The document provides an overview of derivatives and their development in the Indian market. It discusses various types of derivative instruments traded in India, including futures, forwards, options, and swaps. It outlines the key users of derivatives in India, with retail investors being major participants in equity derivatives markets while financial institutions are more active in over-the-counter fixed income markets. The document also provides definitions and examples of common derivative contract types such as forwards, futures, options, and swaps.

1. A
Grand Project
On
Growth of Derivatives in
Indian market
SUBMITTED TO:
GUJARAT UNIVERSITY
In 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. PREFACE
MBA is a professional course wherein for a student to posses only
theoretical knowledge alone is not enough but also to improve practical skill
which is helpful to them in every field of life in their future. Students needs
to have a practical implementation in the current scenario.
As a part of final semester syllabus of MBA we visited Stock Broking
Companies for practical training and also studied on the working of its
different services and prepare report on particular topic.
This training has expanded our horizon of knowledge in practical as well as
theoretical which are vital for any student in management level studies.
After completion of this Project we came to know that when we study
theory but practice it is very difficult to understand. Therefore to serve
dual purpose of practical training has been made compulsory for the student
of MBA.
Such training promotes a student to boost his potentials and the inner
qualities, and thereby students come to know about their reality that how
the theoretical knowledge works in actual sense in any unit. This has indeed
proved to be very useful to us.
2

3. ACKNOWLEDGEMENT
It gives us a great pleasure and personal satisfaction in presenting this report as a
part 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 stock
broking firm..
We are indebted to many individuals who have either directly or indirectly made an
important contribution in the preparation of this report.
we are also grateful to Dr.A.H.Kalro, (Director, AES PGIBM), for giving us an
opportunity to experience the corporate world, and for his valuable inputs on the project.
.We are also thankful to our co guide Prof Falguni Pandya
We would like to thank the entire staff of AESPGIBM library, computer lab especially
Hitanshu sir and Anvesha madam for their immense support. We would also like to
thank 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 for
their help and support.
3

4. Sr No Title Pg NO
1 Introduction to Derivatives 02
2 Development of Derivatives in 03
India
3 Derivative Instrument 04
4 Derivative User 06
5 Types of Derivatives 07
a. forward
b. futures
c. option
d. swap
6 Uses of Derivatives 21
7 History of derivatives 23
8 Recent Development 25
9 Strategies of Derivatives 27
a. Bull Spread
b. Bear Spread
c. Butterfly
d. Strangle
e. Straddle
10 Risk involved 39
11 FII and Derivatives 42
12 Technical analysis 46
13 Derivatives system 49
14 Derivative product 51
15 Derivatives concepts A-Z 55
16 Summarization of derivatives 69
market
17 Bibliography 79
4

5. INTRODUCTION TO DERIVATIVES
Derivatives are financial instruments whose value is derived from the value of something
else. They generally take the form of contracts under which the parties agree to payments
between them based upon the value of an underlying asset or other data at a particular
point 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 for
a high return (at increased risk) to another. The diverse range of potential underlying
assets and payoff alternatives leads to a huge range of derivatives contracts available to
be traded in the market. Derivatives can be based on different types of assets such as
commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a
stock market index, consumer price index (CPI) — see inflation derivatives — or even an
index of weather conditions, or other derivatives). Their performance can determine both
the amount and the timing of the payoffs.
'By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of financial derivatives. These instruments
enhance the ability to differentiate risk and allocate it to those investors most able and
willing to take it - a process that has undoubtedly improved national productivity growth
and standards of living.' -- Alan Greenspan, Chairman, Board of Governors of the US
Federal Reserve System.
5

6. Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875 and, by the early 1900s India had one of the world’s largest futures
industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
In the equity markets, a system of trading called “badla” involving some elements of
forwards trading had been in existence for decades.6 However, the system led to a
number of undesirable practices and it was prohibited off and on till the
Securities and Derivatives
Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the
stock 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 in
collaboration with state-owned financial institutions. NSE improved the efficiency and
transparency of the stock markets by offering a fully automated screen-based trading
system and real-time price dissemination. In 1995, a prohibition on trading options was
lifted. 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 phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the
J. R. Varma Committee in 1998, worked out various operational details such as the
margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared “securities.” This allowed
the regulatory framework for trading securities to be extended to derivatives. The Act
considers 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 derivatives
based on interest rates and foreign exchange. A system of market-determined exchange
rates was adopted by India in March 1993. In August 1994, the rupee was made fully
convertible on current account. These reforms allowed increased integration between
domestic and international markets, and created a need to manage currency risk. Figure 1
shows how the volatility of the exchange rate between the Indian Rupee and the U.S.
6

7. dollar has increased since 1991. The easing of various restrictions on the free movement
of interest rates resulted in the need to manage interest rate risk.
7

8. Derivatives Instruments Traded in India
In the exchange-traded market, the biggest success story has been derivatives on equity
products. Index futures were introduced in June 2000, followed by index options in June
2001, 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 and
Derivatives
.
3 stock indices. All these derivative contracts are settled by cash payment and do not
involve physical delivery of the underlying product (which may be costly).8
Derivatives on stock indexes and individual stocks have grown rapidly since inception. In
particular, single stock futures have become hugely popular, accounting for about half of
NSE’s traded value in October 2005. In fact, NSE has the highest volume (i.e. number of
contracts traded) in the single stock futures globally, enabling it to rank 16 among world
exchanges 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 in
October 2005. Figure 2 illustrates the growth in volume of futures and options on the
Nifty 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 faulty
contract specifications, resulting in the underlying interest rate deviating erratically from
the reference rate used by market participants. Institutional investors have preferred to
trade in the OTC markets, where instruments such as interest rate swaps and forward rate
agreements are thriving. As interest rates in India have fallen, companies have swapped
their fixed rate borrowings into floating rates to reduce funding costs.10 Activity in OTC
markets dwarfs that of the entire exchange-traded markets, with daily value of trading
estimated to be Rs. 30 billion in 2004.
Foreign exchange derivatives are less active than interest rate derivatives in India, even
though they have been around for longer. OTC instruments in currency forwards and
swaps are the most popular. Importers, exporters and banks use the rupee forward market
Derivatives
.
To hedge their foreign currency exposure. Turnover and liquidity in this market has been
increasing, although trading is mainly in shorter maturity contracts of one year or less. In
a currency swap, banks and corporations may swap its rupee denominated debt into
another currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTC
currency options is still muted. There are no exchange-traded currency derivatives in
India.
8

9. Exchange-traded commodity derivatives have been trading only since 2000, and the
growth in this market has been uneven. The number of commodities eligible for futures
trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has
increased almost four times in the same period. However, many contracts barely trade
and, of those that are active, trading is fragmented over multiple market venues, including
central and regional exchanges, brokerages, and unregulated forwards markets. Total
volume of commodity derivatives is still small, less than half the size of equity
derivatives
.
9

10. Derivatives Users in India
The 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 are
exposed to different risks of default from their borrowers. Thus, they are likely to use
derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-
financial institutions are regulated differently from financial institutions, and this affects
their incentives to use derivatives. Indian insurance regulators, for example, are yet to
issue guidelines relating to the use of derivatives by insurance companies.
In India, financial institutions have not been heavy users of exchange-traded derivatives
so far, with their contribution to total value of NSE trades being less than 8% in October
2005. However, market insiders feel that this may be changing, as indicated by the
growing share of index derivatives (which are used more by institutions than by retail
investors). In contrast to the exchange-traded markets, domestic financial institutions and
mutual funds have shown great interest in OTC fixed income instruments. Transactions
between banks dominate the market for interest rate derivatives, while state-owned banks
remain a small presence (Chitale, 2003). Corporations are active in the currency forwards
and swaps markets, buying these instruments from banks.
Why do institutions not participate to a greater extent in derivatives markets? Some
institutions such as banks and mutual funds are only allowed to use derivatives to hedge
their existing positions in the spot market, or to rebalance their existing portfolios. Since
banks have little exposure to equity markets due to banking regulations, they have little
incentive to trade equity derivatives.11 Foreign investors must register as foreign
institutional investors (FII) to trade exchange-traded derivatives, and be subject to
position limits as specified by SEBI. Alternatively, they can incorporate locally as a
Derivatives
Retail investors (including small brokerages trading for themselves) are the major
participants 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 this
instrument has generally failed in most other countries. One reason for this success may
be retail investors’ prior familiarity with “badla” trades which shared some features of
derivatives trading. Another reason may be the small size of the futures contracts,
compared to similar contracts in other countries. Retail investors also dominate the
markets for commodity derivatives, due in part to their long-standing expertise in trading
in the “havala” or forwards markets.
.
10

11. . TYPES OF DERIVATIVES
OTC and exchange-traded
Broadly speaking there are two distinct groups of derivative contracts, which are
distinguished 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 world's 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 world's
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. Common Derivative contract types
There 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. FORWARD CONTRACT
Forward contract is an agreement between two parties to buy or sell an asset (which can be
of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are
separated. 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 no
asset 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 the
price at which the asset changes hands (on the spot date, usually two business days). The
difference 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 works
Suppose that Bob wants to buy a house in one year's time. At the same time, suppose that Andy
currently owns a $100,000 house that he wishes to sell in one year's time. Both parties could
enter into a forward contract with each other. Suppose that they both agree on the sale price in
one year's time of $104,000 (more below on why the sale price should be this amount). Andy
and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said
to have entered a long forward contract. Conversely, Andy will have the short forward
contract.
At the end of one year, suppose that the current market valuation of Andy's 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 in
profit. In contrast, Andy has made a loss of $6,000.
13

14. FUTURES CONTRACT
Futures contract is a standardized contract, traded on a futures exchange, to buy or sell a
certain underlying instrument at a certain date in the future, at a specified price. The future
date is called the delivery date or final settlement date. The pre-set price is called the futures
price. 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 options
contract, which gives the holder the right, but not the obligation. In other words, the owner of
an options contract may exercise the contract. Both parties of a "futures contract" must fulfill
the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is
a cash-settled future, then cash is transferred from the futures trader who sustained a loss to
the one who made a profit. To exit the commitment prior to the settlement date, the holder of
a futures position has to offset their position by either selling a long position or buying back a
short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange's
clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
Futures contracts and exchanges
There are many different kinds of futures contracts, reflecting the many different kinds of
tradable assets of which they are derivatives. For information on futures markets in specific
underlying commodity markets, follow the links.
Foreign exchange market
Money market
Bond market
Equity index market
Soft Commodities market
Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as
specified 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. 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.
Standardization
Futures 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. Futures vs. Forwards
While futures and forward contracts are both a contract to deliver a commodity on a future date
at 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
forward's 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 underlying's 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: Let's 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 forward's daily price changes, while the forward's
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. Some exchanges tolerate 'nonconvergence', the failure of futures contracts and the value of the
physical commodities they represent to reach the same value on 'contract settlement' day at the
designated delivery points. An example of this is the CBOT (Chicago Board of Trade)Soft
Red Winter wheat (SRW) futures. SRW futures have settled more than 20¢ apart on settlement
day and as much as $1.00 difference between settlement days. Only a few participants holding
CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of
commodities to settle futures contracts. Therefore, it's impossible for almost any individual
producer to 'hedge' efficiently when relying on the final settlement of a futures contract for
SRW. The trend is the CBOT continuing to restrict those entities who can actually participate
in settling contracts with commodity to only those that can ship or receive large quantities of
railroad cars and multiple barges at a few selected sites. The CFTC (Commodity Futures
Trading Commission - a regulatory agency headed by a political appointee), which has
oversight of the futures market, has made no comment as to why this trend is allowed to
continue since economic theory and CBOT publications maintain that convergence of contracts
with the price of the underlying commodity they represent is the basis of integrity for a futures
market. It follows that the function of 'price discovery', the ability of the markets to discern the
appropriate value of a commodity reflecting current conditions, is degraded in relation to the
discrepancy in price and the inability of producers to enforce contracts with the commodities
they represent
17

18. OPTION
Options are financial instruments that convey the right, but not the obligation, to engage in a
future transaction on some underlying security. For example, buying a call option provides the
right to buy a specified quantity of a security at a set strike price at some time on or before
expiration, while buying a put option provides the right to sell. Upon the option holder's choice
to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the
contract.
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 will
change in the face of changing conditions. Hence, the risks associated with trading and owning
options can be understood and managed with some degree of precision.
Exchange-traded options form an important class of options which have standardized contract
features and trade on public exchanges, facilitating trading among independent parties. Over-
the-counter options are traded between private parties, often well-capitalized institutions that
have negotiated separate trading and clearing arrangements with each other. Another
important class of options, particularly in the U.S., is employee stock options, which are
awarded 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 are
often used to assemble large parcels of land, and prepayment options are usually included in
mortgage loans. However, many of the valuation and risk management principles apply
across all financial options.
Contract specifications
Every financial option is a contract between the two counterparties with the terms of the
option specified in a term sheet. Option contracts may be quite complicated; however, at
minimum, 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. Types of options
The 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 options
These trades are described from the point of view of a speculator. If they are combined with
other positions, they can also be used in hedging.
Long Call
19

20. Payoffs and profits from a long call.
A trader who believes that a stock's price will increase might buy the right to purchase the
stock (a call option) rather than just buy the stock. He would have no obligation to buy the
stock, only the right to do so until the expiration date. If the stock price increases over the
exercise price by more than the premium paid, he will profit. If the stock price decreases, he
will let the call contract expire worthless, and only lose the amount of the premium. A trader
might buy the option instead of shares, because for the same amount of money, he can obtain a
larger number of options than shares. If the stock rises, he will thus realize a larger gain than if
he had purchased shares
Short Call
Payoffs 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 are
generally considered inappropriate for small investors. The trader selling a call has an
obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases,
the short call position will make a profit in the amount of the premium. If the stock price
increases over the exercise price by more than the amount of the premium, the short will lose
money, with the potential loss unlimited
20

21. Long Put
Payoffs and profits from a long put.
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a
fixed price (a put option). He will be under no obligation to sell the stock, but has the right to
do so until the expiration date. If the stock price decreases below the exercise price by more
than the premium paid, he will profit. If the stock price increases, he will just let the put
contract expire worthless and only lose his premium paid.
Short Put
Payoffs 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 buyer's
option. If the stock price increases, the short put position will make a profit in the amount of the
premium. If the stock price decreases below the exercise price by more than the amount of the
premium, the trader will lose money, with the potential loss being up to the full value of the
stock.
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