Excella trader derivative class

Understanding Futures & Options
www.excellatrader.com

What we will cover?
Introductions to Derivative
Pricing – The Greeks
Trading options in India
Option trading strategies

A Financial Instrument That Derives
What is a derivative?
A Financial instrument that derives its
value from An Underlying asset
The asset can be a share, index, interest
rate, bond, rupee dollar exchange rate,
sugar, crude oil, cotton, coffee and etc.

Case of a wheat farmer:
A wheat farmer may wish to contract to sell
his harvest at a future date to eliminate the
risk of a change in prices by that
date

Uses of Derivatives
Hedging
Speculation
Arbitrage

Index Futures
A barometer for market behavior
A benchmark for portfolio performance
An underlying in derivative instruments

What are options?
An option is a contract, which gives the buyer (holder) the
right, but not the obligation, to buy or sell specified
quantity of the underlying assets, at a specific (strike)
price on or before a specified time (expiration date).

Call Option Put Option
Option Buyer
Buys the right to
buy the underlying
asset at the Strike
Price
Buys the right to sell
the underlying asset
at the Strike Price
Option Seller
Has the obligation
to sell the
underlying asset to
the option holder at
the Strike Price
Has the obligation to
buy the underlying
asset from the
option holder at the
Strike Price

In options the buyer enjoys the right and not the
obligation, to buy or sell the underlying asset.
Limited downside (to the extent of premium paid) for
buyer and unlimited upside. For seller (writer) of the
option, profits are limited whereas losses can be
unlimited.
Prices of options are however, affected by a)prices of
the underlying asset, b)time remaining for expiry of the
contract and c)volatility of the underlying asset.

Terms
Underlying
Strike price
Expiry date
Premium
Exercise
Lot size
American option
European option

Pay Rs.10
Buy
Reliance
at Rs 900
But only if
it is above
900

Option Buyer
Right to buy
Pays premium
Option seller
obligation to sell
Gets premium

Pricing
An option price consists of two parts
Time value and
Intrinsic value
Example
If Nifty is at 5050
And Nifty 5000 call option is at Rs. 75
Intrinsic
value 50
Time
value 25

General Electric is considered a stock with low volatility with a beta of 0.49 for this example.

LONG CALL
Market Opinion - Bullish
Profit +
0
DR
Loss -
Underlying Asset Price
Stock Price
Lower Higher
BEP
S

In-the-money option (ITM)
At-the-money option (ATM)
Out-of-the-money option (OTM)

In the case of Call - Max[0, (St — K)]
In the case of Put - Max[0,K — St]
Time value of an option: The time value of an option
is the difference between its premium and its intrinsic
value.

Option pay offs
Payoff profile of buyer of asset: Long asset

Payoff profile of buyer of asset: Short asset

Payoff for buyer of call option

Payoff for writer of call option

Payoff for buyer of put option

Payoff for writer of put option

Price determination
Price change
Changes in volatility
Time value decay

Delta
Measures of risk from a move of
the underlying price

Delta
When the Underlying
Security...
Increase in Value Decrease in Value
The Long Call will…. Increase in Value Decrease in Value
The Short Call will…. Decrease in Value Increase in Value
The Long Put will…. Decrease in Value Increase in Value
The Short Put will…. Increase in Value Decrease in Value

Delta
Option Position Hedge Position
Long Call – Increases in value as the
underlying increases in value
Short Underlying
Short Call
Long Put
Short Call – Decreases in value as the
Long Underlying
Long Call
Short Put
Long Put – Decreases in value as the
Long Underlying
Short Put
Long Call
Short Put – Increases in value as the
underlying decreases in value
Short Underlying
Long Put
Short Call

Constructing a Delta-neutral strategy
Statistical Volatility 25%
Option Strike Price 100
Days remaining 30
Price of
underlying
Call Option Put Option
Delta of
underlying
80 0.0013 -0.9987 1.0000
85 0.0148 -0.9852 1.0000
90 0.0843 -0.9157 1.0000
95 0.2668 -0.7332 1.0000
100 0.5371 -0.4629 1.0000
105 0.7805 -0.2195 1.0000
110 0.9226 -0.0774 1.0000
115 0.9795 -0.0205 1.0000
120 0.9958 -0.0042 1.0000

•The absolute value of the delta increases as the option goes further in-the-money and
decreases as the option goes out-of-the-money.
•At-the-money call and put options have a delta that is right around 0.50 and -0.50
respectively.
•Put options have a negative delta, which means if the price of an asset goes up, the
price of a put option on that asset goes down.
•Deep in-the-money call options have a delta that approaches +1.00. Conversely, deep
in-the-money put options have a delta that approaches -1.00.
•Deep out-of-the-money calls and puts have deltas that approach zero.
•The delta of the underlying asset itself always remains constant at 1.00.
Price of underlying Call Option Put Option Delta of underlying
80 0.0013 -0.9987 1.0000
85 0.0148 -0.9852 1.0000
90 0.0843 -0.9157 1.0000
95 0.2668 -0.7332 1.0000
100 0.5371 -0.4629 1.0000
105 0.7805 -0.2195 1.0000
110 0.9226 -0.0774 1.0000
115 0.9795 -0.0205 1.0000
120 0.9958 -0.0042 1.0000

Options Strategies
Stock futures price 110
Statistical Volatility 8%
Option Strike Price 110
Days remaining 30
Price of
underlying
Option Theoretical
price
Option
delta
108 2.14 -0.73
109 1.43 -0.58
110 0.91 -0.42
111 0.53 -0.28
112 0.28 -0.16
•Buy 2 stock futures at 110
•Buy 5 put options (110 strike
price) at 0.91 each
Delta of futures 2 x 1.00 = -2.00
Delta of put options 5 x -0.42 = -2.10
Total position delta 2.00 + -2.10 = -0.10

Options Strategies
If you buy the underlying and buy put options so your position is delta neutral:
•When the market goes up, you have a profit on the underlying and you have a smaller loss on the options
(because their delta decreased), so you wind up with a net profit.
•When the market goes down, you have a loss on the underlying but you have a bigger profit on the options
(because their delta increased), so again you have a net profit.

Options Strategies
If you sell (short) the underlying and buy call options so your position is delta neutral:
When the market goes up, you have a loss on the underlying but again you have a bigger profit on the
options (their delta increased), so you have a net profit.
When the market goes down, you have a profit on the underlying but once again, you have a smaller loss
on the options (their delta decreased), so you still have a net profit.

Vega
Changes in implied volatility.

Theta
Theta is a measure of the rate of time
premium decay

Theta
As Time Moves Forward...
Underlying Security Value remains constant
Long Call Decrease in Value
Short Call Increase in Value
Long Put Decrease in Value
Short Put Increase in Value

Gamma
Delta measures the change in price of an option resulting from the change
in the underlying Price. This rate of change of Delta resulting from
movement of the underlying is known as Gamma

Rho
Rho is a risk measure related to changes in
interest rates.

As market
conditions change
the values of...
Rise in price of
the underlying...
Interest
rates Rise...
Volatility
Rise...
Passage
of time...
Dividends
Rise...
Long Underlying Increase No effect No effect No effect Increase
Short Underlying Decrease No effect No effect No effect Decrease
Long Call Increase Increase Increase Decrease Decrease
Short Call Decrease Decrease Decrease Increase Increase
Long Put Decrease Decrease Increase Decrease Increase
Short Put Increase Increase Decrease Increase Decrease

The Black Scholes Model
Model link

Option strategies

SYNTHETIC LONG CALL: BUY STOCK, BUY PUT
Mr. XYZ is bullish about ABC Ltd stock.
He buys ABC Ltd. at current market price of Rs. 4000 on 4th
July.
To protect against fall in the price of ABC Ltd. (his risk), he
buys an ABC Ltd. Put option with a strike price Rs.3900
(OTM) at a premium of Rs. 143.80 expiring on 31st July

Profit +
BEP
Strike Price
3900
Loss - Lower Higher
Stock Price

COVERED CALL
Profit +
0
Loss -
Strike Price
Stock Price
Lower Higher
BEP
Profits are limited . Losses can be unlimited

BULL CALL SPREAD
For Investors who are bullish but at the
same time conservative
BUY A CALL CLOSER TO SPOT PRICE &
WRITE A CALL WITH A HIGHER PRICE
In a market that has bottomed out, when
stocks rise, they rise in small steps for a short
duration. Bull Call Spread can be Used where
gains & losses are limited.
Reliance Spot Price = Rs.250
Premium of 260 CA = Rs.10
Premium of 270 CA = Rs. 6
Strategy – Buy 260 CA @ Rs.10 & Sell 270
CA @ Rs.6
Net Outflow = Rs.4
Stock Price at
Expiration
Net Profit/ Loss
250 -4
260 -4
264 0
266 2
270 6
280 6

Options Trading in India
Day Traders
Premium Sellers
Spread Traders
Theoretical Traders
Private
Banks
Financial
Institutions
Others
Public
Sector
Banks
Foreign
Banks

In general, implied volatility increases when the market is bearish and
decreases when the market is bullish.

1 day before the expiry

Interest Rate Swap
A B
6%
LIBOR+1% LIBOR+1.5%
8%
6.25%
0.50%
BOTH COMPANIES SAVES 0.75%

Triangular Arbitrage
suppose you have $1 million and you are provided with the following
exchange rates:
EUR/USD = 0.8631,
EUR/GBP = 1.4600
USD/GBP = 1.6939.
With these exchange rates there is an arbitrage opportunity:
Sell dollars for euros: $1 million x 0.8631 = 863,100 euros
Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
Sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars
$1,001,373 - $1,000,000 = $1,373

Excella trader derivative class

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