreigninstitutional investors (FII) to trade exchange-traded derivatives, and be subject toposition limits as specified by SEBI. Alternatively, they can incorporate locally as aDerivativesRetail investors (including small brokerages trading for themselves) are the majorparticipants in equity derivatives, accounting for about 60% of turnover in October 2005,according to NSE. The success of single stock futures in India is unique, as thisinstrument has generally failed in most other countries. One reason for this success maybe retail investors’ prior familiarity with “badla” trades which shared some features ofderivatives trading. Another reason may be the small size of the futures contracts,compared to similar contracts in other countries. Retail investors also dominate themarkets for commodity derivatives, due in part to their long-standing expertise in tradingin the “havala” or forwards markets.. 10
  11. 11. . TYPES OF DERIVATIVES OTC and exchange-tradedBroadly speaking there are two distinct groups of derivative contracts, which aredistinguished by the way they are traded in market: Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 516 trillion (as of June 2007) Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial [2] margin from both sides of the trade to act as a guarantee. The worlds largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade). According to BIS, the combined turnover in the worlds derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs(tm) and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive. 11
  12. 12. Common Derivative contract typesThere are three major classes of derivatives: Futures/Forwards, which are contracts to buy or sell an asset at a specified future date. Options, which are contracts that give a holder the right (but not the obligation) to buy or sell an asset at a specified future date. Swaps, where the two parties agree to exchange cash flows.Examples Economic derivatives that pay off according to economic reports ([1]) as measured and reported by national statistical agencies Energy derivatives that pay off according to a wide variety of indexed energy prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc) Commodities Freight derivatives Inflation derivatives Insurance derivatives Weather derivatives Credit derivatives Sports derivatives Property derivatives 12
  13. 13. FORWARD CONTRACTForward contract is an agreement between two parties to buy or sell an asset (which can beof any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date areseparated. It is used to control and hedge risk, for example currency exposure risk (e.g.,forward contracts on USD or EUR) or commodity prices (e.g., forward contracts on oil).One party agrees (obligated) to sell, the other to buy, for a forward price agreed in advance.In a forward transaction, no actual cash changes hands. If the transaction is collateralized,exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise noasset of any kind actually changes hands, until the maturity of the contract.The forward price of such a contract is commonly contrasted with the spot price, which is theprice at which the asset changes hands (on the spot date, usually two business days). Thedifference between the spot and the forward price is the forward premium or forward discount.A standardized forward contract that is traded on an exchange is called a futures contract.Example of how the payoff of a forward contract worksSuppose that Bob wants to buy a house in one years time. At the same time, suppose that Andycurrently owns a $100,000 house that he wishes to sell in one years time. Both parties couldenter into a forward contract with each other. Suppose that they both agree on the sale price inone years time of $104,000 (more below on why the sale price should be this amount). Andyand Bob have entered into a forward contract. Bob, because he is buying the underlying, is saidto have entered a long forward contract. Conversely, Andy will have the short forwardcontract.At the end of one year, suppose that the current market valuation of Andys house is $110,000.Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of$6,000. To see why this is so, one need only to recognize that Bob can buy from Andy for$104,000 and immediately sell to the market for $110,000. Bob has made the difference inprofit. In contrast, Andy has made a loss of $6,000. 13
  14. 14. FUTURES CONTRACTFutures contract is a standardized contract, traded on a futures exchange, to buy or sell acertain underlying instrument at a certain date in the future, at a specified price. The futuredate is called the delivery date or final settlement date. The pre-set price is called the futuresprice. The price of the underlying asset on the delivery date is called the settlement price.A futures contract gives the holder the obligation to buy or sell, which differs from an optionscontract, which gives the holder the right, but not the obligation. In other words, the owner ofan options contract may exercise the contract. Both parties of a "futures contract" must fulfillthe contract on the settlement date. The seller delivers the commodity to the buyer, or, if it isa cash-settled future, then cash is transferred from the futures trader who sustained a loss tothe one who made a profit. To exit the commitment prior to the settlement date, the holder ofa futures position has to offset their position by either selling a long position or buying back ashort position, effectively closing out the futures position and its contract obligations.Futures contracts, or simply futures, are exchange traded derivatives. The exchangesclearinghouse acts as counterparty on all contracts, sets margin requirements, etc.Futures contracts and exchangesThere are many different kinds of futures contracts, reflecting the many different kinds oftradable assets of which they are derivatives. For information on futures markets in specificunderlying commodity markets, follow the links. Foreign exchange market Money market Bond market Equity index market Soft Commodities marketSettlementSettlement is the act of consummating the contract, and can be done in one of two ways, asspecified per type of futures contract: Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration. Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method. 14
  15. 15. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiry on December, the March futures become the nearest contract. This is an exciting time for arbitrage desks, as they will try to make rapid gains during the short period (normally 30 minutes) where the final prices are averaged from. At this moment the futures and the underlying assets are extremely liquid and any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.StandardizationFutures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made. The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation. 15
  16. 16. Futures vs. ForwardsWhile futures and forward contracts are both a contract to deliver a commodity on a future dateat a prearranged price, they are different in several respects: Forwards transact only when purchased and on the settlement date. Futures, on the other hand, are rebalanced, or "marked to market," every day to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset. o The fact that forwards are not rebalanced daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forwards delivery price and the settlement price. This means that one party will incur a big loss at the time of delivery (assuming they must transact at the underlyings spot price to facilitate receipt/delivery). This in turn creates a credit risk. More generally, the risk of a forward contract is that the supplier will be unable to deliver the required commodity, or that the buyer will be unable to pay for it on the delivery day. o The rebalancing of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract. o In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, limiting credit risk in futures. o Example for a futures contract with a $100 price: Lets say that on day 50, a forward with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that forward costs $90. This means that the mark-to- market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price. This money goes, via margin accounts, to the holder of the other side of the future. (A forward-holder, however, would pay nothing until settlement on the final day, potentially building up a large balance. So, except for tiny effects of convexity bias or possible allowance for credit risk, futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forwards daily price changes, while the forwards spot price converges to the settlement price.) Futures are always traded on an exchange, whereas forwards always trade over- the- counter, or can simply be a signed contract between two parties. Futures are highly standardised, whereas some forwards are unique. In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearinghouse. 16
  17. 17. Some exchanges tolerate nonconvergence, the failure of futures contracts and the value of thephysical commodities they represent to reach the same value on contract settlement day at thedesignated delivery points. An example of this is the CBOT (Chicago Board of Trade)SoftRed Winter wheat (SRW) futures. SRW futures have settled more than 20¢ apart on settlementday and as much as $1.00 difference between settlement days. Only a few participants holdingCBOT SRW futures contracts are qualified by the CBOT to make or receive delivery ofcommodities to settle futures contracts. Therefore, its impossible for almost any individualproducer to hedge efficiently when relying on the final settlement of a futures contract forSRW. The trend is the CBOT continuing to restrict those entities who can actually participatein settling contracts with commodity to only those that can ship or receive large quantities ofrailroad cars and multiple barges at a few selected sites. The CFTC (Commodity FuturesTrading Commission - a regulatory agency headed by a political appointee), which hasoversight of the futures market, has made no comment as to why this trend is allowed tocontinue since economic theory and CBOT publications maintain that convergence of contractswith the price of the underlying commodity they represent is the basis of integrity for a futuresmarket. It follows that the function of price discovery, the ability of the markets to discern theappropriate value of a commodity reflecting current conditions, is degraded in relation to thediscrepancy in price and the inability of producers to enforce contracts with the commoditiesthey represent 17
  18. 18. OPTIONOptions are financial instruments that convey the right, but not the obligation, to engage in afuture transaction on some underlying security. For example, buying a call option provides theright to buy a specified quantity of a security at a set strike price at some time on or beforeexpiration, while buying a put option provides the right to sell. Upon the option holders choiceto exercise the option, the party who sold, or wrote, the option must fulfill the terms of thecontract.The theoretical value of an option can be determined by a variety of techniques. These models,which are developed by quantitative analysts, can also predict how the value of the option willchange in the face of changing conditions. Hence, the risks associated with trading and owningoptions can be understood and managed with some degree of precision.Exchange-traded options form an important class of options which have standardized contractfeatures and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions thathave negotiated separate trading and clearing arrangements with each other. Anotherimportant class of options, particularly in the U.S., is employee stock options, which areawarded by a company to their employees as a form of incentive compensation.Other types of options exist in many financial contracts, for example real estate options areoften used to assemble large parcels of land, and prepayment options are usually included inmortgage loans. However, many of the valuation and risk management principles applyacross all financial options.Contract specificationsEvery financial option is a contract between the two counterparties with the terms of theoption specified in a term sheet. Option contracts may be quite complicated; however, atminimum, they usually contain the following specifications: whether the option holder has the right to buy (a call option) or the right to sell (a put option) the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise the expiration date, or expiry, which is the last date the option can be exercised the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount the terms by which the option is quoted in the market, usually a multiplier such as 100, to convert the quoted price into actual premium amount 18
  19. 19. Types of optionsThe primary types of financial options are: Exchange traded options (also called "listed options") are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include: 1. stock options, 2. commodity options, 3. bond options and other interest rate options 4. index (equity) options, and 5. options on futures contracts Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and 3. options on swaps or swaptions. Employee stock options are issued by a company to its employees as compensation.The basic trades of traded stock optionsThese trades are described from the point of view of a speculator. If they are combined withother positions, they can also be used in hedging.Long Call 19
  20. 20. Payoffs and profits from a long call.A trader who believes that a stocks price will increase might buy the right to purchase thestock (a call option) rather than just buy the stock. He would have no obligation to buy thestock, only the right to do so until the expiration date. If the stock price increases over theexercise price by more than the premium paid, he will profit. If the stock price decreases, hewill let the call contract expire worthless, and only lose the amount of the premium. A tradermight buy the option instead of shares, because for the same amount of money, he can obtain alarger number of options than shares. If the stock rises, he will thus realize a larger gain than ifhe had purchased sharesShort CallPayoffs and profits from a naked short call.A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or"write," a call. Because both strategies expose the investor to unlimited losses, they aregenerally considered inappropriate for small investors. The trader selling a call has anobligation to sell the stock to the call buyer at the buyers option. If the stock price decreases,the short call position will make a profit in the amount of the premium. If the stock priceincreases over the exercise price by more than the amount of the premium, the short will losemoney, with the potential loss unlimited 20
  21. 21. Long PutPayoffs and profits from a long put.A trader who believes that a stocks price will decrease can buy the right to sell the stock at afixed price (a put option). He will be under no obligation to sell the stock, but has the right todo so until the expiration date. If the stock price decreases below the exercise price by morethan the premium paid, he will profit. If the stock price increases, he will just let the putcontract expire worthless and only lose his premium paid.Short PutPayoffs and profits from a naked short put.A trader who believes that a stock price will increase can buy the stock or instead sell a put.The trader selling a put has an obligation to buy the stock from the put buyer at the put buyersoption. If the stock price increases, the short put position will make a profit in the amount of thepremium. If the stock price decreases below the exercise price by more than the amount of thepremium, the trader will lose money, with the potential loss being up to the full value of thestock. 21

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