Derivatives Research-

Sub Topic 1 - Introduction to futures and options

A derivative is a contract signed between two parties. The value of a derivative is based upon an  underlying asset (securities, commodities, real estate etc.) or a group of assets (any market index).  The underlying asset could be of any asset type. The most commonly used underlying assets include  commodities, currencies, indexes (such as BANKNIFTY) and stocks.

The two major types of derivatives are -

1) Futures – A future contract obligates the buyer to purchase or sell the underlying asset on a fixed future date at a pre- agreed price. Hypothetically, if ‘A’ bought one ‘ABC LTD.’ Future on 2nd June with an expiration date of 15th June for Rs. 150 by paying the required margin of Rs. 10, then they  will have to buy ‘ABC LTD.’ for Rs 150 on 15th June irrespective of the price on that day. Profit (Loss if  negative) = Price on 15th June (Expiration Date) – 150 (Pre agreed price) – 10(Margin)

2) Options – An Options Contract gives the buyer the right, but not the obligation to purchase or sell  the underlying asset on a fixed future date (or anytime during the contracts tenure) at a pre-agreed  price.

There are two major types of options on the basis of the options they give

a) Call option – A call option gives the buyer the right to buy the underlying asset on a future date at  a pre-agreed price. Individually, A call option is bought when the expected movement is upward and  is sold when the expected movement is downward.

b) Put option - A put option gives the buyer the right to sell the underlying asset on a future date at a  pre-agreed price. Individually, A put option is bought when the expected movement is downward  and is sold when the expected movement is upward.

However, Trading in derivatives is generally carried out by a combination of Options.

Hypothetically, if ‘A’ bought one ‘ABC LTD.’ Call Option on 2nd June with an expiration date of 15th  June for Rs. 150 by paying the required margin of Rs. 10, then they will have the option to buy ‘ABC  LTD.’ for Rs 150 on 15th June irrespective of the price on that day. In this case, the loss is limited to  Rs. 10 (Margin) since the buyer of the call option would not exercise the option if the loss exceeds

the margin. Profit (or loss If negative and limited to – 10) = Price on 15th June (Expiration Date) – 150 (Pre agreed price) – 10 (Margin)

There are two major types of options on the basis of exercising them -

a) American Style Options – American style options are those options which can be exercised any  time during the tenure of the contract. They are denoted by CA (Call American option) and PA (Put American Option).

b) European style Options – European style options are those options which can only be exercised at  their expiration date, and not anytime before. They are denoted by CE (Call European Option) and PE (Put European Option).

There are numerous types of participants in a derivatives market

1) Risk Hedgers – Derivative contracts such as future and options help to reduce the risk of unlimited  loss. For ex, if ‘A’ buys a stock of ‘ABC Ltd’ on for Rs. 150 expecting upward movement in the stock.  However, ‘A’ is also worried that in an unusual situation the stock price might completely crash and

he might have to bear a huge loss. To hedge that risk, ‘A’ can buy a put option for ‘ABC Ltd’ for Rs.  150 and pay the required margin and the maximum loss that ‘A’ will have to bear will be the cost of  the margin. In this case, for ‘A’ to make a profit, the price of the stock of ABC Ltd should be more  than 150 (Original Price) + Margin.

2) Speculators – Speculators generally trade based on their educated guess on where the market is  headed. They help to provide liquidity to the derivatives market and they don’t have any risk to  hedge. They operate at a high level of risk in anticipation of profits.

3) Arbitrageurs – These kinds of traders enter in the market for making risk free profits. Arbitrageurs  simultaneously buy and sell instruments for a different price in different markets. They basically use the inefficiencies of the market to their favour and make profits. Arbitrage Trading is considered risk  free since buying and selling occur simultaneously.

Greeks

An option’s Greeks describes its various risk parameters. They are measures of sensitivities. The five  primary Greeks are Delta (Δ), Gamma (ϒ), Theta (Θ), Vega (ν) and Rho (ρ).

Delta (Δ)

The delta (Δ) of a stock option is the ratio of the change in the price of the stock option to the  change in the price of the underlying stock. It is the number of units of the stock we should hold for  each option shorted in order to create a riskless portfolio. The process of creating a riskless portfolio  is known as delta hedging.

For Example – If the delta is 0.60, it basically means that the options price will move Rs 0.6 for every  1 rupee of movement in the underlying asset.

Call options have a positive delta that ranges from 0 to 1 and at the money options have a delta near  0.5. The delta increases (towards 1) as the option gets deeper in the money. The delta of in the money options approaches 1 and the delta of out the money options approaches 0 as the expiration  date gets nearer.

Put options have a negative delta that ranges from 0 to -1 and at the money options have a delta  near 0.5. The delta of in the money options approaches -1 and the delta of out the money options  approaches 0 as the expiration date gets nearer.

Example – Let us assume – Stock price = Rs. 10, Call premium = Rs. 1, Delta (Δ) = 0.4. Hypothetically,  investor shorts call option for 2000 shares. In this case, the investor shall buy 2000 * 0.4(Delta) = 800  shares. In this case the gain/loss on the options would offset the gain/loss on stocks. If the price of  stock rises by Rs 1, the profit on shares will be Rs 800. If price of share rises by Rs 1 then option price  will go up by Rs 0.4, hence the loss on options will be 2000*0.4 = 800.

In this case, the delta of the overall position is zero, also known as delta neutral.

Gamma (ϒ)

The gamma (ϒ) of a portfolio of options on an underlying asset is the rate of change of the portfolio’s  delta with respect to the price of the underlying asset. Gamma is necessary because delta is only  useful for a given point of time. Hence, Gamma calculates the change in delta with respect to the  price of the underlying asset. If gamma is small, delta changes slowly, and adjustments to keep the  portfolio delta neutral don’t need to be made too frequently. However, if gamma is highly positive  or highly negative, it means that delta is sensitive to the price of the underlying asset. It then  becomes risky to leave a delta neutral portfolio unchanged for a long period of time.

Theta(Θ)

The theta (Θ) of a portfolio of options is the rate of change of the value of the portfolio with respect  to the passage of time when everything else is constant. It is also known as time decay of the  portfolio. Usually, when theta is quoted, time is measured in days, so that theta is the change in the  portfolio value when 1 day passes when everything else is constant. Theta is generally negative  because with the passage of time and everything else remaining constant, the value of an option  tends to decrease. When the stock price is very low, theta is close to zero. For an at-the-money call  option, theta is large and negative.

Vega (ν)

The value of a derivative is liable to change because of movements in volatility as well as because of  changes in the asset price and the passage of time. The vega (ν) of a portfolio of derivatives is the  rate of change of the value of the portfolio with respect to the volatility of the underlying asset. If  vega is highly positive or highly negative, the portfolio’s value is very sensitive to small changes in  volatility. If it is close to zero, volatility changes have relatively little impact on the value of the  portfolio.

Rho (ρ)

The rho of a portfolio of options is the rate of change of the value of the portfolio with respect to the  risk-free interest rate. When interest rates go up then bring down the present value of the excise  price. That is why a rise in interest rates is positive for call options and negative for put options.

Instead of buying derivatives individually, traders combine derivatives to create different strategies to make profits. Some of them are -

1. Covered Call – In this Strategy, the investor buys a future and sells the call option of the  underlying asset. This strategy is used when the trader expects the market to be bullish. The  maximum profit in this strategy = Strike price of the call option – The price of the future +  Premium. The break-even point = Future price – Premium. The maximum loss in this strategy  is unlimited. For ex. Buy FUT NIFTY @15000 and Sell 15100 CE @ 90. In this case, the  maximum profit = 15100 – 15000 +90 = 190. Break even Point = 15000 – 90 = 14910

2.Bull Call Spread – A bull call spread includes one long call with a lower strike price and one  short call with a higher strike price. It is a bullish strategy. The maximum profit = Difference  between the strike prices – Total premium Paid. The maximum loss = Total premium Paid. Break Even Point = Lower Strike Price + Total Premium Paid. For ex. Buy 15100 CE @ 90 and  Sell 15200 CE @ 60. Maximum Profit = 15200 – 15100 – (90 -60) = 70. Maximum Loss = 90 – 60 = 30. Break even Point = 15100 + 30 = 15130.

3. Bear Call Spread - A bear call spread consists of one short call with a lower strike price and  one long call with a higher strike price. It is a bearish strategy. The maximum profit is total  premium received. The maximum loss = Difference between the strike prices – Total  premium received. Breakeven Point = Lower strike price + Total Premium Received. For Ex  Buy 15300 CE @ Rs 30 and Sell 15200 CE @ Rs 60. Maximum Profit = 60 – 30 = 30. Maximum  Loss = 15300 -15200 – 30 = 70. Break Even Point = 15200 + 30 = 15230

4. Collar – A collar strategy consists of buying one future, selling a call option and buying a put  option (Generally out of the money). Maximum Profit = Strike Price of the Call – Price of the  future + Total premium received (or minus total premium paid). Maximum Loss = Price of  Future – Strike Price of Put – Total Premium received. Break Even Point = Future Price + Put  Premium – Call Premium. For ex. Buy FUT @ 15000 Sell 15100 CE @100 Buy 14900 PE @ 90. Maximum Profit = 15100 – 15000 + 100 – 90 = 110. Maximum Loss = 15000 – 14900 -10 =  90. Break Even Point = 15000 + 90 – 100 = 15010

5. Long Straddle - A long straddle consists of one long call and one long put. It is a neutral  strategy and aims to make a profit from major price change on either side. The maximum  profit is unlimited. The maximum loss is limited to the total premium paid. There are two  breaks even points in this strategy. Break Even point(s) = Stock price +/- Total premium. For  Ex Stock Price = 100, Buy 100 CE @ Rs. 5, Buy 100 PE @ Rs. 5. Maximum loss = 5+5 = 10.  Break Even Points = 100 +/- 10 = 90 and 110.

6. Long Strangle - A short straddle consists of one short call and one short put. It is a neutral strategy and aims to make a profit from little or no price change in the underlying stock. The maximum profit is limited to the total premium received. The maximum loss is unlimited.  There are two breaks even points in this strategy. Break Even point(s) = Stock price +/- Total  premium. For Ex Stock Price = 100, Sell 100 CE @ Rs. 5, Sell 100 PE @ Rs. 5. Maximum Profit  = 5+5 = 10. Break Even Points = 100 +/- 10 = 90 and 110.

7. Long Call Butterfly - A long butterfly spread with calls is a three-part strategy that is created  by buying one call at a lower strike price, selling two calls with a higher strike price and  buying one call with an even higher strike price. The differences between the strike prices  are equal. It is a neutral strategy. The maximum profit = Difference between strike prices - Total Premium Paid. The Maximum Loss = Total Premium Paid. There are two breakeven  points. Break Even Point 1 = Highest strike price – Total Premium Paid. Break Even Point 2 =

Lowest Strike Price + Total Premium Paid. For Ex. Buy 15100 CE @ 100, Sell * 2 15200 CE @  65 Buy 15300 CE @ 40. Total Premium Paid = 100 – 65*2 +40 = 10. Maximum Profit = 15200  – 15100 -10 = 90. Maximum Loss = Rs 10. Break Even Point 1 = 15300 – 10 = 15290. Break  Even Point 2 = 15100 + 10 = 15010.