Derivatives

Trading
Overview

Derivatives have made the international and financial headlines in the past for mostly with their
association with spectacular losses or institutional collapses. But market players have traded
derivatives successfully for centuries and the daily international turnover in derivatives trading
runs into billions of dollars.

Are derivative instruments that can only be traded by experienced, specialist traders? Although it
is true that complicated mathematical models are used for pricing some derivatives, the basic
concepts and principles underpinning derivatives and their trading are quite easy to grasp and
understand. Indeed, derivatives are used increasingly by market players ranging from
governments, corporate treasurers, dealers and brokers and individual investors.

Indian scenario

While forward contracts and exchange traded in futures has grown by leaps and bound, Indian
stock markets have been largely slow to these global changes. However, in the last few years,
there has been substantial improvement in the functioning of the securities market. Requirements
of adequate capitalization for market intermediaries, margining and establishment of clearing
corporations have reduced market and credit risks. However, there were inadequate advanced
risk management tools. And after the ICE (Information, Communication, Entertainment) meltdown
the market regulator felt that in order to deepen and strengthen the cash market trading of
derivatives like futures and options was imperative.

Why have derivatives?

Derivatives have become very important in the field finance. They are very important financial
instruments for risk management as they allow risks to be separated and traded. Derivatives are
used to shift risk and act as a form of insurance. This shift of risk means that each party involved
in the contract should be able to identify all the risks involved before the contract is agreed. It is
also important to remember that derivatives are derived from an underlying asset. This means
that risks in trading derivatives may change depending on what happens to the underlying asset.

A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, forex, commodity or any other asset. For
example, if the settlement price of a derivative is based on the stock price of a stock for e.g.
Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on
a daily basis. This means that derivative risks and positions must be monitored constantly.

The purpose of this Learning Centre is to introduce the basic concepts and principles of
derivatives.

We will try and understand

• What are derivatives?

• Why have derivatives at all?
• How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the
movement of a derivative instrument and how is it traded and how one can profit from these
instruments.
FACTORS DRIVING THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal
growth. A large variety of derivative contracts have been launched at
exchanges across the world. Some of the factors driving the growth of
financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns,
reduced risk as well as transactions costs as compared to individual
financial assets.

DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. We take a brief look at various
derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed
price.
Futures: A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardized
exchange-traded contracts.
Options: Options are of two types - calls and puts. 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.
Warrants: Options generally have lives of upto one year, the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally traded
over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.
These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity
index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.
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Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swaption is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver
swaptions and payer swaptions. A receiver swaption is an option to receive fixed and
pay floating. A payer swaption is an option to pay fixed and receive floating.

PARTICIPANTS IN THE DERIVATIVES MARKETS

The following three broad categories of participants - hedgers, speculators,
and arbitrageurs trade in the derivatives market. Hedgers face risk associated
with the price of an asset. They use futures or options markets to reduce or
eliminate this risk. Speculators wish to bet on future movements in the price
of an asset. Futures and options contracts can give them an extra leverage;
that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a
discrepancy between prices in two different markets. If, for example, they
see the futures price of an asset getting out of line with the cash price, they
will take offsetting positions in the two markets to lock in a profit.

What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings
and comes across as an instrument which is the prerogative of a few ‘smart finance
professionals’. In reality it is not so. In fact, a derivative transaction helps cover risk, which would
arise on the trading of securities on which the derivative is based and a small investor, can
benefit immensely.

A derivative security can be defined as a security whose value depends on the values of other
underlying variables. Very often, the variables underlying the derivative securities are the prices
of traded securities.

Let us take an example of a simple derivative contract:

• Ram buys a futures contract.

• He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.
• If the price is unchanged Ram will receive nothing.
• If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the
underlying security. Similarly, futures trading has already started in Sensex futures and Nifty
futures. The underlying security in this case is the BSE Sensex and NSE Nifty.

Derivatives and futures are basically of 3 types:

• Forwards and Futures

• Options
• Swaps

Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or
sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is
exchanged when the contract is entered into.

Illustration 1:

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can
only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from
now. So in order to protect himself from the rise in prices Shyam enters into a contract with the
TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that
he is locking the current price of a TV for a forward contract. The forward contract is settled at
maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn
will pay cash equivalent to the TV price on delivery.

Illustration 2:

Ram is an importer who has to make a payment for his consignment in six months time. In order
to meet his payment obligation he has to buy dollars six months from today. However, he is not
sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a
contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a
contract on a future date it is a forward contract and the underlying security is the foreign
currency.

The difference between a share and derivative is that shares/securities is an asset while
derivative instrument is a contract.

LIMITATIONS OF FORWARD MARKETS

Forward markets world-wide are afflicted by several problems:
• Lack of centralization of trading,
• Illiquidity, and

• Counterparty risk

What is an Index?
To understand the use and functioning of the index derivatives markets, it is necessary to
understand the underlying index. A stock index represents the change in value of a set of stocks,
which constitute the index. A market index is very important for the market players as it acts as a
barometer for market behavior and as an underlying in derivative instruments such as index
futures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE
Sensex has 30 stocks comprising the index which are selected based on market capitalization,
industry representation, trading frequency etc. It represents 30 large well-established and
financially sound companies. The Sensex represents a broad spectrum of companies in a variety
of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE
200. However, trading in index futures has only commenced on the BSE Sensex.
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the
National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index
consists of shares of 50 companies with each having a market capitalization of more than Rs 500
crore.

Futures
Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes is
essential. Choosing the right index is important in choosing the right contract for speculation or
hedging. Since for speculation, the volatility of the index is important whereas for hedging the
choice of index depends upon the relationship between the stocks being hedged and the
characteristics of the index.

Choosing and understanding the right index is important as the movement of stock index futures
is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally
greater than spot stock indexes.

Everytime an investor takes a long or short position on a stock, he also has an hidden exposure
to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment
and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index with
their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Index futures are all futures contracts where the underlying is the
stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can
simply buy a futures contract and hope for a price rise on the futures contract when the rally
occurs. We shall learn in subsequent lessons how one can leverage ones position by taking
position in the futures market.

In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near
3 months duration contracts are available at all times. Each contract expires on the last Thursday
of the expiry month and simultaneously a new contract is introduced for trading after expiry of a
contract.

Example:

Futures contracts in Nifty in July 2001

Contract month Expiry/settlement

July 2001 July 26
August 2001 August 30
September 2001 September 27
On July 27

Contract month Expiry/settlement

August 2001 August 30
September 2001 September 27
October 2001 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract
the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total
value will be 50*4000 (Sensex value)= Rs 2,00,000.

The index futures symbols are represented as follows:

BSE NSE
BSXJUN2001 (June contract) FUTDXNIFTY28-JUN2001
BSXJUL2001 (July contract) FUTDXNIFTY28-JUL2001
BSXAUG2001 (Aug contract) FUTDXNIFTY28-AUG2001

In subsequent lessons we will learn about the pricing of index futures.

Distinction between futures and forwards

Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
hence more liquid hence less liquid

Requires margin payments No margin payment

Follows daily settlement Settlement happens at end of period

FUTURES TERMINOLOGY
• Spot price: The price at which an asset trades in the spot market.
• Futures price: The price at which the futures contract trades in the
futures market.
• Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one- month, two-months and threemonths
expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract ceases trading on the last
Thursday of February. On the Friday following the last Thursday, a new
contract having a three- month expiry is introduced for trading.
• Expiry date: It is the date specified in the futures contract. This is the
last day on which the contract will be traded, at the end of which it will
cease to exist.
• Contract size: The amount of asset that has to be delivered under
one contract. Also called as lot size.
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• Basis: In the context of financial futures, basis can be defined as the
futures price minus the spot price. There will be a different basis for
each delivery month for each contract. In a normal market, basis will
be positive. This reflects that futures prices normally exceed spot
prices.
• Cost of carry: The relationship between futures prices and spot prices
can be summarized in terms of what is known as the cost of carry.
This measures the storage cost plus the interest that is paid to finance
the asset less the income earned on the asset.
• Initial margin: The amount that must be deposited in the margin
account at the time a futures contract is first entered into is known as
initial margin.
• Marking-to-market: In the futures market, at the end of each
trading day, the margin account is adjusted to reflect the investor's
gain or loss depending upon the futures closing price. This is called
marking-to-market.
• Maintenance margin: This is somewhat lower than the initial margin.
This is set to ensure that the balance in the margin account never
becomes negative. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is
expected to top up the margin account to the initial margin level

before trading commences on the next day.

Hedging
We have seen how one can take a view on the market with the help of index futures. The other
benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to
understand how one can protect his portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses
for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs
3000 if the sale is completed.

Cost (Rs) Selling price Profit

1000 4000 3000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts
a new clause in the contract that if Shyam fails to honour the contract he will have to pay a
penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as
incentive.

Shyam defaults Shyam honours

1000 (Initial Investment) 3000 (Initial profit)
 1000 (penalty from Shyam) (-1000) discount given to Shyam
- (No gain/loss) 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial
investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram
has hedged his risk against default and protected his initial investment.

The above example explains the concept of hedging. Let us try understanding how one can use
hedging in a real life scenario.

Stocks carry two types of risk – company specific and market risk. While company risk can be
minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged.
So how does one measure the market risk? Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the movement of the stock.
The beta measures the percentage impact on the stock prices for 1% change in the index.
Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the
beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%.
The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price
movements. In order to hedge a position, a market player needs to take an equal and
opposite position in the futures market to the one held in the cash market. Every portfolio
has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio
of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of
S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to
assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would
offset the losses on the rest of his portfolio. This is achieved by multiplying the relative
volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.

Now let us study the impact on the overall gain/loss that accrues:

Index up 10% Index down 10%

Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain/(Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market
sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall
sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures
market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of
whether the market goes up or not, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of the scrip and
taking a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash
market.

Speculation
Speculators are those who do not have any position on which they enter in futures and options
market. They only have a particular view on the market, stock, commodity etc. In short,
speculators put their money at risk in the hope of profiting from an anticipated price change. They
consider various factors such as demand supply, market positions, open interests, economic
fundamentals and other data to take their positions.

Illustration:

Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in
predicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in
future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of
contracts to close out his position.

Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000

Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However,
if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he
could have sold Sensex futures and made a profit from a falling profit. In index futures players
can have a long-term view of the market up to atleast 3 months.

Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless
profits. When markets are imperfect, buying in one market and simultaneously selling in other
market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower
priced market and selling at the higher priced market. In index futures arbitrage is possible
between the spot market and the futures market (NSE has provided a special software for buying
all 50 Nifty stocks in the spot market.

• Take the case of the NSE Nifty.

• Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.

 • The futures price of Nifty futures can be worked out by taking the interest cost of 3
months into account.

• If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs
1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs
1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs
1070.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40

These kind of imperfections continue to exist in the markets but one has to be alert to the
opportunities as they tend to get exhausted very fast.

The cost of carry model (Futures Price)

The cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves
away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one
can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro
futures for 3 months at Rs 1070.

Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of
arbitrage.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

However, one has to remember that the components of holding cost vary with contracts on
different assets.
Trading strategies
Speculation

We have seen earlier that trading in index futures helps in taking a view of the market, hedging,
speculation and arbitrage. In this module we will see one can trade in index futures and use
forward contracts in each of these instances.

Taking a view of the market

Have you ever felt that the market would go down on a particular day and feared that your
portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and costly to sell all
the stocks in the index. And in the process one could be vulnerable to company specific risk. So
what is the option? The best thing to do is to sell index futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expiry date of
July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

‘X’ makes a profit of Rs 15,600 (200*78)

Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expiry date of
July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of profiting
from an anticipated price change.

Hedging Example :
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways
to control risk. The total risk is measured by the variance or standard deviation of its return
distribution. A common measure of a stock market risk is the stock’s Beta. The Beta of stocks are
available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures contracts to be
entered to reduce the risk to the minimum.

Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of
the company made it worth a lot more as compared with what the market thinks?

Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a sense that it was
worth more than the market price?

A person who feels like this takes a long position on the cash market. When doing this, he faces
two kinds of risks:

1. His understanding can be wrong, and the company is really not worth more than the market
price or

2. The entire market moves against him and generates losses even though the underlying idea
was correct.

Everyone has to remember that every buy position on a stock is simultaneously a buy position on
Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty
position along with it, as incidental baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of
HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty
futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning
Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs
59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.

Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to
be hedged by using Nifty futures contracts. To find out the number of contracts in futures market
to neutralise risk

If the index is at 1200 * 200 (market lot) = Rs 2,40,000

The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000
If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are
underhedged.

Thus, we have seen how one can hedge their portfolio against market risk.

Margins
The margining system is based on the JR Verma Committee recommendations. The actual
margining happens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept of Value-at-
Risk (VaR). The initial margin amount is large enough to cover a one-day loss that can be
encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a
portfolio may stand to lose within a certain horizon time period (one day for the clearing
corporation) due to potential changes in the underlying asset market price. Initial margin amount
computed using VaR is collected up-front.

The daily settlement process called "mark-to-market" provides for collection of losses that have
already occurred (historic losses) whereas initial margin seeks to safeguard against potential
losses on outstanding positions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the
margins payments that would occur.

• A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.

• The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Position on Day 1

Close Price Loss Margin released Net cash outflow

1400*200 =2,80,000 20,000 (3,00,000-2,80,000) 3,000 (45,000-42,000) 17,000 (20,000-3000)
Payment to be made (17,000)

New position on Day 2

Value of new position = 1,400*200= 2,80,000

Margin = 42,000
Close Price Gain Addn Margin Net cash inflow
1510*200 =3,02,000 22,000 (3,02,000-2,80,000) 3,300 (45,300-42,000) 18,700 (22,000-3300)
Payment to be recd 18,700

Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 3,300

Close Price Gain Net cash inflow

1600*200 =3,20,000 18,000 (3,20,000-3,02,000) 18,000 + 45,300* = 63,300
Payment to be recd 63,300

Margin account*

Initial margin = Rs 45,000

Margin released (Day 1) = (-) Rs 3,000

Position on Day 2 Rs 42,000

Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/loss

Day 1 (loss) = (Rs 17,000)

Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000

Total Gain = Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the
close of trade is Rs 63,300.

Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which
are not closed out will be marked-to-market. The closing price of the index futures will be the daily
settlement price and the position will be carried to the next day at the settlement price.

The most common way of liquidating an open position is to execute an offsetting futures
transaction by which the initial transaction is squared up. The initial buyer liquidates his long
position by selling identical futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of
the contract period the difference between the contract value and closing index value is paid.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone
planning to venture in futures trading. Economic dailies and exchange websites
www.nseindia.com and www.bseindia.com are some of the sources where one can look for the
daily quotes. Your website has a daily market commentary, which carries end of day derivatives
summary alongwith the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open
Interest are the three primary data we carry with Index option quotes. The most important
parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day
prices and to track them one has to have access to real time prices.

The following table shows how futures data will be generally displayed in the business papers
daily.

Series First High Low Close Volume (No ofValue (RsNo ofOpen interest (No
Trade contracts) in lakh) trades of contracts)
BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51
BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2
BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1
Total 160 38252 116 54

Source: BSE

• The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for
the June Sensex futures contract.

• The column on volume indicates that (in case of June series) 146 contracts have been
traded in 104 trades.

• One contract is equivalent to 50 times the price of the futures, which are traded. For e.g.
In case of the June series above, the first trade at 4755 represents one contract valued at
4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular
series. For e.g. Open interest in the June series is 51 contracts.

The most useful measure of market activity is Open interest, which is also published by
exchanges and used for technical analysis. Open interest indicates the liquidity of a market and
is the total number of contracts, which are still outstanding in a futures market for a specified
futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a transaction.
This means that the buyer goes long and the seller goes short. Open interest is calculated by
looking at either the total number of outstanding long or short positions – not both.

Open interest is therefore a measure of contracts that have not been matched and closed out.
The number of open long contracts must equal exactly the number of open short contracts.
Action Resulting open interest
New buyer (long) and new seller (short) Trade to form aRise
new contract.
Existing buyer sells and existing seller buys –The oldFall
contract is closed.

New buyer buys from existing buyer. The Existing buyerNo change – there is no increase in long contracts being
closes his position by selling to new buyer. held

Existing seller buys from new seller. The Existing seller No change – there is no increase in short contracts being
closes his position by buying from new seller. held

Open interest is also used in conjunction with other technical analysis chart patterns and
indicators to gauge market signals. The following chart may help with these signals.

Price Open interest Market

Strong
Warning signal
Weak
Warning signal

The warning sign indicates that the Open interest is not supporting the price direction.

Glossary
Backwardation: A market where future prices of distant contract months are lower than the near
months.

Basis: The difference between the Index and the respective contract is the basis i.e. cash netted
for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It
is the strengthening and weakening of basis that is tracked by market players i.e. whether the
basis is widening or narrowing. A widening of basis is indicative of increasing longs and
narrowing means increasing short positions.

Basis Point: It is equal to one hundredth of a percentage point

Contango market: This is a market where futures prices are higher for distant contracts than for
nearby delivery months.

Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically
means the annualized interest cost players decide to pay (receive) for buying (selling) a
respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry
Cost is a widely used parameter not only because it is more interpretable being an annualized
figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio
of Price, Volume and Open Interest in highlighting the market trend.

Delivery month: Is the month in which delivery of futures contracts need to be made.

Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are
invoiced. Also known as the expiry price or the settlement price.

Derivative: A financial instrument designed to replicate an underlying security for the purpose of
transferring risk.
Fair value: Theoretical value of a futures contract derived from a mathematical model of
valuation.

Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or
sell so as to provide the maximum offset of risk. This depends on the

• Value of a Futures contract;

• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be
hedged and underlying (index) from which Future is derived.

Initial margin: The money a customer needs to pay as deposit to establish a position in the
futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.

Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on
closing market prices at the end of the trading day.

Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a
stated price and quantity. No money changes hands at the time the deal is signed.

Futures contract: A futures contract is similar to a forward contract in terms of its working. The
difference is that contracts are standardized and trading is centralized. Futures markets are highly
liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes
the counterparty to both sides of each transaction and guarantees the trade.

Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.

Speculation: Trading on anticipated price changes, where the trader does not hold another
position which will offset any such price movements.

Spread ratio: The number of futures contracts bought, divided by the number of futures contracts
sold.

VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum
loss possible on a particular position, with a specified level of certainty or confidence.

Strike Price: The price at which an option holder may buy or sell the underlying asset, which is
specified in an option contract.

Options
Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more often
than not the scenario is the reverse. Investing in stocks has two sides to it –a) Unlimited profit
potential from any upside (remember Infosys, HFCL etc) or b) a downside which could make you
a pauper.
Derivative products are structured precisely for this reason -- to curtail the risk exposure of an
investor. Index futures and stock options are instruments that enable you to hedge your portfolio
or open positions in the market. Option contracts allow you to run your profits while restricting
your downside risk.

Apart from risk containment, options can be used for speculation and investors can create a wide
range of potential profit scenarios.

We have seen in the Derivatives School how index futures can be used to protect oneself from
volatility or market risk. Here we will try and understand some basic concepts of options.

What are options?

Some people remain puzzled by options. The truth is that most people have been using options
for some time, because options are built into everything from mortgages to insurance.

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares
of the underlying security at a specific price on or before a specific date.

‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if
he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

A Call Option is an option to buy a stock at a specific price on or before a certain date. In this
way, Call options are like security deposits. If, for example, you wanted to rent a certain property,
and left a security deposit for it, the money would be used to insure that you could, in fact, rent
that property at the price agreed upon when you returned. If you never returned, you would give
up your security deposit, but you would have no other liability. Call options usually increase in
value as the value of the underlying instrument rises.

When you buy a Call option, the price you pay for it, called the option premium, secures your right
to buy that certain stock at a specified price called the strike price. If you decide not to use the
option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Options are options to sell a stock at a specific price on or before a certain date. In this way,
Put options are like insurance policies

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence,
protected if the asset is damaged in an accident. If this happens, you can use your policy to
regain the insured value of the car. In this way, the put option gains in value as the value of the
underlying instrument decreases. If all goes well and the insurance is not needed, the insurance
company keeps your premium in return for taking on the risk.

With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which
causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and
sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then
you do not need to use the insurance, and, once again, your only cost is the premium. This is the
primary function of listed options, to allow investors ways to manage risk.

Technically, an option is a contract between two parties. The buyer receives a privilege for which
he pays a premium. The seller accepts an obligation for which he receives a fee.
We will dwelve further into the mechanics of call/put options in subsequent lessons.

Call option
An option is a contract between two parties giving the taker (buyer) the right, but not the
obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a
predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the
contract.

There are two types of options:

• Call Options
• Put Options

Call options

Call options give the taker the right, but not the obligation, to buy the underlying shares at a
predetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between
the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight
a share for 100 shares).

The buyer of a call has purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has
purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55
(40+15) he will break even and he will start making a profit. Suppose the stock does not rise and
instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus
limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better.
Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contract Strike price Call premium

Dec Nifty 1325 Rs 6,000
1345 Rs 2,000

Jan Nifty 1325 Rs 4,500

1345 Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the
risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a
premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and
takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per
contract. Total profit = 40,000/- (4,000*10).

He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is
Rs 35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt to forego his
premium of Rs 5,000. So, in the event the index falls further his loss is limited to the
premium he paid upfront, but the profit potential is unlimited.

Call Options-Long & Short Positions

When you expect prices to rise, then you take a long position by buying calls. You are bullish.

When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put Options
A Put Option gives the holder of the right to sell a specific number of shares of an agreed
security at a fixed price for a period of time.

eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200

This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between
the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000
(Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does
not want to take the risk in the event of price rising so purchases a put option at Rs 70 on ‘X’. By
purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs
15 (premium).
So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if
the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not
want to take the risk in the event the prices rise. So he purchases a Put option on Wipro.

Quotes are as under:

Spot Rs 1040

Jan Put at 1050 Rs 10

Jan Put at 1070 Rs 30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs
30,000/- as Put premium.

His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020

2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the
price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put,
which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the investor will not sell at a
lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He
looses the premium paid Rs 30,000.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.

When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

CALL OPTIONS PUT OPTIONS

If you expect a fall in price(Bearish) Short Long
If you expect a rise in price (Bullish) Long Short
SUMMARY:

CALL OPTION BUYER CALL OPTION WRITER (Seller)

• Pays premium • Receives premium

• Right to exercise and buy the shares • Obligation to sell shares if exercised
• Profits from rising prices • Profits from falling prices or remaining neutral

• Limited losses, Potentially unlimited gain • Potentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

• Pays premium • Receives premium

• Right to exercise and sell shares • Obligation to buy shares if exercised
• Profits from falling prices • Profits from rising prices or remaining neutral

• Limited losses, Potentially unlimited gain • Potentially unlimited losses, limited gain

OPTION TERMINOLOGY
• Index options: These options have the index as the underlying.
Some options are European while others are American. Like index
futures contracts, index options contracts are also cash settled.
30
• Stock options: Stock options are options on individual stoc ks. Options
currently trade on over 500 stocks in the United States. A contract gives the
holder the right to buy or sell shares at the specified price.
• Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his
option on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives
the option premium and is thereby obliged to sell/buy the asset if the
buyer exercises on him.
There are two basic types of options, call options and put options.
• Call option: A call option gives the holder the right but not the obligation to
buy an asset by a certain date for a certain price.
• Put option: A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.
• Option price/premium: Option price is the price which the option buyer
pays to the option seller. It is also referred to as the option premium.
• Expiration date: The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
• American options: American options are options that can be exercised at
any time upto the expiration date. Most exchange-traded options are
American.
• European options: European options are options that can be exercised
only on the expiration date itself. European options are easier to analyze
than American options, and properties of an American option are
frequently deduced from those of its European counterpart.
• In-the-money option: An in-the-money (ITM) option is an option that
would lead to a positive cashflow to the holder if it were exercised
immediately. A call option on the index is said to be in-the-money when the
current index stands at a level higher than the strike price (i.e. spot price >
strike price). If the index is much higher than the strike price, the call is said
to be deep ITM. In the case of a put, the put is ITM if the index is below
the strike price.
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• At-the-money option: An at-the-money (ATM) option is an option that
would lead to zero cashflow if it were exercised immediately. An option on
the index is at-the-money when the current index equals the strike price
(i.e. spot price = strike price).
• Out-of-the-money option: An out-of-the-money (OTM) option is an
option that would lead to a negative cashflow if it were exercised
immediately. A call option on the index is out-of-the-money when the
current index stands at a level which is less than the strike price (i.e. spot
price < strike price). If the index is much lower than the strike price, the
call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.
• Intrinsic value of an option: The option premium can be broken down into
two components - intrinsic value and time value. The intrinsic value of a
call is the amount the option is ITM, if it is ITM. If the call is OTM, its
intrinsic value is zero. Putting it another way, the intrinsic value of a call is
Max[0, (St — K)] which means the intrinsic value of a call is the greater
of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e.
the greater of 0 or (K — St). K is the strike price and St is the spot price.
• Time value of an option: The time value of an option is the difference
between its premium and its intrinsic value. Both calls and puts have time
value. An option that is OTM or ATM has only time value. Usually, the
maximum time value exists when the option is ATM. The longer the time to
expiration, the greater is an option's time value, all else equal. At expiration,

an option should have no time value.

Distinction between futures and options

Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
 Option styles
Settlement of options is based on the expiry date. However, there are three basic styles of
options you will encounter which affect settlement. The styles have geographical names, which
have nothing to do with the location where a contract is agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell the
underlying instrument only on the expiry date. This means that the option cannot be exercised
early. Settlement is based on a particular strike price at expiration. Currently, in India only index
options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract
on the last Thursday of August. Since there are no shares for the underlying, the contract is cash
settled.

American: These options give the holder the right, but not the obligation, to buy or sell the
underlying instrument on or before the expiry date. This means that the option can be exercised
early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are "American Options".

eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the expiration date, which is
the last Thursday of September.

American style options tend to be more expensive than European style because they offer
greater flexibility to the buyer.

Option Class & Series

Generally, for each underlying, there are a number of options available: For this reason, we have
the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style (American or
European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same
underlying, the same expiration date and the same exercise price.

Calls Puts
. JUL AUG SEP JUL AUG SEP
Wipro
1300 45 60 75 15 20 28
1400 35 45 65 25 28 35
1500 20 42 48 30 40 55
eg: Wipro JUL 1300 refers to one series and trades take place at different
premiums

All calls are of the same option type. Similarly, all puts are of the same option type. Options of the
same type that are also in the same class are said to be of the same class. Options of the same
class and with the same exercise price and the same expiration date are said to be of the same
series

Pricing of options
Options are used as risk management tools and the valuation or pricing of the instruments is a
careful balance of market factors.

There are four major factors affecting the Option premium:

• Price of Underlying
• Time to Expiry
• Exercise Price Time to Maturity
• Volatility of the Underlying

And two less important factors:

• Short-Term Interest Rates

• Dividends

Review of Options Pricing Factors

The Intrinsic Value of an Option

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or
the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option,
the strike price must be less than the price of the underlying asset for the call to have an intrinsic
value greater than 0. For a put option, the strike price must be greater than the underlying asset
price for it to have intrinsic value.

Price of underlying

The premium is affected by the price movements in the underlying

instrument. For Call options – the right to buy the underlying at a fixed strike

price – as the underlying price rises so does its premium. As the underlying price falls so does the
cost of the option premium. For Put options – the right to sell the underlying at a fixed strike
price – as the underlying price rises, the premium falls; as the underlying price falls the premium
cost rises.

The following chart summarises the above for Calls and Puts.

Option Underlying price Premium cost

Call

Put

The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the higher its premium will
be. This is because the longer an option’s lifetime, greater is the possibility that the underlying
share price might move so as to make the option in-the-money. All other factors affecting an
option’s price remaining the same, the time value portion of an option’s premium will decrease (or
decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life. When an
option expires in-the-money, it is generally worth only its intrinsic value.

Option Time to expiry Premium cost

Call

Put

Volatility

Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It
reflects a price change’s magnitude; it does not imply a bias toward price movement in one
direction or the other. Thus, it is a major factor in determining an option’s premium. The higher
the volatility of the underlying stock, the higher the premium because there is a greater possibility
that the option will move in-the-money. Generally, as the volatility of an under-lying stock
increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premium

Lower volatility = Lower premium

Option Volatility Premium cost

Call

Put

Interest rates
In general interest rates have the least influence on options and equate approximately to the cost
of carry of a futures contract. If the size of the options contract is very large, then this factor may
take on

some importance. All other factors being equal as interest rates rise, premium costs fall and vice
versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the
buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest
rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to
compensate the buyer premium costs fall. Why should the buyer be compensated? Because the
option writer receiving the premium can place the funds on deposit and receive more interest than
was previously anticipated. The situation is reversed when interest rates fall – premiums rise.
This time it is the writer who needs to be compensated.

Option Interest rates Premium cost

Call

Put

How do we measure the impact of change in each of these pricing determinants on option
premium we shall learn in the next module.

THE GREEKS

Delta ( )
is the rate of change of option price with respect to the price of the
underlying asset. For example, the delta of a stock is 1. It is the slope of the
curve that relates the option price to the price of the underlying asset.
Suppose the of a call option on a stock is 0.5. This means that when the
stock price changes by one, the option price changes by about 0.5, or 50% of the
change in the stock price. Figure 4.16 shows the delta of a stock option.
Gamma ( )
Γ is the rate of change of the option's Delta ( ) with respect to the price of
the underlying asset. In other words, it is the second derivative of the option

price with respect to price of the underlying asset.

Theta ( )
of a portfolio of options, is the rate of change of the value of the portfolio
with respect to the passage of time with all else remaining the same. is
also referred to as the time decay of the portfolio. is the change in the
portfolio value when one day passes with all else remaining the same. We can
either measure "per calendar day" or "per trading day". To obtain the
per calendar day, the formula for Theta must be divided by 365; to obtain

Theta per trading day, it must be divided by 250.

Vega
The vega of a portfolio of derivatives is the rate of change in the value of the
portfolio with respect to volatility of the underlying asset. If is high in
absolute terms, the portfolio's value is very sensitive to small changes in
volatility. If is low in absolute terms, volatility changes have relatively little
impact on the value of the portfolio.

Rho( )
The of a portfolio of options is the rate of change of the value of the
portfolio with respect to the interest rate. It measures the sensitivity of the

value of a portfolio to interest rates.

Options Pricing Models

There are various option pricing models which traders use to arrive at the right value of the
option. Some of the most popular models have been enumerated below.

The Binomial Pricing Model

The binomial model is an options pricing model which was developed by William Sharpe in 1978.
Today, one finds a large variety of pricing models which differ according to their hypotheses or
the underlying instruments upon which they are based (stock options, currency options, options
on interest rates).

The Black & Scholes Model

The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one
of the most popular options pricing models. It is noted for its relative simplicity and its fast mode
of calculation: unlike the binomial model, it does not rely on calculation by iteration.

The intention of this section is to introduce you to the basic premises upon which this pricing
model rests. A complete coverage of this topic is material for an advanced course

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid
during the life of the option) using the five key determinants of an option's price: stock price, strike
price, volatility, time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

Option Strategies :
Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with
different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a
higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and
writes a call with a lower exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows
the investor to participate to a limited extent in a bull market, while at the same time limiting risk
exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call.
The combination of these two options will result in a bought spread. The cost of Putting on this
position will be the difference between the premium paid for the low strike call and the premium
received for the high strike call.

The investor's profit potential is limited. When both calls are in-the-money, both will be exercised
and the maximum profit will be realised. The investor delivers on his short call and receives a
higher price than he is paid for receiving delivery on his long call.
The investors's potential loss is limited. At the most, the investor can lose is the net premium. He
pays a higher premium for the lower exercise price call than he receives for writing the higher
exercise price call.

The investor breaks even when the market price equals the lower exercise price plus the net
premium. At the most, an investor can lose is the net premium paid. To recover the premium, the
market price must be as great as the lower exercise price plus the net premium.

An example of a Bullish call spread:

Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a
strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November
call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are
buying a lower strike price option and selling a higher strike price option. This would result in a
net outflow of Rs 10 at the time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first
position established in the spread is the long lower strike price call option with unlimited profit
potential. At the same time to reduce the cost of puchase of the long position a short position at a
higher call strike price is established. While this not only reduces the outflow in terms of premium
but his profit potential as well as risk is limited. Based on the above figures the maximum profit,
maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price - Lower strike price - Net premium
paid

= 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with
different exercise prices.
To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a
lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes
a put with a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread"
allows the investor to participate to a limited extent in a bull market, while at the same time
limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.
The bull spread can be created by buying the lower strike and selling the higher strike of either
calls or put. The difference between the premiums paid and received makes up one leg of the
spread.

The investor's profit potential is limited. When the market price reaches or exceeds the higher
exercise price, both options will be out-of-the-money and will expire worthless. The trader will
realize his maximum profit, the net premium
The investor's potential loss is also limited. If the market falls, the options will be in-the-money.
The puts will offset one another, but at different exercise prices.

The investor breaks-even when the market price equals the lower exercise price less the net
premium. The investor achieves maximum profit i.e the premium received, when the market price
moves up beyond the higher exercise price (both puts are then worthless).

An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on
a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of
Rs 110 at a premium of Rs 15.

The first position is a short put at a higher strike price. This has resulted in some inflow in terms of
premium. But here the trader is worried about risk and so caps his risk by buying another put
option at the lower strike price. As such, a part of the premium received goes off and the ultimate
position has limited risk and limited profit potential. Based on the above figures the maximum
profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit

= 15 - 5 = 10

Maximum loss = Higher strike price - Lower strike price - Net premium received

= 110 - 90 - 10 = 10

Breakeven Price = Higher Strike price - Net premium income

= 110 - 10 = 100

Key Regulations
In India we have two premier exchanges The National Stock Exchange of India (NSE) and The
Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual
securities.

Options on stock indices are European in kind and settled only on the last of expiration of the
underlying. NSE offers index options trading on the NSE Fifty index called the Nifty. While BSE
offers index options on the country’s widely used index Sensex, which consists of 30 stocks.

Options on individual securities are American. The number of stock options contracts to be traded
on the exchanges will be based on the list of securities as specified by Securities and Exchange
Board of India (SEBI). Additions/deletions in the list of securities eligible on which options
contracts shall be made available shall be notified from time to time.

Underlying: Underlying for the options on individual securities contracts shall be the underlying
security available for trading in the capital market segment of the exchange.

Security descriptor: The security descriptor for the options on individual securities shall be:

 Market type - N
  Instrument type - OPTSTK
 Underlying - Underlying security
 Expiry date - Date of contract expiry
 Option type - CA/PA
 Exercise style - American Premium Settlement method: Premium Settled; CA - Call
American
 PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options contracts on
individual securities shall be as follows:

Options on individual securities contracts will have a maximum of three-month trading cycle. New
contracts will be introduced on the trading day following the expiry of the near month contract.

On expiry of the near month contract, new contract shall be introduced at new strike prices for
both call and put options, on the trading day following the expiry of the near month contract. (See
Index futures learning centre for further reading)

Strike price intervals: The exchange shall provide a minimum of five strike prices for every
option type (i.e call & put) during the trading month. There shall be two contracts in-the-money
(ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike
price interval for options on individual securities is given in the accompanying table.

New contracts with new strike prices for existing expiration date will be introduced for trading on
the next working day based on the previous day's underlying close values and as and when
required. In order to fix on the at-the-money strike price for options on individual securities
contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike
price interval. The in-the-money strike price and the out-of-the-money strike price shall be based
on the at-the-money strike price interval.

Expiry day: Options contracts on individual securities as well as index options shall expire on the
last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall
expire on the previous trading day.

Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till
cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at
the end of the period of 7 calendar days from the date of entering an order.

Permitted lot size: The value of the option contracts on individual securities shall not be less
than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on
individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the
next higher multiple of 100.

Price steps: The price steps in respect of all options contracts admitted to dealings on the
exchange shall be Re 0.05.

Quantity freeze: Orders which may come to the exchange as a quantity freeze shall be the
lesser of the following: 1 per cent of the marketwide position limit stipulated of options on
individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore.
In respect of such orders, which have come under quantity freeze, the member shall be required
to confirm to the exchange that there is no inadvertent error in the order entry and that the order
is genuine. On such confirmation, the exchange at its discretion may approve such order subject
to availability of turnover/exposure limits, etc.
Base price: Base price of the options contracts on introduction of new contracts shall be the
theoretical value of the options contract arrived at based on Black-Scholes model of calculation of
options premiums. The base price of the contracts on subsequent trading days will be the daily
close price of the options contracts. However in such of those contracts where orders could not
be placed because of application of price ranges, the bases prices may be modified at the
discretion of the exchange and intimated to the members.

Price ranges: There will be no day minimum/maximum price ranges applicable for the options
contract. The operating ranges and day minimum/maximum ranges for options contract shall be
kept at 99 per cent of the base price. In view of this the members will not be able to place orders
at prices which are beyond 99 per cent of the base price. The base prices for option contracts
may be modified, at the discretion of the exchange, based on the request received from trading
members as mentioned above.

Exposure limits: Gross open positions of a member at any point of time shall not exceed the
exposure limit as detailed hereunder:

• Index Options: Exposure Limit shall be 33.33 times the liquid networth.

• Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid
networth.

Memberwise position limit: When the open position of a Clearing Member, Trading Member or
Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore,
whichever is higher, in all the option contracts on the same underlying, at any time, including
during trading hours.

For option contracts on individual securities, open interest shall be equivalent to the open
positions multiplied by the notional value. Notional Value shall be the previous day's closing price
of the underlying security or such other price as may be specified from time to time.

Market wide position limits: Market wide position limits for option contracts on individual
securities shall be lower of:

*20 times the average number of shares traded daily, during the previous calendar month, in the
relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of
the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of
the free float in terms of the number of shares of a company.

The relevant authority shall specify the market wide position limits once every month, on the
expiration day of the near month contract, which shall be applicable till the expiry of the
subsequent month contract.

Exercise settlement: Exercise type shall be American and final settlement in respect of options
on individual securities contracts shall be cash settled for an initial period of 6 months and as per
the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from
time to time.

Reading Stock Option Tables

In India, option tables published in business newspapers and is fairly similar
to the regular stock tables.

The following is the format of the options table published in Indian business
news papers:
NIFTY OPTIONS
Contracts Exp.Date Str.Price Opt.Type Open High Low Trd.Qty No.of.Cont. Trd.Value
RELIANCE 7/26/01 360 CA 3 3 2 4200 7 1512000
RELIANCE 7/26/01 360 PA 29 39 29 1200 2 432000
RELIANCE 7/26/01 380 CA 1 1 1 1200 2 456000
RELIANCE 7/26/01 380 PA 35 40 35 1200 2 456000
RELIANCE 7/26/01 340 CA 8 9 6 11400 19 3876000
RELIANCE 7/26/01 340 PA 10 14 10 13800 23 4692000
RELIANCE 7/26/01 320 CA 22 24 16 11400 19 3648000
RELIANCE 7/26/01 320 PA 4 7 2 29400 49 9408000
RELIANCE 8/30/01 360 PA 31 35 31 1200 2 432000
RELIANCE 8/30/01 340 CA 15 15 15 600 1 204000
RELIANCE 8/30/01 320 PA 10 10 10 600 1 192000
RELIANCE 7/26/01 300 CA 38 38 38 600 1 180000
RELIANCE 7/26/01 300 PA 2 2 2 1200 2 360000
RELIANCE 7/26/01 280 CA 59 60 53 1800 3 504000

 The first column shows the contract that is being traded i.e Reliance.
 The second coloumn displays the date on which the contract will expire i.e. the expiry date is the
last Thursday of the month.
 Call options-American are depicted as 'CA' and Put options-American as 'PA'.
 The Open, High, Low, Close columns display the traded premium rates.

Advantages of option trading

Risk management: Put options allow investors holding shares to hedge against a possible fall in
their value. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in. This gives
the call option holder until the Expiry Day to decide whether or not to exercise the option and buy
the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.

Speculation: The ease of trading in and out of an option position makes it possible to trade
options with no intention of ever exercising them. If an investor expects the market to rise, they
may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way
the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a
lower cost than shares, as there is no stamp duty payable unless and until options are exercised.

Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay
than investing directly. However, leverage usually involves more risks than a direct investment in
the underlying shares. Trading in options can allow investors to benefit from a change in the price
of the share without having to pay the full price of the share.
We can see below how one can leverage ones position by just paying the premium.

Option Premium Stock

Bought on Oct 15 Rs 380 Rs 4000
Sold on Dec 15 Rs 670 Rs 4500
Profit Rs 290 Rs 500
ROI (Not annualised) 76.3% 12.5%

Income generation: Shareholders can earn extra income over and above dividends by writing
call options against their shares. By writing an option they receive the option premium upfront.
While they get to keep the option premium, there is a possibility that they could be exercised
against and have to deliver their shares to the taker at the exercise price.

Strategies: By combining different options, investors can create a wide range of potential profit
scenarios. To find out more about options strategies read the module on trading strategies.

Glossary
American style: Type of option contract which allows the holder to exercise at any time up to
and including the Expiry Day.

Annualised return: The return or profit, expressed on an annual basis, the writer of the option
contract receives for buying the shares and writing that particular option.

Assignment: The random allocation of an exercise obligation to a writer. This is carried out by
the exchanges.

At-the-money: When the price of the underlying security equals the exercise price of the option.

Buy and write: The simultaneous purchase of shares and sale of an equivalent number of option
contracts.

Call option: An option contract that entitles the taker (buyer) to buy a fixed number of the
underlying shares at a stated price on or before a fixed Expiry Day.

Class of options: Option contracts of the same type – either calls or puts - covering the same
underlying security.

Delta: The rate in change of option premium due to a change in price of the underlying securities.

Derivative: An instrument which derives its value from the value of an underlying instrument
(such as shares, share price indices, fixed interest securities, commodities, currencies, etc.).
Warrants and options are types of derivative.

European style: Type of option contract, which allows the holder to exercise only on the Expiry
Day.
Exercise price: The amount of money which must be paid by the taker (in the case of a call
option) or the writer (in the case of a put option) for the transfer of each of the underlying
securities upon exercise of the option.

Expiry day: The date on which all unexercised options in a particular series expire.

Hedge: A transaction, which reduces or offsets the risk of a current holding. For example, a put
option may act as a hedge for a current holding in the underlying instrument.

Implied volatility: A measure of volatility assigned to a series by the current market price.

In-the-money: An option with intrinsic value.

Intrinsic value: The difference between the market value of the underlying securities and the
exercise price of the option. Usually it is not less than zero. It represents the advantage the taker
has over the current market price if the option is exercised.

Long-term option: An option with a term to expiry of two or three years from the date the series
was first listed. (This is not available in currently in India)

Multiplier: Is used when considering index options. The strike price and premium of an index
option are usually expressed in points.

Open interest: The number of outstanding contracts in a particular class or series existing in the
option market. Also called the "open position".

Out-of-the-money: A call option is out-of-the-money if the market price of the underlying

securities is below the exercise price of the option; a put option is out-of-the-money if the market
price of the underlying securities is above the exercise price of the options.

Premium: The amount payable by the taker to the writer for entering the option. It is determined
through the trading process and represents current market value.

Put option: An option contract that entitles the taker (buyer) to sell a fixed number of underlying
securities at a stated price on or before a fixed Expiry Day.

Series of options: All contracts of the same class having the same Expiry Day and the same
exercise price.

Time value: The amount investors are willing to pay for the possibility that they could make a
profit from their option position. It is influenced by time to expiry, dividends, interest rates, volatility
and market expectations.

Underlying securities: The shares or other securities subject to purchase or sale upon exercise
of the option.

Volatility: A measure of the expected amount of fluctuation in the price of the particular
securities.

Writer: The seller of an option contract.