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A derivative is a financial instrument that derives or gets it value from some real good or stock (underlying asset). It is in its most basic form
simply a contract between two parties to exchange value based on the action of a real good or service. Common examples of underlying assets
are stocks, bonds, corn, pork, wheat, rainfall, etc.
When one enters into a derivative product arrangement, the medium and rate of repayment are specified in detail. For instance, repayment
may be in currency, securities or a physical commodity such as gold or silver. Similarly, the amount of repayment may be tied to movement of
interest rates, stock indexes or foreign currency.
Application of Financial Derivatives
Risk Management
Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for
limiting risks that individuals and organizations face in the ordinary conduct of their businesses. Successful risk management with derivatives
requires a thorough understanding of the principles that govern the pricing of financial derivatives. Used correctly, derivatives can save costs
and increase returns.
Trading Efficiency
Derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Traders can use a position in one or
more financial derivatives as a substitute for a position in the underlying instruments. In many instances traders find financial derivatives to be a
more attractive instrument than the underlying security. Reason being, the greater amount of liquidity in the market offered by the financial
derivatives and lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying
instrument.
Speculation
Serving as a speculative tool is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are
considered to be risky. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to properly
calculated and well understood risks in pursuit of a reward i.e. profit.
Forward Contract
Future Contract
Standardized
contract
terms
viz.
the
quality,
Cash Settled
Traded through an organized exchange and
thus have greater liquidity. Existence of a
regulatory authority & the clearinghouse,
being the counter party to both sides of a
transaction, provides a mechanism that
For example, if the Index level is 4500, rate of interest (financing cost is 12%), the dividend yield is 4% and the futures contract is for a period of
4 months, the carrying cost in terms of basic points is:
Carrying cost = 4500 (12% 4%) X 4/12 = 120 basis points.
The value of the futures contract is 4500 + 120 = 4620 points for a period of 4 months.
Swaps
A swap can be defined as a barter or exchange. A swap is a contract whereby parties agree to exchange obligations that each of them have
under their respective underlying contracts or we can say a swap is an agreement between two or more parties to exchange sequences of cash
flows over a period in the future. The parties that agree to the swap are known as counter parties. There are two basic kinds of swaps - 1)
Interest rate swaps and 2) Currency swaps.
An interest rate swap contract involves an exchange of cash flows related to interest payments, or receipts, on a notional amount of principal,
that is never exchanged, in one currency over a period of time. Settlements are often made through net cash payments by one counterparty to
the other.
Currency swap/Foreign exchange swap contracts involve a spot sale/purchase of currencies and a simultaneous commitment to a forward
purchase/sale of the same currencies.
Option Contracts
The literal meaning of the word option is choice or we can say an alternative for choice. In derivatives market also, the idea remains the
same. An option contract gives the buyer of the option a right (but not the obligation) to buy / sell the underlying asset at a specified price on or
before a specified future date. As compared to forwards and futures, the option holder is not under an obligation to exercise the right. Another
distinguishing feature is that, while it does not cost anything to enter into a forward contract or a futures contract, an investor must pay to the
option writer to purchase an option contract. The amount paid by the buyer of the option to the seller of the option is referred to as the premium.
For this reward i.e. the option premium, the option seller is under an obligation to sell / buy the underlying asset at the specified price whenever
the buyer of the option chooses to exercise the right.
Option contracts having simple standard features are usually called plain vanilla contracts. Contracts having non-standard features are also
available that have been created by financial engineers. These are called exotic derivative contracts. These are generally not traded on
exchanges and are structured between parties on their own. The final difference between exotic options and regular options has to do with how
they trade. Regular options consist of calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange.
Exotic options are mainly traded over the counter, which means they are not listed on a formal exchange, and the terms of the options are
generally negotiated by brokers/dealers and are not normally standardized as they are with regular options.
Moneyness of an Option:
Options can also be characterised in terms of their moneyness.
I.
An in-the-money option is one that would lead to a positive cash flow to the buyer of the option if the buyer of the option exercises the option at the
current market price.
II.
An at-the-money option is one that would lead to a zero cash flow to the buyer of the option if the buyer of the option exercises the option at the current
market price.
III.
An out-of-the-money option is one that would lead to a negative cash flow to the buyer of the option if the buyer of the option exercises the option at
the current market price.
Call Optioni
Put Optioni
In-the-money
M>E
M<E
At-the-money
M=E
M=E
Out-of-the-money
M<E
M>E
Where M is the prevalent market price for the option contract, and E is the exercise price of the option contract. For a seller / writer of the option the >, < signs
will reverse.
American Option : An american option can be exercised at any time upto the expiration date. Most of the option contracts traded on
exchanges are of the type of american option.
European Option: A European option can be exercised only on the expiration date itself.
Strike Pricei or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at
which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.
Option Premiumi - Premium is the price paid by the buyer to the seller to acquire the right to buy or sell.
Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it
expires worthless.
Exercise Date is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration
date while in case of American Options, the options contract may be exercised any day between the purchase of the contract & its expiration
date (see European/ American Option)
Open Interest - The total number of options contracts outstanding in the market at any given point of time.
Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a
specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option
writer.
Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case
the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is
unlimited.
Option Class: All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all
Sensex Put Options
Option Series: An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600
is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.
Underlying: The specific security / asset on which an options contract is based.
Contract multiplier : The contract multiplier for Sensex Futures is 50 and for Sensex Options is 100. This means that the Rupee value of a
Sensex futures contract would be 50 times the contracted value and in case of Sensex Options, the rupee value would be 100 times the
contracted value. The following table gives a few examples of this notional value.
Ticket Size : The tick size is "0.1" for Sensex Futures. This means that the minimum price fluctuation in the value of a future can be only 0.1.
In Rupee terms, this translates to minimum price fluctuation of Rs. 5 (Tick size X Contract Multiplier = 0.1 X Rs. 50). Likewise, the tick size is
0.05 for Nifty Futures.Margin in F&O trading
Margin in F&O trading
Customer
margin
Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to
ensure fulfillment of contract obligations. Margins are determined on the basis of market risk and contract value also referred to as performance
bond
margin.
For example lets say there are three parties X (Buyer i), Y (Selleri) and Z (Broker), X is interested in buying a futures contract for Rs 100 as he
thinks its price would go up by the settlement date, Y, on the other hand, wants to sell the futures contract for Rs 100 as he thinks its price will
go down by the settlement date. And Z is the broker who will be executing the deal on behalf of investors X & Y.
Since, derivative trading is about taking a call on the upward and downward movement of the price of an underlying and not the absolute or
actual price of the total contract, the Stock Exchange has to be hedged by investors (X & Y) to the extent of the expected margin of loss that
the
investor
might
incur
with
broker
(Z)
acting
as
a
mediator
between
investors
and
exchange.
For example in the case illustrated, where the cost of futures is Rs 100, in all likelihood its value would go up or down by say Rs 10 either way
by the settlement date based on expected volatility which is calculated mathematically. Hence the margin money sought by the Exchange
through the broker from either party would be 10% of the total value (Rs.10 in the given example).
Now lets say by the settlement date, the scrip would be valued at Rs. 108. This means X would have made a profit of Rs 8 while Y would
have incurred a loss of Rs. 8. The broker hence credits the investor Xs account by Rs 8 along with the margin money of Rs 10. Hence in total
X receives Rs 18. On the other hand Y who has incurred a loss will debit Rs. 8 from his margin money which was with the broker and the
remaining
Rs.
2
will
be
transferred
to
the
investors
account.
Therefore the funding that goes to the broker to execute derivative deals is called Margin Funding or Margin Money.
Types of Margins levied in the Futures & Options (F&O) trading
Margins on both Futures and Options contracts comprise of the following: 1) Initial Margin & 2) Exposure margin. In addition to these margins,
in respect of options contracts the following additional margins are collected 1) Premium Margin & 2) Assignment Margin.
Initial margin
The futures/option contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary
and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash which is called
margin. Initial margin for each contract is set by the Exchange. Exchange has the right to vary initial margins at its discretion, either for the
whole market or for individual members
The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin
is deposited before the opening of the day of the Futures transaction.
Initial margin for F&O segment is calculated on a portfolio (a collection of futures and option positions) based approach. The margin calculation
is carried out using a software called SPAN (Standard Portfolio i Analysis of Risk). It is a product developed by Chicago Mercantile Exchange
(CME) and is extensively used by leading stock exchanges of the world. SPAN uses scenario based approach to arrive at margins. Value of
futures and options positions depend on, among others, price of the security in the cash market and volatility of the security in cash market. It is
agreed that both price and volatility keep changing.
To put it simply, SPAN generates about 16 different scenarios by assuming different values to the price and volatility. For each of these
scenarios, possible loss that the portfolio would suffer is calculated. The initial margin required to be paid by the investor would be equal to the
highest loss the portfolio would suffer in any of the scenarios considered. The margin is monitored and collected at the time of placing the buy /
sell order.
The SPAN margins are revised 6 times in a day - once at the beginning of the day, 4 times during market hours and finally at the end of the day.
Obviously,
higher
the
volatility,
higher
the
margins.
Exposure margin
In addition to initial margin, exposure margin is also collected. Exposure margins in respect of index futures and index option sell positions is 3% of the
notional value. For futures on individual securities and sell positions in options on individual securities, the exposure margin is higher of 5% or 1.5 standard
deviation of the LN returns of the security (in the underlying cash market) over the last 6 months period and is applied on the notional value of position.
Premium and Assignment margins
The premium margin is an amount arrived by multiplication of value of option premium with that of option quantity and is charged to buyers of
option contracts. For example, if 1000 call options on ABC Ltd are purchased at Rs. 20/-, and the investor has no other positions, then the
premium margin is Rs. 20,000. The margin is to be paid at the time trade. Assignment Margin is collected on assignment from the sellers of the
contracts.
Others
Variation margin
Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled
daily also (variation margin). The exchange will draw money out of one party's margin account and put it into the others so that each party has
the appropriate daily loss or profit.
Mark-to-market (MTM)
If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This
process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot
value (since any gain or loss has already been previously settled by marking to market).
Additional Margin
In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the
exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move
by
exchange
to
prevent
breakdown.
Clearingi margin
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options
contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required
to
deposit
with
brokers.
Maintenance margin
A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.
Option
Strategies:
Single
Options
Long Call:
The long call option strategy is the most basic option trading strategy whereby the options trader buy call options with the belief that the price of
the underlying security will rise significantly beyond the strike price before the option expiration date. Compared to buying the underlying shares
outright, the call option buyer is able to gain leverage since the lower priced calls appreciate in value faster percentage wise for every point rise
in the price of the underlying stock.
However, call options have a limited lifespan. If the underlying stock price does not move above the strike price before the option expiration
date, the call option will expire worthless.
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Premium Paid
Max Loss = Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Call.
Breakeven Point = Strike Price of Long Call + Premium Paid
Summary:
Long Call
Anticipations
Characteristics
Max profit -
Unlimited.
Max loss
Breakeven
Summary:
Characteristics
Max profit -
Max loss
Unlimited.
Breakeven
Long Put:
The long put option strategy is a basic strategy in options trading where the investor buy put options with the belief that the price of the
underlying security will go significantly below the striking price before the expiration date.
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying = 0
Profit = Strike Price of Long Put - Premium Paid
Max Loss = Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long Put.
Breakeven Point = Strike Price of Long Put - Premium Paid
Summary:
Long Put
A strong, downward move in the underlying asset is
Anticipations
anticipated.
Characteristics
Max profit -
Unlimited.
Max loss
Breakeven
Short Put:
Short Put is sometimes known as a Put Write, Naked Put, Write Put, or Uncovered Put Write.
Maximum Gain: Limited to the premium received for selling the put option.
Maximum Loss: Unlimited in a falling market.
Breakeven = Strike Price - premium value of put options sold.
Summary:
Short Put
Anticipations
Characteristics
Max profit -
Summary:
Bull Call Spread ( Bull Debit Spread )
An upward move in the underlying asset, but the
Anticipations
extent of the move is uncertain.
Characteristics
Limited profit / limited loss.
Difference between the strike prices less net debit of
Max profit spread.
Strike Price of Short Call - Strike Price of Long Call Max profit formula Net Premium Paid - Commissions Paid
Limited to the net debit required to establish the
Max loss
position.
Max loss formula Net Premium Paid + Commissions Paid
Breakeven
Strike Price of Long Call + Net Premium Paid
Summary:
Bull Put Spread ( Bull Credit Spread )
An upward move in the underlying asset, but the
Anticipations
extent of the move is uncertain.
Characteristics
Limited profit / limited loss.
Max profit Limited to the net credit received
Max profit formula Net Premium Received - Commissions Paid
difference between the strike prices less net credit
Max loss
received
Strike Price of Short Put - Strike Price of Long Put
Max loss formula Net Premium Received + Commissions Paid
Breakeven
Strike Price of Short Put - Net Premium Received
It is achieved by selling call options at a specific strike price while also buying the same number of calls, but at a higher strike price. A type of
options strategy used when a decline in the price of the underlying asset is expected.
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying <= Strike Price of Short Call
Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received + Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long Call
Breakeven Point = Strike Price of Short Call + Net Premium Received
Summary:
Bear Credit Spread ( Bear Call Spread )
A downward move in the underlying asset, but the
Anticipations
extent of the move is uncertain.
Characteristics
Limited profit / limited loss.
Max profit Limited to the net credit received.
Max profit formula Net Premium Received - Commissions Paid
Difference between the strike prices less net credit
Max loss
received.
Strike Price of Long Call - Strike Price of Short Call Max loss formula Net Premium Received + Commissions Paid
Breakeven
Strike Price of Short Call + Net Premium Received
Straddles:
Long straddle:
A strategy of trading options whereby the trader will purchase a long call and a long put with the same underlying asset, expiration date and
strike price. The strike price will usually be at the money or near the current market price of the underlying security. The strategy is a bet on
increased volatility in the future as profits from this strategy are maximized if the underlying security moves up or down from present
levels. Should the underylying security's price fail to move or move only a small amount, the options will be worthless at expiration.
Maximum Profit: Unlimited
Maximum Loss: Premiums paid
Breakeven: This strategy breaks even if, at expiration, the stock price is either above or below the strike price by the amount of premium paid. At
either of those levels, one option's intrinsic value will equal the premium paid for both options while the other option will be expiring worthless.
Upside breakeven = strike + premiums received
Downside breakeven = strike - premiums received
Summary:
Anticipations
Characteristics
Max profit
Max profit formula
Max loss
Max loss formula
Breakeven
Short straddle:
An options strategy carried out by holding a short position in both a call and a put that have the same strike price and expiration date. The
maximum profit is the amount of premium collected by writing the options.
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net
Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium
Received + Commissions Paid
Breakeven Point(s): There are 2 break-even points for the short straddle position. The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Summary:
Anticipations
Characteristics
Max profit -
Long strangle:
The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in options trading that involve the simultaneous buying
of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date. The long options
strangle is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience
significant volatility in the near term.
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying < Strike Price of Long Put - Net
Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid
Max Loss = Net Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put.
Breakeven Point(s): There are 2 break-even points for the long strangle position. The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Summary:
Long Strangle ( Strangle Purchase )
A very volatile, immediate, and sharp swing in the
price of the underlying asset is expected. The actual
market direction is uncertain, so the positions of this
strategy will benefit if the underlying asset either rises
or falls, direction is uncertain, so the positions of this
strategy will benefit if the underlying asset either rises
Anticipations
or falls.
Characteristics
Unlimited profit / limited loss.
Max profit Unlimited.
Price of Underlying - Strike Price of Long Call - Net
Premium Paid OR Strike Price of Long Put - Price of
Max profit formula Underlying - Net Premium Paid
Limited to the net debit required to establish the
Max loss
position
Max loss formula Net Premium Paid + Commissions Paid
Upper Breakeven Point = Strike Price of Long Call +
Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put Breakeven
Net Premium Paid
Short strangle:
The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-ofthe-money put and a slightly out-of-the-money call of the same underlying stock and expiration date. The short strangle option strategy is a
limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little
volatility in the near term.
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying is in between the Strike Price of the Short Call and the Strike Price of the Short Put
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net
Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium
Received + Commissions Paid
Breakeven Point(s): There are 2 break-even points for the short strangle position. The breakeven points can be calculated using the following formulae.
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Summary:
Anticipations
Characteristics