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A Stock Index is a number that helps you measure the levels of the
market. Most stock indexes attempt to be proxies for the market they
exist in.
This portfolio is called the index portfolio and attempts a high degree
of correlation with the market.
This is because for someone who wishes to replicate the return on the
market it is infinitely more expensive to buy the whole market and for
small portfolio sizes it is almost impossible.
In India both the BSE-30 Sensex and the S&P CNX Nifty are market
capitalisation weighted indexes.
Typically exchanges around the world compute their own index and
own it too. The Sensex and the Nifty are case in point.
There are notable exceptions like the S&P 500 Index in the U.S.
(owned by S&P which is a credit rating company) and the Strait Times
Index in Singapore (owned by the newspaper of the same name).
Selection Criteria
Industry Representation
Market Capitalisation
It is important from the point of usability for all the stocks that are
part of the index to be highly liquid. The reasons are two-fold.
An illiquid stock has stale prices and this tends to give a flawed value
to the index.
Further for passive fund managers, the entry and exit cost at a
particular index level is high if the stocks are illiquid. This cost is also
called the impact cost of the index.
These are pretty popular world wide with non-resident investors who
like to take an exposure to the entire market.
S&P’s SPDRs and MSCI’s WEBS products are amongst the most
popular products.
Index futures
Index futures are possibly the single most popular exchange traded
derivatives products today.
The S&P 500 futures products is the largest traded index futures
product in the world.
In India both the BSE and NSE are due to launch their own index
futures product on their benchmark indexes the Sensex and the Nifty.
In the age of cross border capital flows and global funds, global index
provider provide the uniformity and standardization in their index
philosophy and methodologies that allows a global fund to compare
performance across regions or sectors.
The future in India looks pretty exciting with Index futures being
launched and Index options expected to follow. Hopefully with the
growing popularity of ETF’s we might see SEBI allowing them in India
too.
Introduction to Derivatives
Derivative is a product/contract which does not have any value on its
own i.e. it derives its value from some underlying.
Forward contracts
Future contracts
Options
Pricing Futures
Set of assumptions
S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.
Hedge terminology
o Daily Margins
o Initial Margins
o Special Margins
Daily Margins
Initial Margins
Naked positions
Short positions 100 [exp (3st ) - 1]
Long positions 100 [1 - exp (3st)]
Where (st)2 = l(st-1)2 + (1-l)(rt2)
Spread positions
• Liquid assets
Customer level
Market level
• Higher liquidity
Future
Terminology
Call Options
Put Options
Market players
Options undertakings
Options Classifications
OPTIONS PRICING
TRADING STRATEGIES
SPREADS
Terminology
Options are of two basic types: The Call and the Put Option
A call option gives the holder the right to buy an underlying asset
by a certain date for a certain price. The seller is under an obligation
to fulfill the contract and is paid a price of this which is called "the
call option premium or call option price".
A put option, on the other hand gives the holder the right to sell an
underlying asset by a certain date for a certain price. The buyer is
under an obligation to fulfill the contract and is paid a price for this,
which is called "the put option premium or put option price".
There are two kind of options based on the date. The first is the
European Option which can be exercised only on the maturity date.
The second is the American Option which can be exercised before
or on the maturity date.
Cash settled options are those where, on exercise the buyer is paid
the difference between stock price and exercise price (call) or
between exercise price and stock price (put). Delivery settled
options are those where the buyer takes delivery of undertaking
(calls) or offers delivery of the undertaking (puts).
Call Options
The following example would clarify the basics on Call Options.
Illustration 1:
An investor buys one European Call option on one share of Reliance
Petroleum at a premium of Rs. 2 per share on 31 July . The strike
price is Rs.60 and the contract matures on 30 September . The
payoffs for the investor on the basis of fluctuating spot prices at any
time are shown by the payoff table (Table 1). It may be clear form the
graph that even in the worst case scenario, the investor would only
lose a maximum of Rs.2 per share which he/she had paid for the
premium. The upside to it has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart
completely reverse of the call options buyer. The maximum loss that
he can have is unlimited though a profit of Rs.2 per share would be
made on the premium payment by the buyer.
A European call option gives the following payoff to the investor: max
(S - Xt, 0).
The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at time 't'
C - European Call Option Premium
Payoff - Max (S - Xt, O )
Graph
Exercising the Call Option and what are its implications for the
Buyer and the Seller?
The Call option gives the buyer a right to buy the requisite shares on
a specific date at a specific price. This puts the seller under the
obligation to sell the shares on that specific date and specific price.
The Call Buyer exercises his option only when he/ she feels it is
profitable. This Process is called "Exercising the Option". This leads
us to the fact that if the spot price is lower than the strike price then
it might be profitable for the investor to buy the share in the open
market and forgo the premium paid.
Put Options
The European Put Option is the reverse of the call option deal. Here,
there is a contract to sell a particular number of underlying assets
on a particular date at a specific price. An example would help
understand the situation a little better:
Illustration 2:
An investor buys one European Put Option on one share of Reliance
Petroleum at a premium of Rs. 2 per share on 31 July. The strike
price is Rs.60 and the contract matures on 30 September. The payoff
table shows the fluctuations of net profit with a change in the spot
price.
Graph
These are the two basic options that form the whole gamut of
transactions in the options trading. These in combination with other
derivatives creat a whole world of instruments to choose form
depending on the kind of requirement and the kind of market
expectations.
Market players
Options undertakings
Stocks
Foreign Currencies
Stock Indices
Commodities
Others - Futures Options, are options on the futures contracts or
underlying assets are futures contracts. The futures contract
generally matures shortly after the options expiration
Options Classifications
Options are often classified as
In the money - These result in a positive cash flow towards the
investor
At the money - These result in a zero-cash flow to the investor
Out of money - These result in a negative cash flow for the investor
Example:
Calls
Reliance 350 Stock Series
Naked Options: These are options which are not combined with an
offsetting contract to cover the existing positions.
OPTIONS PRICING
Favourable
Unfavourable
SPOT PRICES: In case of a call option the payoff for the buyer is
max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it
is favourable for the buyer. It is the other way round for the seller,
more the Spot Price higher are the chances of his going into a loss.
STRIKE PRICE: In case of a call option the payoff for the buyer is
shown above. As per this relationship a higher strike price would
reduce the profits for the holder of the call option.
In case of the put option both these factors increase and lead to a
decline in the put value. A higher expected growth leads to a higher
price taking the buyer to the position of loss in the payoff chart. The
discounting factor increases and the future value becomes lesser.
TRADING STRATEGIES
Strategy 1:
By this the investor covers the position that he got in on the call
option contract and if the investor has to fulfill his/her obligation on
the call option then can fulfill it using the Rel.Petrol. share on which
he/she entered into a long contract. The payoff table below shows the
Net Profit the investor would make on such a deal.
Strategy 2:
The payoff chart describes the payoff of buying the call option at the
various spot rates and the profit from selling the share at Rs.58 per
share at various spot prices. The net profit is shown by the thick line.
Illustration 5:
An investor enters into buying a put option on one share of Rel. Petrol.
At a strike price of Rs.60 and a premium of Rs.6 per share. The
maturity date is two months from now and alongwith this option
he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per
share.
Strategy 4:
This strategy is just the reverse of the above and looks at the case of
taking short positions on the tock as well as on the put option.
Illustration 6:
An investor enters into selling a put option on one share of Rel. Petrol.
At a strike price of Rs.60 and a premium of Rs.6 per share. The
maturity date is two months from now and alongwith this option
he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per
share.
All the four cases describe a single option with a position in a stock.
Some of these cases look similar to each other and these can be
explained by Put-Call Parity.
Or
The second equation shows that a long position in a stock and a short
position in a call is equivalent to the short put position and cash
equivalent to Xe-r(T-t) + D.
The first equation shows a long position in a stock combined with long
put position is equivalent to a long call position plus cash equivalent
to Xe-r(T-t) + D.
Top
SPREADS
The above involved positions in a single option and squaring them off
in the spot market. The spreads are a little different. They involve
using two or more options of the same type in the transaction.
Strategy 1:
Bull Spread:
Illustration
The premium on call with X1 would be more than the premium on call
with X2. This is because as the strike price rises the call option
becomes unfavourable for the buyer. The payoffs could be generalised
as follows.
S >= X2 S - X1 X2 - S X2 - X1 X2 - X1 - c1 + Both
c2
S >= X1 0 0 0 c2 - c1 None
The spread could be in the money, on the money and out of money.
Another side of the Bull Spread is that on the Put Side. Buy at a low
strike price and sell the same stock put at a higher strike price.
This contract would involve an initial cash inflows unlike the Bull
Spread based on the Call Options. The premium on the low strike put
option would be lower than the premium on the higher strike put
option as more the strike price more is favourability to buy the put
option on the part of the buyer.
Illustration