Specialization Project On

“A STUDY OF FINANCIAL DERIVATIVES”

(FUTURE, FORWARDS & OPTION)

Submitted in partial fulfilment for the award of the degree of

Master of Management Studies (MMS)

(Under University of Mumbai)

Submitted By

ALLAKONDA PRASAD BABU RAJAMANI

(Roll No: F/402)

Under the Guidance of

Dr. Sucheta Pawar

2017-2019

Parle Tilak Vidyalaya Association’s Institute of Management

Chitrakar Ketkar Marg, Vile Parle (East),

Mumbai-400057

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 CERTIFICATE

I, Dr, SUCHETA PAWAR hereby certify that Mr. PRASAD BABU ALLAKONDA MMS
student of Parle Tilak Vidyalaya Association’s Institute of Management has completed
specialization project titled “A STUDY ON FINANCIAL DERIVATIVES (FUTURE,
FORWARDS & OPTION)” in the academic year 2018-19. The work of the student is
original, and the information included in the project is true to the best of my knowledge.

Dr. Sucheta Pawar Dr. Harish Kumar S. Purohit

Faculty Guide Director

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 DECLARATION

I, Mr. PRASAD BABU ALLAKONDA MMS Student of Parle Tilak Vidyalaya

Association’s Institute of Management, hereby declare that I have completed the project
titled “A STUDY ON FINANCIAL DERIVATIVES (FUTURE, FORWARDS &
OPTION)” during the Academic Year 2018-2019.

The report work is original, and the information/data and the references included in the report
are true to the best of my knowledge. Due credit is extended on the work of Literature by
endorsing it in the Bibliography as per the prescribed format.

Prasad Babu Allakonda

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 ACKNOWLEDGEMENT

I am extremely grateful to Dr. Harish Kumar S. Purohit, Director of Parle Tilak

Vidyalaya Association’s Institute of Management, Vile Parle for his invaluable help and
guidance throughout my work. He kindly evinced keen interest and kind guidance has
enriched my work and furnished some useful comments, which could enrich the work
substantially.

I am thanking full to my internal guide Dr. Sucheta Pawar, Associate Professor of Parle
Tilak Vidyalaya Association’s Institute of Management, Vile Parle for his keen guidance
and support to work upon as a fully fledge project and guiding me at each step, interacting
with her gave me a completely different view to look at a subject, throughout its completion.

In fact, it is very difficult to acknowledge all the names and their nature of help and
encourage in this project provided by them. I would however like to thank all for their
support and encouragement extended directly or indirectly to me by all.

Sincerely,

Prasad Babu Allakonda

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 INDEX

Sr. No Particulars Page No.

1 Title Page 1

2 Institution Certificate 2

3 Declaration 3

4 Acknowledgement 4

5 Table of Contents 5

6 List of tables & Figures 6

7 Executive Summary 7

8 Introduction 8

9 Overview of Stock Market 9 - 12

10 Objectives & Need for the Study 13

11 Literature Review 14 – 15

12 Research Methodology 16

13 Scope of the Study 17

14 Analysis & Findings 18 – 43

15 Recommendations & Suggestions 44

16 Conclusion 45

17 Bibliography, Reference & Websites 46

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 LIST OF TABLES & FIGURES

Table No. Description Page No.

7.6 Long Position 23

7.6 Short Position 24

7.8 Payoff Long Future and P&L on Expiry (Graph Chart 1) 25

7.8 Payoff Short Future and P&L on Expiry (Graph Chart 2) 26

7.9 Payoff Long Call Options 27

7.9 Payoff Short Call Options 28

7.9 Payoff Long Put Options 29

7.9 Payoff Short Put Options 30

7.10 Bullish Vertical Spreads Call Option 31 - 32

7.10 Bullish Vertical Spreads Put Option 32 – 33

7.10 Bearish Vertical Spreads Call Options 33 - 34

7.10 Bearish Vertical Spreads Put Options 34 – 35

7.10 Long Straddle Options 35

7.10 Short Straddle Options 37

7.10 Long Strangle Options 38 - 39

7.10 Short Strangle Options 39

7.10 Covered Call Options 40

7.10 Protective Put Options 41

7.10 Coller Position Options 42

7.10 Butterfly Spreads Options 43

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 EXECUTIVE SUMMARY
“Derivatives are financial contracts whose value is derived from some underlying
asset”. These assets can include equities, bonds, exchange rates, commodities, residential and
commercial mortgages. The more common forms of these contracts include options,
forward/futures and swaps. A considerable portion of financial innovation over the last 30
years has come from the emergence if derivatives markets.

Generally, the benefits of derivatives fall into the areas of (i) Hedging and Risk
Management, (ii) Price Discovery and (iii) Enhancement of liquidity. Even in the current
financial crisis, the derivatives scapegoat, credit default swaps (CDs), had played some
positive roles.

For E.g. CDs enabled lenders to hedge their risk and offer loans. When the securitization
market for loans, bonds and mortgages shutdown in the summer of 2007, a number of
financial institutions were left holding large loan portfolios. Using the CDs market, some of
these financial institutions smartly hedged out their risk exposure.

In addition, CDs and other credit derivatives have played a very important role in
disseminating information to both the public and to regulators: from judging the quality of
financial firm’s bankruptcy prospects in a remarkably prescient way, from proving credit risk
estimates that were central to UK government bailout plan, and from revealing in early 2007
declines in values of subprime backed assets.

Risk is the unsaid factor that is a part and parcel of any financial activity. We have been
learning since childhood that good returns is the reward for any risk. In the financial world,
the biggest risk is losing all money and gain can be earning tremendous return. This feature
can be seen in the capital market, especially the derivatives market. This magical move
requires a deep knowledge of markets also the fundamental and technical analytical skills
need to be strong.

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 CHAPTER 1. INTRODUCTION
In this fast-growing world, we can see there are so many competitions among Countries,
States, Industries, etc. from Macro level to Micro level. This competition resulted into
comparison in terms of growth, development, earning, success in their respective profession
etc. Everything in this world we see that they are tried to measure in monetary terms which
lead to efforts in those activities which provided more monetary value to an individual.
Gradually over the years it was found that the person who has more monetary stability, holds
a greater position. This resulted into a race of earning more and more money, so as to
established their dominant position in this competitive world.

In olden days kings used to be considered supreme and all nation activities used to be under
king’s guidance and for performing these tasks the king used to give money. Then people
came with their own business at small level, then the family business was started (HUF) for
further more expansion 2 or more partners came together to form a firm after all this when
the need was felt that the business should be started at a bigger level but the finds were
adequate the concept of the company began where the funds were welcomed from general
public and in return they were given share certificate and return in terms of profit.

Traditionally it was believed that if money is put into share market then it will surely get
exhausted but later people are started getting knowledge and developed an interest into it and
also the regulatory body like SEBI (Securities Exchange Board of India) regulated the
transactions through BSE (Bombay Stock Exchange) and NSE (National Stock Exchange)
which help the boost the confidence among the people into these markets. The people started
trading into Cash, Currencies, Derivatives and Commodities which gave better returns when
compared to other investments. In this market the one having a greater risk and greater
returns is Derivatives.

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 CHAPTER 2. OVERVIEW OF STOCK MARKET

Indian stock markets have shown very rapid changes in last 4 to 5 years. According to
various sources there are over 5000 companies are listed on BSE and for NSE there are
1500+ companies running on the scroll. Each company may have multiple securities listed on
an exchange. The market capitalization of all listed stocks now exceeds $ 2.1 trillion which
ranks Seventh position in league table of the World’s biggest stock markets. Total turnover
or the value of all sales and purchases on the BSE & NSE till date i.e. in January month of
2019 it was $ 20 million.

As large number of indices are also available to fund managers. The two leading stock
markets indices are NSE 50 shares (Nifty) index and BSE 30 shares (SENSEX) index. There
are index funds that invests in the securities that form part of one or the other index. Besides,
in the derivatives market, the fund managers can buy or sell futures contracts or options
contracts on these indices. Both BSE & NSE also have others sectoral indices that track the
stocks of companies in specific industry group such as FMCG, IT, Finance, Petrochemical
and Pharmaceutical while, the SENSEX and NIFTY indices track large capitalization stocks.
Although, BSE & NSE also have mid-cap indices tracking company shares. The number of
industries or sectors represented in various indices or in the listed category exceeds 50. BSE
has 140 scrips in its specified group A list, which are basically large capitalization stocks,
group B1 list includes over 1100 stocks, many of which are mid-cap companies. The rest of
B2 group includes over 4500 shares, largely low-capitalization.

2.1 National Stock Exchange (NSE)

The National Stock Exchange of India Ltd. (NSE) is the leading stock exchange in India and
the second largest in the world by Numbers of traders in equity shares from January to June
2018, according to World Federation of Exchange (WFE) report.

NSE launched electronic screen-based trading in 1994, derivatives trading (in the form of
index futures) and internet trading in 2000, which were each the first of its kind in India.

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NSE has a fully integrated business model comprising our exchange listings, trading services,
clearing & settlement services, indices, market data feeds, technology solutions and financial
education offerings. NSE also overseas compliance by trading and clearing members and
listed companies with the rules and regulations of the exchange.

2.2 NSE NIFTY 50

The NIFTY 50 is a diversified 50 stock index accounting for 12 sectors of the economy. It is
used for a variety of purpose such as benchmarking fund portfolio’s, index-based derivatives
and index funds.

NIFTY 50 is owned and managed by NSE Indices Limited. NSE Indices is India’s
specialised company focused upon the index as a core product.
 The NIFTY 50 Index represents about 62.9% of the free float market capitalization of
the stocks listed on NSE as on 31st March, 2017.
 The total traded of NIFTY 50 Index constituents for the last six months ending March
2017 is approximately 43.8% of the traded value of all stocks on the NSE.
 Impact cost of the NIFTY 50 for a portfolio size of Rs. 50 lakhs are 0.02% for the
month March 2017.
 NIFTY 50 is ideal for derivatives trading.

2.3 NSE MIDCAP INDEX

Its primary object is to capture the movement of the midcap segment of the market. It
includes top 50 companies based in full market capitalization from Midcap 150 index and on
which derivative contracts are available on National Stock Exchange (NSE). In case such
stocks do not have derivatives contract available on them it could have less than 50 stocks in
the index.
 It represents about 5.8% of the free float market capitalization of the stocks listed on
NSE as on 31st March, 2017.
 The total traded value for the last six months ending March 2017, of all index
constituents is approximately 13% of the traded value of all stocks on NSE.
 This index was computed using market capitalization weighted method from the
launch date till 25th February, 2010.

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2.4 Bombay Stock Exchange (BSE)
Established in 1875, BSE (Formerly known as Bombay Stock Exchange Ltd), is Asia’s first
& the Fastest Growing Stock Exchange in world with the speed of 6 micro seconds and one
of India’s leading exchange groups. Over the past 143 years, BSE has facilitated the growth
of the Indian Corporate Sector by providing it an efficient capital raising platform. Popularly
known as BSE, the bourse was established as ‘The Native Share & Stock Brokers’
Association in 1875. In 2017 BSE become the 1st listed stock exchange of India.

Today BSE provides an efficient and transparent market for trading in Equity, Currencies,
Debt instruments, Derivatives, Mutual funds. BSE SME is India’s largest SME platform
which has listed over 250 companies and continues to grow at a steady pace. BSE STAR MF
is India’s largest online mutual fund platform which process over 27 lakhs transactions per
month and adds almost 2 lakhs new SIP’s every month. BSE Bond, the transparent and
efficient electronic book mechanism process for private placement of debt securities, is the
market leader with more than Rs. 2.09 lakhs crore of fund raising from 530 issuances
(FY 2017-18).

2.5 BSE SENSEX

BSE’s popular equity index – the S&P BSE Sensex is India’s most widely tracked stock
market benchmark index. It is traded internationally on the EUREX as well as leading
exchanges of the BRCS nations (Brazil, Russia, China and South Africa). It is a “Market
Capitalization Weighted” index of 30 components stocks representing a sample of large, well
established and leading companies. The base year of Sensex is 1978-79.

As per market capitalization methodology, the level of index reflects the total market value of
all 30 components stocks from industries related to particular base period. The total value of a
company is determined by multiplying the price of its stocks by the number of shares
outstanding. It is much easier to graph a chart base on indexed values then one based on
actual values world over majority of the well-known indices are constructed using “Market
Capitalization Weighted Method”. The divisor is only link to original base period value of the
Sensex.
New base year average = old base year average * (new market value / old market value)

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2.6 OTC Equity Derivatives
 Traditionally equity derivatives have a long history in India in the OTC Market.
 Options of various kinds (called Teji, Mandi & Fatak) in un-organized markets were
traded as early as 1900 in Mumbai.
 The SCRA however banned all kind of options in 1956.

2.7 Product Speculations BSE 30 Sensex Futures

 Contract Size – Rs. 50 times the Index.
 Tick Size – 0.1 points or Rs.5.
 Expiry Date – last Thursday of the month.
 Settlement Basis – cash settled.
 Contract Cycle – 3 months.
 Active Contracts – 3 nearest months.

2.8 Product Specification NSE Nifty Futures

 Contract Size – Rs. 200 times the Index.
 Tick Size – 0.05 points or Rs.10.
 Expiry Date – last Thursday of the month.
 Settlement Basis – cash settled.
 Contract Cycle – 3 months.
 Active Contracts – 3 nearest months.

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 CHAPTER 3. OBJECTIVES & NEEDS OF THE STUDY
3.1 Objectives:

 To study the role of derivatives in Indian Financial Market.

 To understand what are Futures, Forwards & Options in derivatives.

 To understand how does the market participants work in derivative market.

3.2 Needs for the Study:

Different investment avenues are available to investors. Stock market also offers good
investment opportunities to the investors and they also carry certain risk which is associated
with. The investors should compare the risk and expected yields after adjustment off tax on
various instruments while taking investment decisions. The investor may seek advice from
experts and consultancy include stock brokers and analysts while making investment
decisions. The objective here is to make the investor aware of the functioning of the
derivatives.

 Derivative act as a risk hedging tool for the investors. The objective is to help the
investor in selecting the appropriate derivates instrument to attain maximum risk and
to construct the portfolio in such a manner to meet the investor should decide how
best in reach the goals from the securities available.
 To identify investor objective constraints and performance, which help formulate the
investment policy?
 To develop and improvement of strategies within investment policy are formulated.
They will help the selection of asset classes and securities in each class depending up
on their risk return attributers.

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 CHAPTER 4. LITERATURE REVIEW

 Bartram e.t.a.l (2003), The purpose of the paper was to find the countries where the
use of financial derivatives is made, for this purpose the data from 48 countries was
taken including United States. They also tried to find If the firm value has an impact
on the derivatives use. In the study it was found that the use of derivatives was made
by almost all countries however the weightage given by different countries to the
different derivatives options were varying. In these countries most of the firm invests
in derivatives in general then followed by currency derivatives then interest rate
derivatives and at least interest was shown in commodity price derivatives. It was also
found that the firms having higher firm value were mostly attracted towards trading in
derivatives.

 Danijela Milos (2007), This research paper analyses which type of derivatives are in
more demand in Croatian and Slovenian Non-Financial Companies. It tries to find
how risk management is done in these companies using derivatives. It was found that
the trading in Forward contracts and Swap contracts are much more than the other
derivative contracts. The futures are more evidently used in Slovenian company and
this company makes use of all types of derivatives when compared to Croatian
company. It shows that Slovenian company can manage their risks more efficiently.

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 Yalavatti, Prakash (2015), Conducted research on “A Study of Strategic Growth in
Indian Financial Derivatives Market”. as per him past two eras have been observed
that there is multiple growth in international trade and businesses due to adaption of
LPG factor all over the world. As a result, in the demand for international money and
financial tools has increased at global level. Due to this our exchange rate, stock
prices and interest rates of different financial markets have increased the financial risk
to the corporates and investors too internationally. Therefore, in order to manage the
risk, the fresh instruments have been developed in the financial markets, which we
popularly known as financial derivatives at national and global financial market.

 Bhatt, Dr. Babaraju (2014), This research analysed that about the perception of
investors towards derivatives as an investment avenue. As we know the derivative are
risk management tool that support in effective management of risk by various
stakeholders. Derivative market provides a chance of transfer risk, which means one
avoid and one wish to agree it. India experiences a very huge success and encourage
in equity derivatives. However, the derivative turnover on the NSE has surpassed the
equity market turnover.

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 CHAPTER 5. RESEARCH METHODOLOGY
Research Methodology is a systematic procedure of collecting information in order to analyse
and verify a phenomenon, the collection of information is done in two principle sources.
They are follows:

Secondary Data:
For the purpose of the study, use of secondary data has been made. In this process the
information is being collected from the authentic sites which helped in getting correct
information.
 www.nseindia.com
 Financial newspapers, Economics times.

Books:
 The information is also collected from modules of NISM and other reference books.
 The NSE site is used for the purpose of taking the lie examples, so as to understand
the practical applicability of the derivative contracts.

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 CHAPTER 6. SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to futures and options in the
Indian context; the study is not based on the international perspective of derivative market.

The study is limited to analysis made for the types of instruments of derivatives each strategy
is analysed according to its risk and return characteristics and derivatives performance against
the profit and policies of the company.

The present study on futures and options is very much appreciable on the grounds that it
gives deep insights about the F&O market. It would be essential for the perfect way of
trading in F&O. An investor can choose the fight underlying or portfolio for investment
which is risk free. The study would explain the various ways to minimize the losses and
maximize the profits. The study would help the investors how their profit/loss is reckoned.
The study would assist in understanding of F&O segments. The study assists in knowing the
different factors that cause for the fluctuations in the F&O market. The study provides
information related to the byelaws of F&O trading. The studies elucidate the role of F&O in
India Financial Markets.

6.1 Derivative Markets Today:

 The prohibition on options in SCRA was removed in 1995. Foreign currency options
in currency pairs other than Rupee were the first options permitted by RBI.
 The RBI has permitted Options, Interest Rate Swaps, Currency Swaps and other risk
reductions OTC derivatives products.
 Besides the Forward Market in currencies has been a vibrant market in India for
several decades.
 In addition, the Forward Markets Commission has allowed the setting up of
commodities futures exchanges. Today we have 18 commodities exchange most of
which trade futures.
e.g. The Indian Peppers and Spice Traders Association (IPSTA) and the Coffee
Owners Futures Exchange of India (COFEI).
 In 2000 an amendment to the SCRA expanded the definition of securities to included
Derivatives thereby enabling stock exchanges to trade derivatives products.
 The year 2000 will herald the instruction of exchange traded equity derivatives in
India for the first time.

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 CHAPTER 7. ANALYSIS & FINDINGS
A Derivative is a financial instrument that derives its value from an underlying asset. It is a
financial contract whose price/value is dependent upon price of one or more basic underlying
asset, these contracts are legally binding agreements made on trading screens of stock
exchange to buy or sell an asset in the future. The most commonly used derivatives contracts
are Forwards and Options.

The main objective of this study is to analyse the derivative market in India and to analyse
the operations of Futures and Options. Derivative market is an innovation to cash market,
approximately its daily turnover reaches to the equal stage pf cash market. However, in cash
market the profit/loss of the investor depend on the market price of the underlying asset.
Derivatives mostly used for hedging purpose. For e.g. In bullish market the call option writer
incurs more losses so the investor is suggested to go for a call option to hold, where as the put
option holder suffers in a bullish market, so he is suggested to write a put option. In bearish
market the call option holder will incur more losses so the investor is suggested to go for a
call option to write, where as the put option writer will get more losses, so he is suggested to
hold a put option.

7.1 Derivatives is derived from the following products:

A. Shares
B. Debentures
C. Mutual Funds
D. Gold
E. Steel
F. Interest Rate
G. Currencies

7.2 Functions of Derivative Market:

 Prices in an organized derivatives market reflect the perception of market participants
about the future and lead the prices of underlying to the perceived future level.
 Derivatives market helps to transfer risks from those who have them but may not like
them to those who have an appetite for them.
 Derivative markets help increase savings and investment in the long run.

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7.3 Types of Derivatives Contracts:
1. Forwards
 A forward contract is nothing but an agreement to sell something at a future
date. The price at which this transaction will take place is decided in the
present. If these contracts have to be reversed before their expiry date,
otherwise it may not be favourable since each party has one and only option
i.e. to deal with the other party.
 Suppose today a contract is entered by the buyer and seller that on next day
the seller will sell a dozen of mangoes for Rs. 300. Then the buyer feels that
the price will go up to Rs. 350 and then the seller feels that the price will go
down to Rs. 250. So, on the contract of day 1-person assumption would be
true in that case the other party can default or reject the contract as there is no
3rd party involved.
 It can be seen that very few people enter into forward contract due to risk of
default.
 Brokerage is given on contract day so broker is not concerned about the
performance of contract.

2. Futures
 A futures contract is very similar to a forward’s contract. It is also mandate to
sale of commodity at a future date but at a price which is decided in the
present. These contracts are standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-
decided sizes and pre-decided expiry date. Due to these contracts are listed on
the exchange, they have to follow a daily settlement procedure needs to be
settled on that very day.
 In futures contract that price of Rs. 300 is decided by exchange.
 Here normally the shares are purchased in lots.
 Futures contract expiry is on month’s last Thursday.

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3. Options
 Options are two types CALL and PUT.
 Calls give the buyer the right but not the obligation to buy a given quantity of
the underlying asset, at a given price on or before a given future date.
 Puts give the buyer the right, but not the obligation to sell a given quantity of
the underlying asset at a given price on or before a given date.
 The purchase is on premium but here premium is same as margin in forwards
and futures.
 The purchase at spot price or at strike price.
 The price above the spot price is ITM (In the Money), the price at spot price is
ATM (At the Money) and if spot price greater than the lower prices are OTM
(Over the Money) for Call option.
 When the market goes up then money is invested into long call and if the
market down then the money is invested into short call.
 If the market goes down then the money is invested into long put and if the
market goes up then the money invested into short put.
 In long call or long put maximum profit is unlimited and when maximum loss
is the amount of premium paid.
 In short call or short put maximum loss is unlimited and when maximum
profit is the amount of premium received.
 Short call or put is made only for the purpose of hedging.

4. Swaps
 A swap is a contract where there is a buy and sell of the financial instruments
between the two parties.
 It was introduced in the market in the year 1981, and the two parties that had
entered into the contract were IBM and World Bank.
 In a swap agreement flow of cash is determined by the parties to the contracts
for their mutual benefit.
 Swaps agreement are an extension to the forwards contracts.
 Swaps agreement help the parties to the contract from price fluctuations of
currencies, commodities and interest rates.
 The two commonly used swaps are Interest rate swaps and Currency swaps.

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7.4 Participants in the Derivatives Market:
On the basis of the motive on which the transaction is entered into the participants are named
as arbitrageurs, hedgers, speculators and margin traders.

 Arbitrageurs – It means when a person takes a benefit of the price differences

between two markets i.e. NSE and BSE. The person buys from market with low price
and sells it to high price markets. The people having more money usually indulge in
such activities. The person including into such activity are arbitrageurs.

 Hedgers – It is usually entered into market in order to protects themselves from price
changes and losses. Here the intension is not to make profit but is to be safe. In
intension is not to make profit but is to be safe. In this way of hedgers try to hedge
themselves by taking the absolute opposite position so that the loss in one would
offset the profit in the other.

 Speculators – These are who predict the market and take their actions accordingly.
Unlike hedgers the motive here is to make profits and for this purpose they take risk.
The risks are passed by the hedgers in order to get a safe position in the market. The
person to whom the risk is passed are the speculators.

 Margin Traders – Many people in the market and they have different ways of
investing into these markets. In this market the people can trade by paying a small
sum of the total amount to be paid it is termed as margin. The people who make use
of this mechanism and trade into the markets as the margin traders.

In a financial derivative are used to manage various risks such as market risk, liquidity risk,
credit risk and operational risk. Derivatives was not used wisely but now as the hedging
concept is been evolved in derivatives it has increased in the derivative transaction across
nations. The derivatives usually help the people to manage the risk by hedging and then get a
good amount of return which was otherwise difficult to achieve.

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7.5 Risk associated with derivatives trading:

1) Market Risk – While making investment, the decision is backed with a proper study
of the market, companies, fundamentals and technical analysis. The market risk is the
normal risk of faced by the investors. However, has a major influence in the
investment decision.

2) Liquidity Risk – This risk arises when the investor has lack of funds in relation to
buying any stock. Sometimes the investors feel that necessity of funds in between the
investment i.e. before the maturity then the liquidity risk arises as sometimes it
becomes difficult to close out the trade before the maturity.

3) Interconnection Risk - There are different derivatives instruments and also there are
many dealers in the market. These dealers have a hold on the derivatives instruments
creating a connection between them. This connection has its own risk is known as
interconnection risk. In this market, if there is any problem with one party then the
whole market gets effected.

4) Counterparty Risk - It is that risk which has raised because of the default made by
the party to the transaction. This type of risk is mostly seen in OTC transaction as the
stock exchange hardly has a control over these activities. This risk can be managed by
trading with those who are trustworthy and it is even better if exchange acts as a
mediator.

5) Credit Risk – It is that risk that every party to the contracts faces due to non-
performances of the party which can lead to loss. The risk raised when a person has
committed or extended or invested into any contract.

6) Operational Risk – It is that risk that which is caused due to inefficient internal
process of any organization. This inefficiency can cause risk that can be direct or
indirect in nature.

7) Legal Risk - Whenever there is any dispute or grievance in the organization that
particu+9+lar organization exposed to legal risk.

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7.6 How are Future contracts used as a tool to hedge risk?

Future contracts are the most widely used contracts to mitigate the risk. A future contract is
an arrangement between the parties to the contract for purchase or sell of an underlying asset
at a particular price on a particular date involving exchange as a mediator for its smooth
functioning. The companies or the corporations prefer to enter into future contract so that
they can manage risk of the price fluctuations in the market. Every investor has an aim that he
should remove the risk however practically it is not possible, maximum it can be reduced.

I. Long Position - When the investor, be it the individual or the company knows that he
is going to buy in future a particular asset then he takes a long position in the future
contract. The investor thus hedges his position and reduces his risk. This can be
explained with following example:

7.6. Table No: 1 Long Position in Future Contracts.

Particulars Amount
Buying Quantity 200 kg apples
Spot Price $5/kg of apples
Future Price $4/kg of apples
Contract Period 6 months

The company who wishes to buy apples will enter into future contract with the seller of
apples to supply him with 200 kg apples at $4/kg after 6 months thus the buyer is safe from
any further rise in the price of the apples thus has reduced the possibility of loss in the
contract. This decision of entering into a contract is made by the buyer because he has
estimated that the prices of the apples after 6 months will be rising on the contrary the seller
of the contract has agreed to enter into the contract because he has predicted that the prices of
his apples is likely to fall after 6 months. Thus, for the same contract the predictions are
different thus there was a contract. That is why it is said that the main indicator of the market
is not the prices but the psychology of the people entering into contract. In this case, at the
time of execution of contract only one party would be gaining because of his correct analysis
of market. In this case, if price will be rising after 6 months then buyer is at profit and if the
prices of the apples fall then the seller is at profit.

23 | P a g e
 II. Short Position - If an individual or a company wants to sell a particular item then he
takes a short position i.e. he sells the underlying asset first and buys it later. Taking
this move in the future contract the person hedges his position. This can be
understood using the below example:

7.6 Table No: 2 Short Position in Futures Contract.

Particulars Amount
Selling Quantity 2000 Kg Mangoes.
Spot Price $7/Kg of Mangoes.
Future Price $5/Kg of Mangoes.
Contract Period 6 Months

The Company ABC has short sold the futures contract. It means Company ABC is predicting
that the price of mangoes will go down, so it has sold at future rate $5/kg of mangoes. In this
contract if the future price will be lower as predicted will benefit Company ABC as the
Company by entering into contract has fixed its price of $5/kg of mangoes, thus hedging the
risk. However, if the prices of mangoes go up then it would be loss for the Company.

7.7 Exiting Before Expiry:

The future contract creates an obligation to both the parties to the contract to perform their
part of contract till the time of settlement. However, the settlement can be done before the
expiry of the term. If the party to the contract feels that exiting the contract would be essential
then the party can exit before expiry. However, this can be done only if the party takes the
opposite position of what he is currently holding i.e. if you are currently buying XYZ then to
close this position you need to sell the XYZ. This is a usual practice for stocks however in
actual if you have purchased 3 contacts from Mr. P then, to close the position 3 contracts are
to be sold to Mr. Q. It is because these positions are offsetting the market position but it is
little complicated.

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7.8 Payoff of buyers in a Future Contract:

I. Long Payoff Futures - Let’s assume that a person A enters into future contract to buy
at $50 i.e. he will be purchasing the underlying asset at $50 on expiry. If on the expiry
the price increases to $90 then, Mr. A will buy at $50 and sell it $90 making a profit
of $40 and if the prices goes down at $10 on expiry then, Mr. A will be purchasing he
underlying asset on expiry at $50 and then in case if he sells the same on expiry in the
cash market at $30 then he will be incurring a loss of $20.

7.8 Table No: 3 Payoff of buyers in a Long Future Contract.

Long futures at $50

Market price at expiry Long futures payoff

$10 -40
$20 -30
$30 -20
$40 -10
$50 0
$60 10
$70 20
$80 30
$90 40

Graph No: 1 The Profit /Loss on Expiry when presented graphically represents payoff chart.

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 II. Short Payoff Futures - In the market the way long position is taken similarly short
position is also taken. If the long position is taken in the market and there is no one
else to take the short position then the transaction cannot take place. The position
taken in the short future is always opposite to that taken in long position.

7.8 Table No: 4 Payoff of buyers in the Short Future Contract.

Short futures at $50

Market price at expiry Long futures payoff

$10 40
$20 30
$30 20
$40 10
$50 0
$60 -10
$70 -20
$80 -30
$90 -40

Let us assume that Mr. B enters into short contract at $50 on the expiry date. In this case, it is
beneficial if the prices go down and if prices go up then there is a loss to that extent. If the
prices have gone to $70 on expiry then Mr. B has incurred a loss of $20 on per underlying
however if the prices have gone down i.e. $10 there is a profit of $40 per underlying.

Graph No: 2 Profit & Loss on expiry when Short Futures Payoff.

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7.9 Payoff Charts for An Option:

There are 2 types of option contract one being Long on option and other is short on option
which is further subdivided into long call and long put, short call and short put respectively.

I. Long Call - Suppose on March 1st, 2019 Nifty is at 9460. Mr. A takes a call option
for buying when the strike price is 9500 when the premium was 105 on expiry. He
buyer has the right but not the obligation to buy. If Nifty is above the strike price then
the option can be exercised as it can lead to profit however if the Nifty one expiry is
below strike price then the option will not be exercised and if both are equal then the
option is exercised. This can be understood with following example:

Strike price: 9500

Premium: 105

7.9 Table No: 5 Payoff for a Long Call Option.

Nifty at Expiry Premium paid Buy Nifty at Sell Nifty at Payoff for Long
Call Position
9300 -105 -9300 9300 -105
9400 -105 -9400 9400 -105
9500 -105 -9500 9500 -105
9600 -105 -9500 9600 -5
9700 -105 -9500 9700 95
9800 -105 -9500 9800 195
9900 -105 -9500 9900 295
10000 -105 -9500 10000 395
10100 -105 -9500 10100 495

If the lot size is 75 then the contract value for the Nifty option is 9500*75=7,12,500 and the
maximum loss for the buyer would be 105*75=7,875.

Here the loss is limited to Rs. 7,875 whereas the profit is unlimited.

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 II. Short Call - If in the market there is an option buyer there has to be an option seller
so as to complete the transaction else the transaction cannot take place. In the short
call option, the loss is unlimited and the maximum profit is the premium received. If
Nifty is above the strike price then the option cannot be exercised as it can lead to loss
however if the Nifty on expiry is below strike price then the option will be exercised
and if both are equal then the option is exercised. This can be understood by following
table:

Strike price: 9500

Premium: 105

7.9 Table No: 6 Payoff for Short Call Option.

Nifty at Expiry Premium paid Buy Nifty at Sell Nifty at Payoff for Short
Call Position
9300 -105 -9300 9300 105

9400 -105 -9400 9400 105

9500 -105 -9500 9500 105
9600 -105 -9500 9600 5
9700 -105 -9500 9700 -95
9800 -105 -9500 9800 -195
9900 -105 -9500 9900 -295
10000 -105 -9500 10000 -395
10100 -105 -9500 10100 -495

Here the profit is limited to the amount of premium received i.e. 105 but the loss can be
unlimited to the extent of the change in the price of the market.

III. Long Put - Suppose on March 1st, 2019 the Nifty is at 9460 and a person has an
option to buy a put option on the expiry date which is 28 th March 2019 at a premium
of Rs. 150. Here if Nifty is above the strike price then the option cannot be exercised
as it can lead to loss however if the Nifty on expiry is below strike price then the
option will be exercised and if both are equal then the option is exercised as it
becomes the break-even point.

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Strike price: 9500

Premium: Rs. 150

7.9 Table No: 7 Payoff for Long Put Option.

Nifty at Expiry Premium paid Buy Nifty at Sell Nifty at Payoff for Long
Put Position
9100 -150 -9100 9500 250
9200 -150 -9200 9500 150
9300 -150 -9300 9500 50
9400 -150 -9400 9500 -50
9500 -150 -9500 9500 -150
9600 -150 -9600 9600 -150
9700 -150 -9700 9700 -150
9800 -150 -9800 9800 -150
9900 -150 -9900 9900 -150
10000 -150 -10000 10000 -150
10100 -150 -10100 10100 -150

From the table it can be seen that the profit is unlimited whereas the loss is limited to the
extent of the premium paid Rs. 160. If there is a favourable condition for the buyer then he
can have any number of gains by entering into contact.

The contract price is 75*9500=7,12,500 and the maximum loss is 160*75=12,000.

III. Short put - This position is same as long call and exactly opposite to that of short call
and long put. If Nifty is above the strike price then the option can be exercised as it
can lead to profit however if the Nifty one expiry is below strike price then the option
will not be exercised and if both are equal then the option is exercised.

Strike price: 9500

Premium: 150

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7.9 Table No: 8 Payoff for Short Put Option.

Nifty at Expiry Premium paid Buy Nifty at Sell Nifty at Payoff for Short
Put Position
9100 -150 -9100 9500 -250
9200 -150 -9200 9500 -150
9300 -150 -9300 9500 -50
9400 -150 -9400 9500 50
9500 -150 -9500 9500 150
9600 -150 -9600 9600 150
9700 -150 -9700 9700 150
9800 -150 -9800 9800 150
9900 -150 -9900 9900 150
10000 -150 -10000 10000 150
10100 -150 -10100 10100 150

The contract value is 75*9500=7,12,000 (lot size is 75) and the loss here is unlimited
however the profit is limited.

7.10 Option Strategies - A Measure of Risk Management?

There are various strategies that investors use so as to protect their money from uncertain
conditions in the market. The strategies thus used while carrying out option transactions are
known as option strategy. There are various option trading strategies, they are as under:

 Option spreads.
 Straddle.
 Strangle.
 Covered call.
 Protective put.
 Collar.
 Butterfly spread.

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(A) Option spreads:

Spreads are the combination of option transactions with different strike price and have
different maturity but are traded for the same underlying asset. This is done so as to limit the
loss but the profit also gets limited. There are three categories in this: Vertical spreads,
Horizontal spreads & Diagonal spreads.

(I) Vertical spreads - These spreads are those who have variety of strike price but has same
expiry. They can be created by using calls or puts or the combination of both. These are of 2
types: (a) Bullish Vertical Spreads- Using calls & Using puts, (b) Bearish Vertical Spreads -
Using calls & Using puts.

(a) Bullish Vertical Spread Using Calls - The market is a bull market when it is expected
that the market will rise but in this case the trader also looks for minimizing the cost. The
trader thus takes one long position at a lower strike and sells at higher strike using a call
option. In this initially the outflow would be more however subsequently it will result in cash
inflow. For e.g. A trader decides to enter in a long call option at a strike of 9200 at a
premium of 350 and the market is expected to not go above 9800, so if short selling is done at
9800 then the premium to be received is 140. The payoffs are as under:

7.10 Table No: 9.1 Bullish Vertical Spread using Calls.

Option Call Call

Long/ Short Long Short
Strike 9200 9800
Premium 350 140
Spot 9500

7.10 Table No: 9.2 Bullish Vertical Spread using Calls.

Current Market Price Long Call Short Call Net Flow

9000 -350 140 -210
9100 -350 140 -210
9200 -350 140 -210
9300 -250 140 -110
9400 -150 140 -10
9500 -50 140 90
9600 50 140 190

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 9700 150 140 290
9800 250 140 390
9900 350 40 390
10000 450 -60 390
10100 550 -160 390
10200 650 -260 390

Here as we can see the maximum profit is limited to 390 and maximum loss is limited to 210
and the breakeven point here is 9410 where the net cash flow is zero.

(b) Bullish Vertical Spread Using Puts - Here the market is bullish and the trader wishes to
take a short put option. If the price rises then the trader will be getting only the premium but
if the prices will reduce then unlimited loss needs to be borne by the trader. So, for this net
premium receipt strategy can be used by taking lower strike price where the premium would
be less and the loss would be reduced. For e.g. when a trader takes short put option at the
strike of 9800 where the premium received would be 400 and takes a long-put position at
strike of 9500 and pays a premium of 230.

7.10 Table No: 10.1 Bullish Vertical Spread using Puts.

Option Put Put

Long/ Short Short Long
Strike 9800 9500
Premium 400 230
Spot 9500

7.10 Table No: 10.2 Bullish Vertical Spread using Puts.

Current Market Price Short Put Long Put Net Flow

9000 -500 270 -230
9100 -400 170 -230
9200 -300 70 -230
9300 -200 -30 -230
9400 -100 -130 -230
9500 0 -230 -230
9600 100 -230 -130

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 9700 200 -230 -30
9800 300 -230 70
9900 400 -230 170
10000 400 -230 170
10100 400 -230 170
10200 400 -230 170

Here we can see that the maximum profit is limited to 170 whereas the unlimited loss is equal
to 230. The breakeven point here is 9730 where there is no profit no loss.

(c) Bearish Vertical Spreads Using Calls - The bearish market is that market where the
prices are expected to fall. The trader shorts a low strike at a high premium. If the prices get
high then there would be unlimited losses so to hedge this position long call is to be bought at
a higher strike where lesser premium is required to be paid. For e.g. A trader takes a short
call at a strike of 9200 where the premium to be received is 140 and subsequently takes a
long call at a strike of 9800 and premium to be paid being 350. The spot rate being 9500.

7.10 Table No: 11.1 Bearish Vertical Spreads using Calls.

Option Call Call

Long/ Short Long Short
Strike 9200 9800
Premium 140 350
Spot 9500

7.10 Table No: 11.2 Bearish Vertical Spreads using Calls.

Current Market Price Long Call Short Call Net Flow

9000 -140 350 210
9100 -140 350 210
9200 -140 350 210
9300 -140 250 110
9400 -140 150 10
9500 -140 50 -90
9600 -140 -50 -190
9700 -140 -150 -290
9800 -140 -250 -390

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 9900 -40 -350 -390
10000 60 -450 -390
10100 160 -550 -390
10200 260 -650 -390
10300 360 -750 -390

Here the maximum loss is 390 and the maximum profit is 210 and the breakeven point is at
9410.

(d) Bearish Vertical Spread Using Puts - Here the trader takes a long-put option for which
premium is required to be paid as he is bearish on market and also for cost reduction he shorts
at a low strike and receives a premium. For e.g. A trader takes a long call at a strike of 9800
for which he is required to pay a premium of 400 and then he takes a short position at a strike
of 9500 where the premium is 230. The spot rate is 9500.

7.10 Table No: 12.1 Bearish Vertical Spread using Puts.

Option Put Put

Long/ Short Long Short
Strike 9800 9500
Premium 400 230
Spot 9500

7.10 Table No: 12.2 Bearish Vertical Spread using Puts.

Current Market Price Short Put Long Put Net Flow

9000 -270 500 230
9100 -170 400 230
9200 -70 300 230
9300 30 200 230
9400 130 100 230
9500 230 0 230
9600 230 -100 130
9700 230 -200 30
9800 230 -300 -70
9900 230 -400 -170

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 10000 230 -400 -170
10100 230 -400 -170
10200 230 -400 -170

Here it can be seen that the maximum loss is limited to 170 and the maximum gain is limited
to 230. The breakeven point where the profit and loss are the same is 9730.

(II) Horizontal Spread - In the horizontal spread there exists same strike price, same type
but the difference exists only at the expiry. The other name for horizontal spread is time
spread or the calendar spread. Here, the payoff table gets impossible to be drawn as the
expiry of the underlying asset is different. The 2 underlying’s have different time values and
due to this there exists horizontal spreads. The time value between the underlying may
increase or get reduced; this is the belief of the trader. Thus, horizontal spread is a gap
between prices of 2 options to check if the price gap is expanding or contracting.

(III) Diagonal Spread - Diagonal spread is the mix of 2 options with similar underlying but
different expiries and with different strike prices. Here also like Horizontal spread it is
impossible to draw the pay offs and also it is more complex in nature and becomes difficult at
the time of its implementation. These spreads are suitable for the over the counter
transactions.

(B) Straddle:
It involves options with same prices and maturity. It is mainly of 2 types: Long Straddle &
Short Straddle.

(I) Long Straddle - It is that condition where position is created by purchasing the call
option and the put option of the same strike price and the same expiry. The maximum loss of
a person at this position would be the premium paid for acquiring the underlying asset. The
price fluctuation on any side would firstly result in recovering the premium back and
subsequently it would result in profits.

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7.10 Table No: 13.1 Long Straddle Position using Options.

Option Call Put

Long/ Short Long Long
Strike 7000 7000
Premium 357 236
Spot 7000

7.10 Table No: 13.2 Long Straddle Position using Options.

Current Market Price Long Call Long Put Net Flow

6200 -357 564 207
6300 -357 464 107
6400 -357 364 7
6500 -357 264 -93
6600 -357 164 -193
6700 -357 64 -293
6800 -357 -36 -393
6900 -357 -136 -493
7000 -357 -236 -593
7100 -257 -236 -493
7200 -157 -236 -393
7300 -57 -236 -293
7400 43 -236 -193
7500 143 -236 -93
7600 243 -236 7
7700 343 -236 107
7800 443 -236 207

Here it can be noted that when there is huge difference in prices then it results into profits and
with the slight fluctuation in prices it leads to losses. It can also be seen that at the strike price
maximum loss can be occurred i.e. 593. It can also be seen that there exist two breaks even
points; one at 7593 and other at 6407.

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(II) Short Straddle – It is formed when short position is taken for the call and put option. It
has an inverse relationship with the long straddle. In this the trader expects the price to be less
volatile. The short position is taken in order to get benefit from the premiums. Whatever is
profitable in long straddle results in loses in short straddle and vice versa.

7.10 Table No: 14.1 Short Straddle Position using Options.

Option Call Put

Long/ Short Short Short
Strike 7200 7000
Premium 357 236
Spot 7100

7.10 Table No: 14.2 Short Straddle Position using Options.

Current Market Price Short Call Short Put Net Flow

6200 357 -564 -207
6300 357 -464 -107
6400 357 -364 -7
6500 357 -264 93
6600 357 -164 193

6700 357 -64 293

6800 357 36 393
6900 357 136 493
7000 357 236 593
7100 257 236 493
7200 157 236 393
7300 57 236 293
7400 -43 236 193
7500 -143 236 93
7600 -243 236 -7
7700 -343 236 -107
7800 -443 236 -207

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Here it can be seen that the maximum profit is at the spot price or the price near it i.e. the
profit is 593 but the loss can be unlimited so only when less fluctuations (up to Rs. 500) are
expected then a person should enter short straddle position.

(C) Strangle:
This strategy is similar to that of straddle position in outlook but the difference lies in the
execution, the cost and the degree of after effect. It also has two types:

(I) Long strangle - In this unlike straddle, the prices move in either direction also it has
different strikes. Here the options are traded out of the money and the premium to be paid is
also low. The maximum cost for these transactions would the amount of premium paid for
purchase of options and the same premium can become his maximum loss. Let us understand
with the help of a table:
7.10 Table No: 15.1 Long Strangle Position using Options.

Option Call Put

Long/ Short Long Long
Strike 7200 7000
Premium 245 240
Spot 7100

7.10 Table No: 15.2 Long Strangle Position using Options.

Currency Market Price Long Call Long Put Net Flow

6200 -245 560 315
6300 -245 460 215
6400 -245 360 115
6500 -245 260 15
6600 -245 160 -85
6700 -245 60 -185
6800 -245 -40 -285
6900 -245 -140 -385
7000 -245 -240 -485
7100 -245 -240 -485
7200 -245 -240 -485
7300 -145 -240 -385
7400 -45 -240 -285
7500 55 -240 -185

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 7600 155 -240 -85
7700 255 -240 15
7800 355 -240 115

In this the profit that is expected is unlimited whereas the loss is restricted to 485 the
breakeven points are 7685 and 6515.

(II) Short strangle - Long strangle is opposite of short strangle in terms of out of money
options. The market is assumed to remain stagnant during the term of options. When long
strangle will make gains the short strangle will be making losses and vice versa.
7.10 Table No: 16.1 Short Strangle Position using Options.

Option Call Put

Long/ Short Short Short
Strike 7200 7000
Premium 245 240
Spot 7100

7.10 Table No: 16.2 Short Strangle Position using Options.

Current Market Price Short Call Short Put Net Flow

6200 245 -560 -315
6300 245 -460 -215
6400 245 -360 -115
6500 245 -260 -15
6600 245 -160 85
6700 245 -60 185
6800 245 40 285
6900 245 140 385
7000 245 240 485
7100 245 240 485
7200 245 240 485
7300 145 240 385
7400 45 240 285
7500 -55 240 185
7600 -155 240 85
7700 -255 240 -15
7800 -355 240 -115

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Here it can be seen that the maximum profit is at the spot price or the price near it i.e. the
profit is 485 but the loss can be unlimited so only when less fluctuations are expected then a
person should enter short straddle position. The breakeven points are 2 one being 7685 and
other being 6515.

(D) Covered Call:

Whenever shares are purchased, not all are sold within a short period of time. So, an investor
would like to earn an extra income from these shares as a return on its holding so that his
procurement cost is reduced. Let us understand with the help of table:
7.10 Table No: 17.1 Covered Call Position using Options.
Long Stock 2590
Strike Price 2600
Premium 10

7.10 Table No: 17.2 Covered Call Position using Options.

Current Market Price Stock Call Net Flow

2540 -50 10 -40
2550 -40 10 -30
2560 -30 10 -20
2570 -20 10 -10
2580 -10 10 0
2590 0 10 10
2600 10 10 20
2610 20 0 20
2620 30 -10 20
2630 40 -20 20
2640 50 -30 20

At the strike price of 2600 the covered call strategy resembles short put strategy known as
synthetic short put position. At price of 2600 if there are price changes then arbitrage benefits
can be taken. The strike of sold call option is important as if this price is near strike then it
will fetch a higher premium and if it is far from strike then there is an opportunity to hold the
asset for a long period.

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In the covered call the strategy is that, till the time the market price does not reach the
expected exit price, calls can be sold at the target price using long position.

(E) Protective Put:

Whenever in the market an investor takes a long position in the market he certainly is
exposed to risk of fall in price which can further result in loss of MTM and portfolio value. If
the price falls then either the shares are to be sold in cash market or short selling is to be done
and in both the cases the investor gets out of market. So, in such cases it is beneficial to buy a
put option as if the assumptions of the investors stand to be correct then this can help in
making profits.
7.10 Table No: 18.1 Protective Put Position using Options.

Long Cash 2600

Strike Price 2600
Premium 30

7.10 Table No: 18.2 Protective Put Position using Options.

Current Market Price Long Cash Long Put Net Flow

2540 -60 30 -30
2550 -50 20 -30
2560 -40 10 -30
2570 -30 0 -30
2580 -20 -10 -30
2590 -10 -20 -30
2600 0 -30 -30
2610 10 -30 -20
2620 20 -30 -10
2630 30 -30 0
2640 40 -30 10
2650 50 -30 20
2660 60 -30 30

Here we can see that whatever is the reduction in price the maximum loss to be suffered is 30
and the profit that can be made by this combination is unlimited. The breakeven point in this
example is at strike price 2630.

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(F) Collar:
A collar strategy is an extended version of covered call strategy. In the covered call when
prices moved down there was a risk of losing more so in order to reduce that risk collar
option is used. In this along with short call long put position is also taken.

7.10 Table No: 19.1 Collar Position using Options

Long Stock 2590 Long Put 2580

Short Call 2600 Premium 7
Premium 10

7.10 Table No: 19.2 Collar Position using Options.

Current Market Price Long Stock Short Call Long Put Net Flow
2540 -50 10 33 -7
2550 -40 10 23 -7
2560 -30 10 13 -7
2570 -20 10 3 -7
2580 -10 10 -7 -7
2590 0 10 -7 3
2600 10 10 -7 13
2610 20 0 -7 13
2620 30 -10 -7 13
2630 40 -20 -7 13
2640 50 -30 -7 13

Here though the gains get restricted to 13 but the losses are also restricted to the amount of
premium paid. The breakeven point here is 2587.

(G) Butterfly Spread:

The butterfly spread is an extended version of short straddle. In the short straddle we have
seen that the losses are unlimited. The traders want to limit the loss for which they buy a
money call and one from money put. When this strategy is put in a table we can see a
pictorial payoff which resembles butterfly, due to which the strategy is named to be butterfly
spread. The strategy can be formed using only calls or only puts or combination of calls and
puts. Here we will be taking a Long call position 1 and 2 with strikes 7000 and 7200 and the

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premium for the same being Rs. 330 and Rs. 200 respectively, also short call position 1 and 2
is taken with strike 7100 for both where the premium to be received is Rs. 250.

7.10 Table No: 20 Butterfly Spread Position using Options.

Current Market Long Short Long Short Net Flow

Price Call 1 Call 1 Call 2 Call 2
6500 -230 150 -100 150 -30
6600 -230 150 -100 150 -30
6700 -230 150 -100 150 -30
6800 -230 150 -100 150 -30
6900 -230 150 -100 150 -30
7000 -230 150 -100 150 -30
7100 -130 150 -100 150 70
7200 -30 50 -100 50 -30
7300 70 -50 0 -50 -30
7400 170 -150 100 -150 -30
7500 270 -250 200 -250 -30
7600 370 -350 300 -350 -30
7700 470 -450 400 -450 -30

Here as we can see there is limited profit which is 70 in this case and the loss is also limited
i.e. 30 in this case.

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 CHAPTER 8. RECOMMENDATION & SUGGESTION
 Enhance education and knowledge among all market participants, there should be
promotion of attaining professional expertise in derivatives by the central government
of India, by financial institutions already trading in derivatives as well as those
financial institution interested in using derivatives products, and by end users.
 Regulation needs to be dynamic in order to adapt to change in market structure and
financial products innovation.
 Government of India should become more active in the local derivatives market by
assessing and informing market participants about the impact of derivatives trading on
underlying economic factors and their effects on monetary and exchange rate policies.

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 CHAPTER 9. CONCLUSION
The futures and options are the widely used derivatives across the world. There is a great
amount of risk involved in such contracts so in order to mitigate the risks involved in its
various strategies mentioned above are used. The use of these strategies not only help in
increasing the profits but also reduce the amount of losses involved in it thus helping in risk
management.

However, different strategies are to be used in the different market circumstances. The
strategy should be used making proper analysis of the market. If the proper choice of strategy
is used then only it will help in Risk management.

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 CHAPTER 10. BIBLIOGRAPHY

Research Papers:

- Mujacevic, E., Ivanovic, V, (2008), Risk management of financial derivatives, hrcak.

- Bartram, S, M, Brown, G, W, Fehle, F, R, (2009), International evidence on financial

derivatives usage, Wiley Online Library, 38, 105.

- Sprcic, D, M, (2007), The derivatives as financial risk management instruments: the

case of creation and Slovenian non-financial companies, hrcak, 31.

Websites:

https://www.thebalance.com/derivatives-markets-definition-and-examples-1031157

https://www.thebalance.com/what-are-derivatives-3305833

https://themarketmogul.com/importance-derivatives-risk-management/

https://www.investopedia.com/ask/answers/06/futureshedge.asp

http://moneymaven.io/economonitor/api/amp/economonitor/emerging-markets/chapter-10-executive-
summary-derivatives-the-ultimate-financial-innovation-qjSqlBEmq0ypV7tGq_LH1A/

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