A basic knowledge about derivatives and its role in financial world

1. All About Derivatives
Presented by:
Anup Chakraborty
#9811222713
anupchakraborty@hotmail.com

2. What are Derivatives
Derivatives are financial instruments
whose value depend on the value of
other, more basic underlying assets.
Underlying asset can be a commodity,
currency, equity, interest rate,
exchange rate etc.

3. Derivative Products
Convertibles
Warrants
GDR’s and ADR’s
Mutual Fund Units
Real estate units
Exchangeables
Forward
Futures
Options

4. Forward Contracts
A forward contract is a particularly simple
derivative.
It is an agreement to buy or sell an asset at a
certain future time for a certain price.
The contract is negotiated privately usually
between two parties.
The quality and quantity of the asset is not
standardized.
The time and place of delivery is not standard.
The parties to the contract assumes counter
party risk.
It is normally not traded on the exchanges.

5. Futures Contract
Every futures contract is a forward contract.
Futures contracts:
are entered into through exchange, traded on exchange
and clearing corporation/house provides the settlement
guarantee for trades.
are of standard quantity, standard quality.
have standard delivery time and place.

6. The Global derivatives Industry
1874 commodity futures
1972 currency futures
1973 equity options
1981 currency swaps
1982 Index futures, interest rate
swaps, currency options
1983 Option on index, option on
futures

7. Introduction to futures
Choice of initial product:
Index futures
Options on index
Stock futures
Options on stocks

8. Introduction to futures
Trading mechanism
Contract design:
Multiplier
Contract size
Tick size
Expiration month and date
Open interest, volume position

9. Futures – definition
A futures is a legally binding agreement
to buy or sell something in the future at
a price which is determined today.
Pricing
Futures = Spot+Cost of carry –dividend (if any)

10. Operational Mechanism
Cash settled
Initial Margin (upfront)
Mark-to-Market margin (daily)

11. Salient Features of Futures
Market
Concept of basis:
Can be both +ve or -ve.
Basis may change its sign several times during
the life of the contract.
Turns to 0 at maturity.
[Both cash and futures prices converge at
maturity]
B
A
S
I
S
Life of the contract
Maturity

12. Economic Payoff for Futures Contracts
-25
-20
-15
-10
-5
0
5
10
15
20
25
80
82
84
86
88
90
92
94
96
98
100
102
104
106
108
110
112
114
116
118
120
Asset Price
Gain/Loss

13. Option - definition
option is the right given by the option seller
to the option buyer to buy or sell specific
asset at a specific price on or before a
specific date.

14. How much does an option
cost?
The premium is the price you pay for
the option.
For buyer of an option
Risk : limited to the amount of premium
paid
Profit potential: unlimited

15. Option Terminology
Call Option
Option to buy
Put Option
Option to sell
Option Buyer
has the right but not the obligation
Option Writer/Seller
has the obligation but not the right

16. Option Terminology
Option Premium
Price paid by the buyer to acquire the right
Strike Price OR Exercise Price
Price at which the underlying may be purchased
Expiration Date
Last date for exercising the option
Exercise Date
Date on which the option is actually exercised

17. Types of Options
American Option (options on stocks)
can be exercised any time on or before the
expiration date
European Option (options on index)
can be exercised only on the expiration
date (options on index)

18. Call option
A buyer of call option has the right but not
the obligation to buy the underlying at the
set price by paying the premium upfront.
He can exercise his option on or before
expiry.

19. Break-even (Call option)
Call= strike +premium +fees
There are two ways you can liquidate your position.
exercise your option
sell back the same option contract you purchased.

20. Call Buyer V/s Seller
Call Buyer
Pays premium
Has right to exercise resulting in a long position in
the underlying
Time works against buyer
Call Seller
Collects premium
Has obligation if assigned resulting in a short
position in the underlying
Time works in favor of seller

21. Economic Payoff for Call Option
-20
-15
-10
-5
0
5
10
15
20
80
82
84
86
88
90
92
94
96
98
100
102
104
106
108
110
112
114
116
118
120
Asset Price
Gain/Loss
Buy Call
Sell Call

22. Put option
A buyer of Put option has the right but not the
obligation to sell the underlying at the set
price by paying the premium upfront.
He can exercise his option on or before
expiry.

23. Break-even (Put option)
Put= strike -premium -fees
There are two ways you can liquidate your position.
exercise your option
sell back the same option contract you
purchased.

24. Put Buyer V/s Seller
Put Buyer
Pays premium
Has right to exercise resulting in a short position in
the underlying
Time works against buyer
Put Seller
Collects premium
Has obligation if assigned resulting in a long
position in the underlying
Time works in favor of seller

25. Economic Payoff for Put Option
-20
-15
-10
-5
0
5
10
15
20
80
82
84
86
88
90
92
94
96
98
100
102
104
106
108
110
112
114
116
118
120
Asset Price
Gain/Loss
Buy Put
Sell Put

26. Assignment
• When holder of an option exercises the right,
a randomly selected option seller is obligated
to be assigned into the underlying contract.

27. Option Valuation
Option Premium = Intrinsic Value
+
Time Value
Option Premium >= 0
Intrinsic Value >= 0
Time Value >= 0

28. Option Valuation
Intrinsic Value
Difference between Exercise Price and Spot
Price
Cannot be negative
For a Call Option
St - K
For a Put Option
K - St
St = Spot price at time t

29. Time Value
Amount buyers are willing to pay for the
possibility that, at some time prior to
expiration, the option may become profitable
Cannot be negative
An at-the-money option has the maximum
time value of any strike price, i.e. more time
value than either an in or out-of-the-money
option.

30. Strike Prices
In-the-money
Option with intrinsic value
At-the-money
Exercise Price = Market Price
Out-of-the-money
No intrinsic value
some time value possible

31. Factors affecting option values
Current Price of the underlying asset
(S)
Exercise Price of the option(K)
Interest Rates (Rf)
Time to Expiry (T)
Volatility of prices of the underlying
asset (σ)

32. Effect of an increase in each pricing factor on the option
value, holding other factor constant
Sr.
No.
Pricing factor Call option Put option
1 Current Asset price(St) Increase decrease
2 Strike price decrease Increase
3 volatility Increase Increase
4 Time to expiration Increase Increase
5 Interest rate Increase decrease

33. Option pricing models
Black-Scholes Model
Pce=S*N(d1)-Ke-Rf.t
*N(d2)
Normal distribution function
Binomial Model
Pce=Ke-Rf.t
*N(-d2)- S*N(-d1)
Binomial distribution Function

34. Option Greeks
Measuring Option Price Sensitivity

35. Option Greeks
Option Greeks are mathematical outputs from
an Option Valuation Model which help you to
understand the possible future movement in
Option Values based on various underlying
parameters.
Greeks help you in possible predictions of
Option Values and help you to fine tune your
buy sell hedge decisions much better.
Greeks used- Delta, Gamma, Vega, Theta
and Rho.

36. Delta (∆)
Delta stands for the change in the
Option Value for a given change in the
price of Shares.
For example, if the Delta of a Call Option
is 0.65, the meaning is: If the share
price moves up by Re 1.00, the Call
Option will rise up by Rs 0.65.

37. Delta (∆)
Bullish Positions
Long futures
Long call
Short put
Have positive (+) deltas
Bearish Positions
Short futures
Short call
Long put
Have negative (-) deltas

38. Delta Neutral Position
The construction of a strategy where
the total delta position on the long side
and total delta position on the short side
are equal (or approximately offsetting).
Example: Sell 1 Futures Contract (Delta =
1.0) and Buy 2 At-the-money Calls (Delta =
2* (-0.5), delta of the position is 0.0

39. Gamma (γ)
Gamma stands for the change in Delta
itself for a given change in the share
price. Technically, it is called a second
order derivative.

40. Gamma (γ)
Positive Gamma Position
Long Calls
Long Puts
Negative Gamma Position
Short Calls
Short Puts
(Delta)+(Gamma)=(New Delta) for incremental
increase in the underlying
(Delta)-(Gamma)=(New Delta) for incremental
decrease in the underlying

41. Vega (κ)
Derivative of the option pricing formula
with reference to the volatility of the
asset returns (σ)
Measures the estimated change in the
option premium for a change in σ.

42. Vega (κ)
Vega indicates impact of Volatility
For example: if Vega is 0.09, the meaning is
that the Option Value will rise by Rs 0.09 for
an increase of 1% in Volatility. If the current
Volatility of Satyam is 35% and the Value of
an Option is Rs 11, the implication is that
were the Volatility to move up to 36%, the
Option Value would rise to Rs 11.09.

43. Vega (κ)
Positive Vega Position
Long Calls
Long Puts
Negative Vega Position
Short Calls
Short Puts

44. Vega (κ)
Original Option Premium + Vega = New
Option Premium for 1% increase in
Implied Volatility
Original Option Premium - Vega = New
Option Premium for 1%
decrease in Implied Volatility

45. Theta (τ)
Theta determines precisely how much
the value of the Option will decrease by
passage of time(T).
For example, if the Theta of an Option
is –0.17, this means the value of this
Option will decrease by Rs 0.17 on
passage of one day.

46. Rho (ρ)
Derivative of the option pricing formula
with reference to the risk free rate of
interest (Rf)
Measures the estimated change in the
option premium for a change in Rf.

47. Position Delta Gamma Vega Theta
Long future +ve 0 0 0
Short future -ve 0 0 0
Long call +ve +ve +ve -ve
Short call -ve -ve -ve +ve
Long put -ve +ve +ve -ve
Short put +ve -ve -ve +ve

48. Trading Strategies

49. Key Points
• Options can be a very effective tool to take
advantage of a rising or falling underlying. The
following points may be kept in mind while
purchasing options:
• The time value of option premiums decay towards
expiration, so market timing is very important.
• Choose an option month that allows enough time for the
anticipated move in the underlying.
• In-the-money calls are initially more responsive to underlying
price changes than out-of-the-money calls.
• Choose a strike price level that offers a good risk/reward
ratio given the expected price movement.

50. Vertical Spreads
• Buying a call (put) and selling a call
(put) with different strike prices but the
same expiration month.
• Two types of vertical spreads
• Bull Spreads
• Bear Spreads

51. Debit / Credit Spreads
Debit Spreads entail a net pay-out of
option premium
Credit Spreads entail a net collect of
option premium

52. Bear Vertical Spreads
Bear Call Spread (Credit Spread)
Bear Put Spread (Debit Spread)
Bear Spreads have a negative delta and
consist of:
Buying the higher strike call (put)
Selling the lower strike call (put)

53. Economic Payoff of Bear Spread
-200
-150
-100
-50
0
50
100
150
200
3000
3100
3200
3300
3400
3500
3600
3700
3800
3900
4000
4100
4200
4300
4400
4500
4600
4700
4800
4900
5000
Sensex Level
Profit/Loss

54. Bear Vertical Spreads
Maximum loss occurs above upper strike
price
Maximum profit occurs below lower strike
price
Breakeven level equals:
Lower strike plus credit (call spread)
Upper strike minus debit (put spread)
Have net negative delta, that is, benefit from
a decline in market price levels.

55. Bull Vertical Spreads
Bull Call Spread (Debit Spread)
Bull Put Spread (Credit Spread)
Bear Spreads have a positive delta and
consist of:
Buying the lower strike price call (put)
Selling the higher strike price call (put)

56. Economic Pay off for Bull Spread
-150
-100
-50
0
50
100
150
Sensex level
Profit/Loss

57. Bull Vertical Spreads
Maximum loss occurs below lower strike price
Maximum profit occurs above upper strike
price
Breakeven level equals:
Lower strike plus debit (call spread)
Upper strike minus credit (put spread)
Have net positive delta, that is, benefit from
an increase in market price levels.

58. Option Straddles
Consist of buying a put and buying a
call (Long Straddle). Both legs have the
same strike price and same expiration;
OR
Consist of selling a put and selling a call
(Short Straddle). Both legs have the
same strike price and same expiration.

59. Long Straddles
Maximum loss is equal to net debit, or
total premium paid
Maximum profit is unlimited
Breakeven levels are equal to:
common strike price plus or minus net
debit
Net delta is approximately zero when
strike price is at-the-money

60. Economic Pay off for Long Staddle
-400
-200
0
200
400
600
800
3200
3400
3600
3800
4000
4200
4400
4600
4800
5000
Sensex level
Profit/Loss

61. Short Straddles
Maximum profit is equal to net credit
Maximum loss is unlimited
Breakeven levels are equal to:
common strike price plus or minus net
credit
Net delta is approximately zero when
strike price is at-the-money

62. Economic Pay-off for Short Straddle
-800
-700
-600
-500
-400
-300
-200
-100
0
100
200
300
3200
3300
3400
3500
3600
3700
3800
3900
4000
4100
4200
4300
4400
4500
4600
4700
4800
4900
5000
Sensex Levels
Profit/(Loss)

63. Option Strangles
Consist of buying a put and buying a call
(Long Strangle) with the put strike lower than
the call strike, and both option legs have the
same expiration;
OR
Consist of selling a put and selling a call
(Short Strangle) with the put strike lower than
the call strike, and both options legs have the
same expiration

64. Long Strangles
Maximum loss is equal to net debit, or total
premium paid
Maximum profit is unlimited
Breakeven levels are equal to:
put strike minus net debit
call strike plus net debit
Net delta is approximately zero when strikes
are equi-distant from current underlying price

65. Economic Pay off for Long Strangle
-200
-100
0
100
200
300
400
500
600
Sensex level
Profit/Loss

66. Short Strangles
Maximum profit is equal to net credit
Maximum is loss unlimited
Breakeven levels are equal to:
put strike minus net credit
call strike plus net credit
Net delta is approximately zero when
strikes are equi-distant from current
underlying price

67. Economic Pay off for Short
Strangle
-600
-400
-200
0
200
Sensex level
Profit/Loss

68. Long Butterfly
Consist of buying a call option with low
strike (3600) and selling 2 call options
with medium strike (4000) and buying
one more call option with high strike
(4400) price.
The same position can be created with
puts, but it is less common.

69. Long Butterfly
Maximum profit is limited and equal to
the difference between the lower and
middle strikes minus the net initial debit
( -400 + 2*105 - 10 = -200 ) of
establishing the spread.
Maximum loss is limited to the net initial
debit of establishing the spread.

70. Economic Pay off for Long Butterfly
-300
-200
-100
0
100
200
300
Sensex level
Profit/Loss

71. Short Butterfly
Consist of selling a call option with low
strike (3600) and buying 2 call options
with medium strike (4000) and selling
one more call option with high strike
(4400) price.
The same position can be created with
puts, but it is less common.

72. Short Butterfly
Maximum profit is equal to the net credit
of the establishing the spread.
Maximum loss is limited to the
difference between the lower and
middle strikes minus the net initial credit
(+400 - 2*105 + 10 = 200 )

73. Economic Pay off for Short Butterfly
-300
-200
-100
0
100
200
300
Sensex level
Profit/Loss

74. Horizontal Spread
Horizontal Spread is a spread in which
two legs of the spread have different
expiration date but the same strike
prices. This spread may also be called
as time spread or calendar spread.

75. Diagonal spread
Diagonal Spread is a spread in which
two legs of the spread have different
strike prices and different expiration
date. It has a features of both vertical
and horizontal spreads and so may be
called a hybrid product.

76. Thank You