Derivatives basics and Risk reward

1. Derivatives
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Naga srinivasarao

2. Concept of Derivatives
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 A derivative is a financial instrument that derives its performance from the performance of an underlying
asset. Underlying Asset can be Equity, Forex, commodity or any other asset.
 Derivatives are created in the form of legal contracts. They involve two parties—the buyer and the seller
(sometimes known as the writer)—each of whom agrees to do something for the other, either now or
later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns
(holds) the derivative and holds a long position. The seller is referred to as the short because he holds a
short position

3. Participants in Derivatives
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 Hedging: Hedging transaction is a position that a market participant takes in order to limit risks related to
another position or transaction that the market participant is involved in. The hedging transaction usually
involves derivatives, such as options or futures contracts.
 Speculation: Speculators trade based on their educated guesses on where they believe the market is
headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock
and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a
profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can
be extremely risky.
Arbitrage : Arbitrage implies taking advantage of price differences in the same or similar financial
instruments. The golden rule of making money is also embedded in arbitrage: You want to buy low and sell
high. Arbitrage opportunities may arise between different derivative markets.

4. Major Types Of Derivative
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Forwards: A forward contract is an over-the-counter derivative contract in which two parties agree that one
party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed
price they agree on when the contract is signed.
Futures : Futures contracts are specialized versions of forward contracts that have been standardized and that
trade on a futures exchange. By standardizing these contracts and creating an organized market with rules,
regulations, and a central clearing facility, the futures markets offer an element of liquidity and protection
against loss by default.
Options: An option is a derivative contract in which one party, the buyer, pays a sum of money to the other
party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either
on a specific expiration date or at any time prior to the expiration date.
Swaps : A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of
cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and
the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed
series.

5. Forwards
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Forward:
A forward contract is a customized contract between two entities, where settlement takes place on a specific
date in the future at today’s pre-agreed price
Salient features:
 Bilateral contracts and hence exposed to counter-party risk
 Customized contract hence unique
 Contract price not available in public domain
 On expiry, settlement is by delivery
 If the party wants to reverse the contract, it has to go to the same counterparty

6. Futures
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 A futures contract is a legal agreement to buy or sell a particular commodity or asst at a predetermined
price at a specified time in the future. Futures contracts are standardized for quality and quantity to
facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to
buy the underlying asset when the futures contract expires. The seller of the futures contract is taking
on the obligation to provide the underlying asset at the expiration date.
 These contracts are traded and settled on exchanges.
 Future contracts can be on individual scrips, indices, Commodity or forex

7. Forward and Futures…..A
comparison
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Forwards
 OTC in nature
 Customized contract terms
 Hence less liquid
 No margin payment
 Settlement happens at end of the
period
 Counterparty risk
Futures
 Trade on an organized exchange
 Standardized contract terms
 Hence more liquid
 Requires margin payments
 Follow daily cash settlement
 Exchange clearing house itself acts as the
counterparty.(Guaranteed Settlement)

8. Futures terminology
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Spot Price: A spot price is the current price in the marketplace at which a given asset such as a security,
commodity or currency can be bought or sold for immediate delivery.
Futures Price: The agreed-upon price of a futures contract.
Daily settlement: At the end of each day, the clearinghouse engages in a practice called mark to market,
also known as the daily settlement.
Initial margin: The amount that must be deposited in a clearinghouse account when entering into a
futures contract.
Settlement price: The official price, designated by the clearinghouse, from which daily gains and losses
will be determined and marked to market.
Maintenance margin: The minimum amount that is required by a futures clearinghouse to maintain a
margin account and to protect against default. Participants whose margin balances drop below the
required maintenance margin must replenish their accounts.
Expiry Date: The date upon which a futures contract expires is known as its expiration date.
Lot size: The number of shares you buy in one transaction.

9. Payoff for Buyer Future at 40 USD
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20 40 60
-20
0
+20
Stock
Profit
Loss
Futures contracts have linear payoffs. In simple words, it means that the losses as
well as profits for the buyer and the seller of a futures contract are unlimited.

10. 40 80 120
-40
0
+40
stock
Profit
Loss
Futures contracts have
linear payoffs. In simple
words, it means that the
losses as well as profits
for the buyer and the
seller of a futures
contract are unlimited.
Payoff for Seller Future at 40 USD
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11. Pricing of futures
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 When the underlying is combined with the derivative to produce a perfect hedge, all of the risk is
eliminated and the position should earn the risk-free rate. The overall process of pricing derivatives by
arbitrage and risk neutrality is called arbitrage-free pricing.
 But in market price depends on demand supply scenario, which in turn, depends on market’s view on
underlying.
Note: However this relationship does not hold in most commodity futures Because convenience yield and
Storage cost
Theoretically,
Futures price = Spot price + interest for duration till expiry
The futures pricing formula simply states –
Stock Futures Price = Spot price *(1+ rf – d)
Where, rf = Risk free rate,d – Dividend

12. When to buy or sell a future
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• Buy Futures when you are bullish
• Sell Futures when you are bearish

13. Options
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An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party,
the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either
on a specific expiration date or at any time prior to the expiration date.
The person with the right is called the buyer of the option. The person with the obligation is called the
writer of the option

14. Types of Options
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• Based on the right:
Call option: An option that gives the holder the right to buy an underlying asset from another party
at a fixed price over a specific period of time. The stock, bond, or commodity is called the underlying
asset.
 Put option: An option that gives the holder the right to sell an underlying asset to another party at a
fixed price over a specific period of time.
• Based on the exercise:
- American :An option contract that can be exercised at any time up to the option’s expiration date.
- European: An option contract that can only be exercised on the option’s expiration date.

15. Options Terminology
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Premium: The amount of money a buyer pays and seller receives to engage in an option transaction.
Strike price: The fixed price at which an option holder can buy or sell the underlying.
Expiry date: The date upon which a futures contract expires is known as its expiration date
Holder of option: Buyer of an option
Writer of option: short seller of an option
In the Money: Options that, if exercised, would result in the value received being worth more than the payment required
to exercise.
At the money: An option in which the underlying’s price equals the exercise price.
Out of Money. Options that, if exercised, would require the payment of more money than the value received and
therefore would not be currently exercised.

16. Payoff for buyer of call option
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150
6
0
Stock
Profit
Loss
When to Use: Investor is
very
bullish on the stock / index.
Risk: Limited to the Premium.
(Maximum loss if market
expires
at or below the option strike
price). Our example 6 USD is
maximum loss
Reward: Unlimited.
Breakeven: Strike Price +
Premium

17. Payoff for seller of call option
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150
6
0
Stock
Profit
Loss
When to use: Investor is very
aggressive and he is very
bearish about the stock /
index.
Risk: Unlimited.
Reward: Limited to the amount
of premium our example
Maximum profit 6usd.
Break-even Point: Strike Price
+ Premium

18. Payoff for buyer of put option
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150
6
0
Stock
Profit
Loss
A long Put is a Bearish
strategy. To take advantage of a
falling market an investor can
buy Put options.
When to use:
Investor is bearish about the
stock /index.
Risk: Limited to the amount of
Premium paid. (Maximum loss if
stock / index expires at or
above the option strike price).
Reward: Unlimited.
Break-even Point: Stock Price
- Premium

19. Payoff for the writer(Seller) of put option
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150
6
0
Stock
Profit
Loss
When to Use: Investor is very
Bullish on the stock / index.
The main idea is to make a
short term income.
Risk: Put Strike Price – Put
Premium.
Reward: Limited to the
amount of Premium received.
Breakeven: Put Strike Price -
Premium

20. Pricing of Options
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Price of option is called premium (Option Premium = Intrinsic Value + Time Value)
The two components of an option premium are the intrinsic value and time value of the option
 Intrinsic Value (Call) = Underlying Price – Strike Price
 Intrinsic Value (Put) = Strike Price – Underlying Price
 In-the-Money (Call) = Strike Price < Underlying Price
 In-the-Money (Put) = Strike Price > Underlying Price
Any premium that is in excess of the option's intrinsic value is referred to as its time value.
 Time Value = Premium – Intrinsic Value
In general, the more time to expiration, the greater the time value of the option. It represents the amount of time the
option position has to become profitable due to a favourable move in the underlying price. Time value decreases over
time and decays to zero at expiration.

21. Options Pricing: Factors That Influence Option Price
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1.Underlying Price:
The most influential factor on an option premium is the current market price of the underlying asset. In general, as
the price of the underlying increases, call prices increase and put prices decrease. Conversely, as the price of the
underlying decreases, call prices decrease and put prices increase.
2.Time Until Expiration
The longer an option has until expiration, the greater the chance it will end up in-the- money (profitable). As
expiration approaches, the option's time value decreases.
 The longer the time until expiration, the higher the option price.
 The shorter the time until expiration, the lower the option price.
If Spot prices Call prices will ... Put prices will ...
increases Increase Decrease
Decreases Decrease Increase

22. NAGA
3.Expected Volatility
Volatility is the degree to which price moves, whether it goes up or down. It is a measure of the speed and magnitude
of the underlying's price changes. option premiums are generally higher if the underlying exhibits higher
volatility because it will have higher expected price fluctuations.
The greater the expected volatility, the higher the option value.
4.Interest Rates
interest rates and dividends have small, but measurable, effects on option prices. In general, as interest rates rise, call
premiums increase and put premiums decrease.
If interest rates Call prices will ... Put prices will ...
Rise Increase Decrease
Fall Decrease Increase

23. NAGA
5.Dividends
Dividends can affect option prices because the underlying stock's price typically drops by the amount of any cash
dividend on the ex-dividend date. As a result, if the underlying's dividend increases, call prices will decrease and put
prices will increase. Conversely, if the underlying's dividend decreases, call prices will increase and put prices will
decrease
If dividends ... Call prices will ... Put prices will ...
Increase Decrease Increase
Decrease Increase Decrease

24. Benefits of trading in F&O
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Risk Allocation, Transfer, and Management:
Derivatives provide an effective method of transferring risk from parties who do not want the risk to parties who do.
Information Discovery:
One of the advantages of futures markets has been described as price discovery. futures price is sometimes thought of as
predictive. Fact that derivative markets require less capital, information can flow into the derivative markets before it gets
into the spot market. The difference may well be only a matter of minutes or possibly seconds, but it can provide the
edge to astute traders.
Operational Advantages:
Derivatives have lower transaction costs than the underlying. Derivative markets also typically have greater liquidity than
the underlying spot markets, a result of the smaller amount of capital required to trade derivatives than to get the
equivalent exposure directly in the underlying.
Market Efficiency:
When prices deviate from fundamental values, derivative markets offer less costly ways to exploit the mispricing. As
noted earlier, less capital is required, transaction costs are lower, and short selling is easier. This increased willingness to
trade increases the number of market participants, which makes the market more liquid. A very liquid market may not
automatically be an efficient market

25. Thankyou for visiting. ..
If you need more clarification Please do not hesitate to contact me.. In future I am
planning to add 15 Strategies using Futures Vs Options
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