Products in derivatives market

PRODUCTS IN DERIVATIVES MARKET
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A PROJECT REPORT ON
BY JASMEET SINGH

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I. Derivatives markets, products and participants
1. Introduction
Derivatives have been associated with a number of high-profile corporate events
that roiled the global financial markets over the past two decades. To some critics,
derivatives have played an important role in the near collapses or bankruptcies of
Barings Bank in 1995,
Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in and
American International Group (AIG) in 2008. Warren Buffet even viewed derivatives
as time bombs for the economic system and called them financial weapons of mass
destruction (Berkshire Hathaway Inc (2002)).
But derivatives, if “properly” handled, can bring substantial economic benefits. These
Instruments help economic agents to improve their management of market and
credit risks.
The key differences of these markets will be highlighted. Section 6 reviews some
recent credit events and to what extent counterparty risk has played a role.

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2. ORIGIN OF FINANCIAL DERIVATIVES
Financial derivatives have emerged as one of the biggest markets of the world during the past
two decades. A rapid change in technology has increased the processing power of computers and
has made them a key vehicle for information processing in financial markets. Globalization of
financial markets has forced several countries to change laws and introduce innovative financial
contracts which have made it easier for the participants to undertake derivatives transactions.
Early forward contracts in the US addressed merchants‘ concerns about ensuring that there were
buyers and sellers for commodities. ‗Credit risk‘, however remained a serious problem. To deal
with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT)
in 1848. The primary intention of the CBOT was to provide a centralized location (which would
be known in advance) for buyers and sellers to negotiate forward contracts. In 1865, the CBOT
went one step further and listed the first ‗exchange traded‖ derivatives contract in the US. These
contracts were called ‗futures contracts‖. In 1919, Chicago Butter and Egg Board, a spin-off of
CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile
Exchange (CME).
The CBOT and the CME remain the two largest organized futures exchanges, indeed the two
largest ―financial‖ exchanges of any kind in the world today. The first exchange-traded financial
derivatives emerged in 1970‘s due to the collapse of fixed exchange rate system and adoption of
floating exchange rate systems. As the system broke down currency volatility became a crucial
problem for most countries. To help participants in foreign exchange markets hedge their risks
under the new floating exchange rate system. Foreign currency futures were introduced in 1972
at the Chicago Mercantile Exchange.
In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange
(CBOE) to facilitate the trade of options on selected stocks. The first stock index futures contract
was traded at Kansas City Board of Trade. Currently the most popular stock index futures

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3. Some concepts basic and Growth of Derivatives Market
The Oxford dictionary defines a derivative as something derived or obtained from
another, coming from a source; not original. In the field of financial economics, a
derivative security is generally referred to a financial contract whose value is derived
from the value of an underlying asset or simply underlying.
There are a wide range of financial assets that have been used as underlying,
including equities or equity index, fixed-income instruments, foreign
Currencies, commodities, credit events and even other derivative securities.
Depending on the types of underlying, the values of the derivative contracts can be
derived from the corresponding equity prices, interest rates, exchange rates,
commodity prices and the probabilities of certain credit events.
The derivative market growth is spectacular. In order to understand modern day finance you must at
least have an idea about what derivatives are and how they function. Monitoring certain derivatives
markets can be crucial in understanding market risk which has a direct effect on equities as equities are
usually the last to respond to market developments in terms of other securities. For investors who do
not have a large capital base or tons of money to invest with, understanding current market risk is vital.
We may not have the cash/liquidity to ride out spouts of deflationary markets. Seeing your stock
position down over 50% can be disheartening. Above is a chart of the growth in the derivatives market.

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II. Major types of derivatives
There are five main types of derivatives contracts: forwards; futures, options
warrants and swaps.
This section discusses the basics of these five types of derivatives with the help of
some specific examples of these instruments.

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1. Forwards and futures contracts
Forward and futures contracts are usually discussed together as they share a similar
feature:
a forward or futures contract is an agreement to buy or sell a specified quantity of an
asset at a specified price with delivery at a specified date in the future.
But there are important differences in the ways these contracts are transacted. First,
participants trading futures can realise gains and losses on a daily basis while
forwards transaction requires cash settlement at delivery. Second, futures contracts
are standardised while forwards are customised to meet the special needs of the
two parties involved (counterparties). Third, unlike futures contracts which are
settled through established clearing house, forwards are settled between the
counterparties. Fourth, because of being exchange-traded, futures are regulated
whereas forwards, which are mostly over-the-counter (OTC) contracts, and loosely
regulated (at least in the run up to the global financial crisis).
This importance of exchange-traded versus OTC instruments will be discussed
further in later section.
2. Options contracts
Options contracts can be either standardized or customized. There are two types of
option: call and put options. Call option contracts give the purchaser the right to buy
a specified quantity of a commodity or financial asset at a particular price (the
exercise price) on or before a certain future date (the expiration date). Similarly, put
option contracts give the buyer the right to sell a specified quantity of an asset at a
particular price on a before a certain future date. These definitions are based on the
so-called American-style option. And for a European style option, the contract can
only be exercised on the expiration date.
In options transaction, the purchaser pays the seller – the writer of the options – an
amount for the right to buy or sell. This amount is known as the option premium.
Note that an important difference between options contracts and futures and
forwards contracts is that options do not require the purchaser to buy or sell the
underlying asset under all circumstances. In the event that options are not exercised
at expiration, the purchaser simply loses the premium paid. If the options are
exercised, however, the option writer will be liable for covering the costs of any
changes in the value of the underlying that benefit the purchasers.

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3. Swaps
Swaps are agreements between two counterparties to exchange a series of
cash payments for a stated period of time. The periodic payments can be charged
on fixed or floating interest rates, depending on contract terms. The calculation of
these payments is based on an agreed-upon amount, called the notional principal
amount or simply the notional
.

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III . FORWARDS
1. Meaning
A forward contract is a private transaction - a futures contract is not. Futures contracts are
reported to the future's exchange, the clearing house and at least one regulatory agency. The
price is recorded and available from pricing services.
Forwards have credit risk, but futures do not because a clearing house guarantees against default
risk by taking both sides of the trade and marking to market their positions every night. Mark to
market is the process of converting daily gains and losses into actual cash gains and losses each
night. As one party loses on the trade the other party gains, and the clearing house moves the
payments for the counterparty through this process.
Forwards are basically unregulated, while future contract are regulated at the federal
government level. The regulation is there to ensure that no manipulation occurs, that trades are
reported in a timely manner and that the professionals in the market are qualified and honest.
What are forward deals?
A forward deal is a contract where the buyer and seller agree to buy or sell an asset or currency
at a spot rate for a specified date in the future (usually up to 60 days). Forward contracts are
conducted as a way to cover (hedge) future movements in exchange rates. Margin spreads are
higher than in Day Trading but no renewal fees are charged. Forward deals with easy-forex®
are
only offered in some world regions.

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In Global Financial Markets, for many years, options have been a means of conveying
rights from one party to another at a specified price on or before a specific date. Options to buy
and sell are commonly executed in real estate and equipment transactions, just as they have been
for years in the securities markets. There are two types of option agreements: CALLS and PUTS.
A CALL OPTION is a contract that conveys to the owner the right, but not the
obligation, to purchase a prescribed number of shares or futures contracts of an
underlying security at a specified price before or on a specific expiration date.
A PUT OPTION is a contract that conveys to the owner the right, but not obligation,
to sell a prescribed number of shares or futures contracts of an underlying security at a
specified price before or on a specific expiration date.
Consequently, if the market in a security were expected to advance, a trader would
purchase a call and, conversely, if the market in a security were expected to decline, a trader
would purchase a put. With the advent of listed options, the inconvenience and difficulties
originally associated with transacting options have been greatly diminished.
Exchange-traded options have many benefits including flexibility, leverage, limited
risk for buyers employing these strategies, and contract performance guaranteed by Stock
Exchanges. Options allow you to participate in price movements without committing the large
amount of funds needed to buy stock outright. Options can also be used to hedge a stock
position, to acquire or sell stock at a purchase price more favorable than the current market price,
or, in the case of writing (selling) options, to earn premium income. Options give you options.
You‘re not just limited to buying, selling or staying out of the market. With options, you can
tailor your position to your own financial situation, stock market outlook and risk tolerance.
Whether you are a conservative or growth-oriented investor, or even a short-term,
aggressive trader, your broker can help you select an appropriate options strategy. The strategies
presented do not cover all, or even a significant number, of the possible strategies utilizing
options. These are the most basic strategies, however, and will serve well as building blocks for
more complex strategies.

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Despite their many benefits, options are not suitable for all investors. Individuals should
not enter into option transactions until they have read and understood the risk disclosure section
coming later in this document which outlines the purposes and risks thereof. Further, if you have
only limited or no experience with options, or have only a limited understanding of the terms of
option contracts and basic option pricing theory, you should examine closely another industry
document.
Options are currently traded on the following Indian exchanges: The Stock Exchange,
Mumbai (BSE) and National Stock Exchange (NSE). Like trading in stocks, an option trading is
regulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly markets
for the Purchase and sale of standardized options. It must be noted that, despite the efforts of
each exchange to provide liquid markets, under certain conditions it may be difficult or
impossible to liquidate an option position.

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2. Settlement of forward contracts
Forward Markets and Contracts: Settlement Procedures
The differences between long and short positions in forward markets are as follows:
The long position holder is the buyer of the contract and the short position holder is the
seller of the contract.
The long position will take the delivery of the asset and pay the seller of the asset the
contract value, while the seller is obligated to deliver the asset versus the cash value of
the contract at the origination date of this transaction.
When it comes to default, both parties are at risk because typically no cash is exchanged
at the beginning of the transaction. However, some transactions do require that one or
both sides put up some form of collateral to protect them from the defaulted party.
Procedures for Settling a Forward Contract at Expiration
A forward contact at expiration can be settled in one of two ways:
1. Physical Delivery - Refers to an option or futures contract that requires the actual
underlying asset to be delivered on the specified delivery date, rather than being traded
out with offsetting contracts. Most derivatives are not actually exercised, but are traded
out before their delivery dates. However, physical delivery still occurs with some trades:
it is most common with commodities, but can also occur with other financial instruments.
Settlement by physical delivery is carried out by clearing brokers or their agents.
Promptly after the last day of trading, the regulated exchange's clearing organization will
report a purchase and sale of the underlying asset at the previous day's settlement price
(also referred to as the "invoice price"). Traders who hold a short position in a physically
settled security futures contract to expiration are required to make delivery of the
underlying asset. Those who already own the assets may tender them to the appropriate
clearing organization. Traders who do not own assets are obligated to purchase them at
the current price.

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2. Exchanges specify the conditions of delivery for the contracts they cover. Acceptable
locations for delivery (in the case of commodities or energies) and requirements as to the
quality, grade or nature of the underlying asset to be delivered are regulated by the
exchanges. For example, only certain Treasury bonds may be delivered under the
Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may be
delivered under the Coffee, Sugar and Cocoa Exchange's coffee future. In many
commodity or energy markets, parties want to settle futures by delivery, but exchange
rules are too restrictive for their needs. For example, the New York Mercantile Exchange
requires that natural gas be delivered only at the Henry Hub in Louisiana, a location that
may not be convenient for all futures traders.
3. Cash Settlement - Refers to an option or futures contract that requires the counterparties
to the contract to net out the cash difference in the value of their positions. The
appropriate party receives the cash difference. In the case of cash settlement, no actual
assets are delivered at the expiration of a futures contract. Instead, traders must settle any
open positions by making or receiving a cash payment based on the difference between
the final settlement price and the previous day's settlement price. Under normal
circumstances, the final settlement price for a cash-settled contract will reflect the
opening price for the underlying asset. Once this payment is made, neither the buyer nor
the seller of the futures contract has any further obligations on the contract.
Example: Settling a Forward Contract
Let's return to our sailboat example from the first part of this section. Assume that at the end of
12 months you are a bit ambivalent about sailing. In this case, you could settle your forward
contract with John in one of two ways:
1. Physical Delivery - John delivers that sailboat to you and you pay him $150,000, as
agreed.
2. Cash Settlement - John sends you a check for $35,000. (The difference between your
contract's purchase price of $150,000 and the sail boat's current market value of
$165,000.)
The same options are available if the current market price is lower than the forward contract's
settlement price. If John's sailboat decreases in value to $135,000, you could simply pay John
$15,000 to settle the contract, or you could pay him $150,000 and take physical possession of the
boat. (You would still suffer a $15,000 loss when you sold the boat for the current price of
$135,000.)

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3. KEY FEATURES OF FORWARD CONTRACTS
A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to
buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a
later time, but the price is determined at the time of purchase. Key features of forward contracts
are:
Highly customized - Counterparties can determine and define the terms and features to fit
their specific needs, including when delivery will take place and the exact identity of the
underlying asset.
All parties are exposed to counterparty default risk - This is the risk that the other party
may not make the required delivery or payment.
Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
Underlying assets can be a stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
They tend to be held to maturity and have little or no market liquidity.
Any commitment between two parties to trade an asset in the future is a forward contract.
Example
Let's assume that you have just taken up sailing and like it so well that you expect you might buy
your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to
upgrade to a newer, larger model in 12 months. You and John could enter into a forward contract
in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in 12 months
for that price. In this scenario, as the buyer, you have entered a long forward contract.
Conversely, John, the seller will have the short forward contract. At the end of one year, you find
that the current market valuation of John's sailboat is $165,000. Because John is obliged to sell
his boat to you for only $150,000, you will have effectively made a profit of $15,000. (You can
buy the boat from John for $150,000 and immediately sell it for $165,000.) John, unfortunately,
has lost $15,000 in potential proceeds from the transaction.
Like all forward contracts, in this example, no money exchanged hands when the contract was
negotiated and the initial value of the contract was zero.

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4. Default Risk in Forward Contract
A drawback of forward contracts is that they are subject to default risk. Regardless
of whether the contract is for physical or cash settlement, there exists a potential
for one party to default, i.e. not honor the contract. It could be either the buyer or
the seller. This results in the other party suffering a loss. This risk of making
losses due to any of the two parties defaulting is known as counter party risk.

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VI. FUTURES
1. Introduction
A futures contract is an agreement between a buyer and a seller that calls for the seller to deliver
to the buyer a specified quantity and grade of an identified commodity or security , at a fixed
date in the future , at a price agreed to when the contract is first entered into. All futures contracts
have to be bought and sold on designated contract markets known as futures exchanges.
A financial futures contract is an exchange traded contract for the delivery of standardised
amounts of the underlying financial instrument at a future date. The price for the financial
instrument is agreed on the day the contract is bought or sold and gains or losses are incurred as
a result of subsequent price fluctuations. Unlike 1forward contracts, futures contracts are readily
tradeable , reflecting the standardisation of contract terms.
The purchase or sale of a futures contract is, therefore, a commitment to make or take delivery
of a specific financial instrument, at a predetermined date in the future, for which the price is
established at the time of the initial transaction. Transactions are actually entered into in the
futures exchange either through the ―open outcry‖ method on the exchange floor or through a
screen-based trading system.
Contracts are standardised which means that participants can buy and sell them freely on the
futures exchange with precise knowledge of the contracts being traded.
The contract specifies both the type of the financial instrument and its ‗quality‘ in terms of such
matters as coupon rate and maturity. The instruments specified must be delivered at or during a
specified month in the future (known as delivery date) - usually in a cycle of March, June,
September and December. Exact delivery details vary according to the nature of the instrument
or indicator. For contracts based on stock-market indices, no physical delivery can take place,
and settlement is based on a cash payment calculated on movement of the index.
Although contracts are traded between the buyer and the seller on the exchange floor, each has
an obligation not to the other, but to the clearing house. This feature ensures that futures markets
are free of credit risk.
Participants may offset equal numbers of bought and sold contracts of the same type and delivery
month and thereby close out a position without actually communicating the original
counterparty..

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2. Evolution of futures markets -
The modern day futures markets originated in the USA in the 19th century to facilitate
the grain trade. Much of their early history is directly linked to the city of Chicago and the needs
of farmers and grain merchants. Forward pricing was regularised for only a few specific
commodities by the Chicago Board Of Trade in 1848. Formal futures trading was subsequently
established in 1865, at the time of the American Civil War and at a time when the prices of staple
commodities such as cotton and grain would fluctuate dramatically and often quite
unpredictably.
The result of all this wild fluctuations in prices was that the producers, mainly farmers,
had no idea what was a fair price to accept for their goods. The buyers and processors, on the
other hand had no control over their expenditures. All parties could see the benefits of having a
contractual agreement wherein future commodities prices could be fixed. Thus, the mechanism
of a futures contract was created and formalised specifically for the purpose of eliminating price
risk.
In 1960, 4 million contracts changed hands during the year on all futures exchanges in
USA. In 1990, nearly 280 million contracts were traded, more each week than in all of 1960. In
the last decade alone, they have jumped from 98 million to 400 million contracts. Trading in
foreign exchange futures began in 1972 and in treasury bill futures in 1977. The introduction of
stock-index futures in 1982 completed the transformation.
The changing nature of futures has brought in new types of market participants. Today,
the largest and most prestigious financial institutions such as banks, mutual funds, pension funds,
insurance companies and other endowment funds all over the world use futures as a tool in their
investment strategy. Futures markets have become an integral part of how these institutions
manage their risks and portfolio of assets.

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3. Classification of Futures Contracts:
In a futures contract there are two parties:
1. The long position, or buyer, agrees to purchase the underlying at a later date or at the
expiration date at a price that is agreed to at the beginning of the transaction. Buyers
benefit from price increases.
2. The short position, or seller, agrees to sell the underlying at a later date or at the
expiration date at a price that is agreed to at the beginning of the transaction. Sellers
benefit from price decreases.
Prices change daily in the marketplace and are marked to market on a daily basis.
At expiration, the buyer takes delivery of the underlying from the seller or the parties can agree
to make cash settlement.

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KEY FEATURES OF FUTURE CONTRACTS
Future contracts are also agreements between two parties in which the buyer agrees to buy an
underlying asset from the other party (the seller). The delivery of the asset occurs at a later time,
but the price is determined at the time of purchase.
Terms and conditions are standardized.
Trading takes place on a formal exchange wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties to trade these
contracts.
There is no default risk because the exchange acts as a counterparty, guaranteeing
delivery and payment by use of a clearing house.
The clearing house protects itself from default by requiring its counterparties to settle
gains and losses or mark to market their positions on a daily basis.
Futures are highly standardized, have deep liquidity in their markets and trade on an
exchange.
An investor can offset his or her future position by engaging in an opposite transaction
before the stated maturity of the contract.
Example: Future Contracts
Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per
bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for his
next crop, while McDonald's is trying to secure a buying price in order to determine how much
to charge for a Big Mac next year. The farmer and the corporation can enter into a futures
contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in December at a
price of $3.50 per bushel. The contract locks in a price for both parties. It is this contract - and
not the grain per se - that can then be bought and sold in the futures market.
Most transactions in the futures market are settled in cash, and the actual physical commodity is
bought or sold in the cash market. For example, let's suppose that at the expiration date in
December there is a blight that decimates the tomato crop and the spot price rises to $5.50 a
bushel. McDonald's has a gain of $2 per bushel on its futures contract but it still has to buy
tomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offset
against the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10 million
is offset against the higher price for which he can now sell his tomatoes.

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Margin Money
In the stock market, a margin is a loan that is made to the investor. It helps the investor to reduce
the amount of her own cash that she uses to purchase securities. This creates leverage for the
investor, causing gains and losses to be amplified. The loan must be paid back with interest.
Margin % = Market Value of the stock - Market value of the debt divided by the market
value of the stock
An initial margin loan in the U.S can be as much as 50%. The market value of the
securities minus the amount borrowed can often be less than 50%, but the investor must
keep a balance of 25-30% of the total market value of the securities in the margin account
as a maintenance margin.
A margin in the futures market is the amount of cash an investor must put up to open an account
to start trading. This cash amount is the initial margin requirement and it is not a loan. It acts as a
down payment on the underlying asset and helps ensure that both parties fulfill their obligations.
Both buyers and sellers must put up payments.
Initial Margin
This is the initial amount of cash that must be deposited in the account to start trading contracts.
It acts as a down payment for the delivery of the contract and ensures that the parties honor their
obligations.
Maintenance Margin
This is the balance a trader must maintain in his or her account as the balance changes due to
price fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If the
balance in the trader's account drops below this margin, the trader is required to deposit enough
funds or securities to bring the account back up to the initial margin requirement. Such a demand
is referred to as a margin call. The trader can close his position in this case but he is still
responsible for the loss incurred. However, if he closes his position, he is no longer at risk of the
position losing additional funds.
Futures (which are exchange-traded) and forwards (which are traded OTC) treat margin accounts
differently. When a trader posts collateral to secure an OTC derivative obligation such as a
forward, the trader legally still owns the collateral. With futures contracts, money transferred
from a margin account to an exchange as a margin payment legally changes hands. A deposit in a
margin account at a broker is collateral. It legally still belongs to the client, but the broker can
take possession of it any time to satisfy obligations arising from the client's futures positions

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Variation Margin
This is the amount of cash or collateral that brings the account up to the initial margin amount
once it drops below the maintenance margin.
Settlement Price
Settlement price is established by the appropriate exchange settlement committee at the close of
each trading session. It is the official price that will be used by the clearing house to determine
net gains or losses, margin requirements and the next day's price limits. Most often, the
settlement price represents the average price of the last few trades that occur on the day. It is the
official price set by the clearing house and it helps to process the day's gains and loses in
marking to market the accounts. However, each exchange may have its own particular
methodology. For example, on NYMEX (the New York Mercantile Exchange) and COMEX
(The New York Commodity Exchange) settlement price calculations depend of the level of
trading activity. In contract months with significant activity, the settlement price is derived by
calculating the weighted average of the prices at which trades were conducted during the closing
range, a brief period at the end of the day. Contract months with little or no trading activity on a
given day are settled based on the spread relationships to the closest active contract month, while
on the Tokyo Financial Exchange settlement price is calculated as the theoretical value based on
the expected volatility for each series set by the exchange.

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4. TYPES OF FUTURES CONTRACT
The different types of futures contracts are:
1. Commodity futures - These contracts relate to delivery of an underlying commodity.
These are the oldest known futures contracts and are traded in almost every country.
Oilseeds, cotton, grain, potato, gold, silver and copper are some of the commodities
covered by futures contracts.
2. Foreign exchange futures - These are futures contracts in which the underlying asset is a
particular currency. These contracts are traded most frequently in the forex markets of the
world primarily to hedge against unfavourable changes in currency rates.
3. Treasury bill futures - These futures contracts are based on the underlying Treasury bill
instruments. Specific futures contracts exist for specific duration of treasury bills. E.g. -
91 day, 182 day, and 364 day T-bill futures.
4. Futures on securities - These contracts are based on a specific underlying individual security
or share.

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5. Economic benefits of futures markets
Price Discovery –
The heart of the futures exchanges is the trading pit where buyers and sellers meet each day to
conduct business. Each trader who enters the trading pits bring with him specific market
information such as supply and demand figures, current exchange rates, inflation rates, weather
forecasts, etc., that contributes to ongoing price discovery function. As trades between buyers
and sellers are executed, the fair market value (price) of a given commodity or security is
discovered and these prices are disseminated instantaneously to businesses throughout the world.
Futures prices are viewed by businessmen and traders as leading price indicators.
Price Risk Management –
The second economic function provided by futures markets is price risk management, the
most common method being hedging. In it‘s simplest form, hedging is the practice of offsetting
the price risk inherent in any cash market position by an equal and opposite position in the
futures markets. Hedgers use futures markets as buffers protect the business from adverse price
changes that could negatively impact the bottom line profitability of the business.
Benefits for the prudent financial manager
Today‘s widespread use of futures has surprised veteran financial managers who believed they
were risky products. However, just the opposite has been proven true - major institutional
investors, faced with unprecedented changes in prices, have realised it was imprudent not to use
futures to manage cash- market price risks.
Fund managers have seen that using futures often improves the rate of return and the
overall performance of the portfolio. By including futures in their investment strategies, fund
managers may be able to reduce higher transaction costs, which they normally experience in the
cash markets.
The key benefits of using futures for the prudent financial manager are -
Lower transaction costs.
Ease of execution.
Lower market impact costs (since bid-ask spreads reduce due to greater liquidity).
Negligible counterparty default risk (since all transactions are through clearing house).

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Stock index future contract and its advantages
A stock-index futures contract is a contract to buy or sell the face value of the underlying
stock index; where the face value is defined as being the value of the index multiplied by a
specified monetary amount (called the multiplier).
This product makes it possible to equate the value of a stock index with that of a specific
basket of shares having the following specifications :-
The total value of the shares must match the monetary value of the index.
The shares selected must correspond to the set of shares used to create the index.
The amount of each holding must be in proportion to the market capitalization of each of the
companies included in the index.
The profit or loss from a stock-index futures contract that is settled on delivery is the
difference between the value of the index at delivery date and the value on the date of entering
into the contract. It is important to emphasise that the delivery at settlement date cannot be in
underlying stocks of the index, but must be in cash. The futures index at expiration is set equal to
the cash index on that day.
Advantages:
1. Actual Purchase Of Securities Not Involved - Stock index futures permit investment in the
stock market without the trouble and expense involved in buying the individual securities.
2. High Leverage Due To Margin System - Operating under a margining system, stock-index
futures allow full participation in market moves without significant commitment of capital. The
margin levels allow leverage of between 10 to 40 times.
3. Lower Transaction Costs - The transaction costs are typically 60 - 75 % lower than those for
physical share transactions.
4. Hedging Of Share Portfolio - Portfolio managers for large share portfolios can hedge the value
of their investment against adverse fluctuations without having to alter the composition of the
portfolio periodically.

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Impact of stock-index futures on cash markets
Since the introduction of stock-index futures in USA in 1982, the trading of these products has
become very popular worldwide. The stock-index futures have outpaced the traditional cash
markets in terms of volumes traded and popularity. One of the reasons for the success of stock-
index futures is its ability to provide a new dimension to trading for a whole spectrum of traders
from long-term investors to aggressive speculators
Introduction of trading in stock-index futures would increase volume in the underlying secondary
markets in India. The trading in stock-index futures would also make the markets more complete
than before. Therefore, there is ample evidence to support the introduction of futures trading in
India

25
Effects of the futures markets on spot market -
Researchers have argued that futures contracts have a beneficial impact on the markets
for reasons like completion of otherwise incomplete markets, expansion of information available
to market participants and the pooling of risk across securities and investors. On the other hand,
it has been claimed by some, mainly market observers and policy makers, that futures contracts
encourage speculation in the underlying assets market, with all its deleterious side effects, which
are accentuated by the rapid advances and disseminations, information processing, trading
technology and architecture of the markets.
The most widespread argument is that futures markets are inherently more volatile than
cash markets, presumably because their participants are more highly leveraged and speculatively
oriented than cash market investors. It is feared that such excess volatility may spill over from
the futures markets by risk arbitrage and portfolio insurance. This fear stems from the belief that
futures markets bring with them uninformed or irrational speculators, who trade in the cash
market as well as the futures markets. It is argued that such speculators drive the prices up or
down in quest for short-run ―bandwagon‖ profits(Stein, 1961)1
. Economists have analysed these
arguments and have concluded that it would take a considerable number of speculators to
destabilse cash markets.
Influence of Programmed trading on Share price volatility
Programmed trading may increase the volatility of an index computed from the prices of the last
trade in each share. An analysis of the effects of programmed trading on the volatility of the S&P
500 index found that fluctuations in the last trade prices due to switching between the bid and
ask prices had led to a considerable increase in the spot volatility(Harris, Soriano‘s and Shapiro,
1990)

26
6. TRADE PROCESS
In electronic trading, customers (who have been pre-approved by a brokerage for electronic
trading) send buy or sell orders directly from their computers to an electronic marketplace
offered by the relevant exchange. There are no brokers involved in the process. Traders see the
various bids and offers on their computers. The trade is executed by the traders lifting bids or
hitting offers on their computer screens. The trading pit is, in essence, the trading screen and the
electronic market participants replace the brokers standing in the pit. Electronic trading offers
much greater insight into pricing because the top five current bids and offers are posted on the
trading screen for all market participants to see. Computers handle all trading activity - the
software identifies matches of bids and offers and generally fills orders according to a first-in,
first-out (FIFO) process. Dissemination of information is also faster on electronic trades. Trades
made on CME® Globex®, for example, happen in milliseconds and are instantaneously
broadcast to the public. In open outcry trading, however, it can take from a few seconds to
minutes to execute a trade.
Price Limit
This is the amount a futures contract's price can move in one day. Price limits are usually set in
absolute dollar amounts - the limit could be $5, for example. This would mean that the price of
the contract could not increase or decrease by more than $5 in a single day.
Limit Move
A limit move occurs when a transaction takes place that would exceed the price limit. This
freezes the price at the price limit.
Limit Up
The maximum amount by which the price of a futures contract may advance in one trading day.
Some markets close trading of these contracts when the limit up is reached, others allow trading
to resume if the price moves away from the day's limit. If there is a major event affecting the
market's sentiment toward a particular commodity, it may take several trading days before the
contract price fully reflects this change. On each trading day, the trading limit will be reached
before the market's equilibrium contract price is met.
Limit Down
This is when the price decreases and is stuck at the lower price limit. The maximum amount by
which the price of a commodity futures contract may decline in one trading day. Some markets
close trading of contracts when the limit down is reached, others allow trading to resume if the
price moves away from the day's limit. If there is a major event affecting the market's sentiment
toward a particular commodity, it may take several trading days before the contract price fully
reflects this change. On each trading day, the trading limit will be reached before the market's
equilibrium contract price is met.
Locked Limit
Occurs when the trading price of a futures contract arrives at the exchange's predetermined limit
price. At the lock limit, trades above or below the lock price are not executed. For example, if a
futures contract has a lock limit of $5, as soon as the contract trades at $5 the contract would no

27
longer be permitted to trade above this price if the market is on an uptrend, and the contract
would no longer be permitted to trade below this price if the market is on a downtrend. The main
reason for these limits is to prevent investors from substantial losses that can occur as a result of
the volatility found in futures markets.
Futures - Marking to Market Process
 Futures contracts are ―marked to market‖ daily.
 Generates cash flows to (or from) holders of foreign currency futures from
(or to) the clearing house.
At the initiation of the trade, a price is set and money is deposited in the account.
At the end of the day, a settlement price is determined by the clearing house. The account
is then adjusted accordingly, either in a positive or negative manner, with funds either
being drawn from or added to the account based on the difference in the initial price and
the settlement price.
The next day, the settlement price is used as the base price.
As the market prices change through the next day, a new settlement price will be
determined at the end of the day. Again, the account will be adjusted by the difference in
the new settlement price and the previous night's price in the appropriate manner.
If the account falls below the maintenance margin, the investor will be required to add additional
funds into the account to keep the position open or allow it to be closed out. If the position is
closed out the investor is still responsible for paying for his losses. This process continues until
the position is closed out.
 Mechanics:
 Buy a futures contract this morning at the price of f0,T
 At the end of the day, the new price is f1,T
 The change in your futures account will be:
[f1,T - f0,T] x Contract Face Value = Cash Flow

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V. Futures vs. Forwards
Futures differ from forwards in several instances:
1. A forward contract is a private transaction - a futures contract is not. Futures contracts are
reported to the future's exchange, the clearing house and at least one regulatory agency.
The price is recorded and available from pricing services.
2. A future takes place on an organized exchange where the all of the contract's terms and
conditions, except price, are formalized. Forwards are customized to meet the user's
special needs. The future's standardization helps to create liquidity in the marketplace
enabling participants to close out positions before expiration.
3. Forwards have credit risk, but futures do not because a clearing house guarantees against
default risk by taking both sides of the trade and marking to market their positions every
night. Mark to market is the process of converting daily gains and losses into actual cash
gains and losses each night. As one party loses on the trade the other party gains, and the
clearing house moves the payments for the counterparty through this process.
4. Forwards are basically unregulated, while future contract are regulated at the federal
government level. The regulation is there to ensure that no manipulation occurs, that
trades are reported in a timely manner and that the professionals in the market are
qualified and honest.

29
Difference between Forward & Future Contract

30
Futures vs. Forwards

31
V. OPTIONS
1. HISTORY
Ancient Origins
Although it isn‘t known exactly when the first option contract traded, it is known that the
Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a
mathematician and philosopher in ancient Greece used options to secure a low price for olive
presses in advance of the harvest. Thales had reason to believe the olive harvest would be
particularly strong. During the off-season when demand for olive presses was almost non-
existent, he acquired rights—at a very low cost—to use the presses the following spring. Later,
when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the
equipment to others at a much higher price.
Early Options in America
In America, options appeared on the scene around the same time as stocks. In the early
19thCentury, call and put contracts—known as ―privileges‖—were not traded on an exchange.
Because the terms differed for each contract, there wasn‘t much in the way of a secondary
market. Instead, it was up to the buyers and sellers to find each other. This was typically
accomplished when firms offered specific calls and puts in newspaper ads.
Chicago Board of Trade
In the late 1960s, as exchange volume for commodities began to shrink, the Chicago
Board of Trade (CBOT) explored opportunities for diversification into the option market. Joseph
W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option
market and concluded that two key ingredients for success were missing.
To replace the put-call dealers, who served only as intermediaries, the CBOT created a
system in which market makers were required to provide two-sided markets. At the same time,
the presence of multiple market makers made for a competitive atmosphere in which buyers and
sellers alike could be assured of getting the best possible price.

32
Chicago Board Options Exchange (CBOE)
After four years of study and planning, the Chicago Board of Trade established the Chicago
Board Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, 1973.
The CBOE‘s first home was actually a smoker‘s lounge at the Chicago Board of Trade. After achieving
first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following
year. Along the way, the new exchange achieved several important milestones.
As the number of underlying stocks with listed options doubled to 32, exchange membership
doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance
companies to include options in their portfolios. For these reasons, option volume continued to grow. By
the end of 1974, average daily volume exceeded 200,000 contracts.
Exchange Traded Options
There are a variety of different types of options (e.g., stock options, index options). Once the
basic principles are understood, they can easily be applied to the other financial instruments. Exchange-
traded stock options, also known as equity options, differ from those granted to employees by their
company in a number of important ways.

33
2. Meaning
WHAT IS AN OPTION?
We all know many opportunities exist in trading today. Everywhere you turn, someone is
waiting to inform you of the tremendous profits to be realized in the stock and futures markets.
However, many people are unaware of the derivative trading possibilities that are available
within and across several different markets. Option trading is just one of the many ways to
participate in these secondary markets. And contrary to popular belief, this potential trading
arena is not limited strictly to the practice of selling or writing options.
Options are an important element of investing in markets, serving a function of managing
risk and generating income. Unlike most other types of investments today, options provide a
unique set of benefits. Not only does option trading provide a cheap and effective means of
hedging one‘s portfolio against adverse and unexpected price fluctuations, but it also offers a
tremendous speculative dimension to trading.
One of the primary advantages of option trading is that option contracts enable a trade to
be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual
cost. And since an option‘s price mirrors that of the underlying asset at the very least, any
favorable return in the asset will be met with a greater percentage return in the option provides
limited risk and unlimited reward.
With options, the buyer can only lose what was paid for the option contract, which is a
fraction of what the actual cost of the asset would be. However, the profit potential is unlimited
because the option holder possesses a contract that performs in sync with the asset itself. If the
outlook is positive for the security, so too will the outlook be for that asset‘s underlying options.
Options also provide their owners with numerous trading alternatives. Options can be
customized and combined with other options and even other investments to take advantage of
any possible price dislocation within the market. They enable the trader or investor to acquire a
position that is appropriate for any type of market outlook that he or she may have, be it bullish,
bearish, choppy, or silent.

34
CALL and PUT
 Call: gives the holder the right to buy
 Put: gives the holder the right to sell
An option is common form of a derivative. It's a contract, or a provision of a contract, that gives
one party (the option holder) the right, but not the obligation to perform a specified
transaction with another party (the option issuer or option writer) according to specified terms.
Options can be embedded into many kinds of contracts. For example, a corporation might issue
a bond with an option that will allow the company to buy the bonds back in ten years at a set
price. Standalone options trade on exchanges or OTC. They are linked to a variety of underlying
assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded
options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or
baskets of assets).
There are two main types of options: calls and puts:
Call options provide the holder the right (but not the obligation) to purchase an
underlying asset at a specified price (the strike price), for a certain period of time. If the
stock fails to meet the strike price before the expiration date, the option expires and
becomes worthless. Investors buy calls when they think the share price of the
underlying security will rise or sell a call if they think it will fall. Selling an option is also
referred to as ''writing'' an option.
Put options give the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the option expires.
Investors buy puts if they think the share price of the underlying stock will fall, or sell
one if they think it will rise. Put buyers - those who hold a "long" - put are either
speculative buyers looking for leverage or "insurance" buyers who want to protect their
long positions in a stock for the period of time covered by the option. Put sellers hold a
"short" expecting the market to move upward (or at least stay stable) A worst-case
scenario for a put seller is a downward market turn. The maximum profit is limited to
the put premium received and is achieved when the price of the underlyer is at or above
the option's strike price at expiration. The maximum loss is unlimited for an uncovered
put writer.

35
The Options Game
Call Option Put Option
Option buyer or
option holder
Buys the right to buy the
underlying asset at the specified
price
Buys the right to sell the
underlying asset at the specified
price
Option seller or option
writer
Has the obligation to sell the
underlying asset (to the option
holder) at the specified price
Has the obligation to buy the
underlying asset (from the option
holder) at the specified price

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3. BASICS OF OPTIONS
Both put and call options have three basic characteristics: exercise price, expiration date and time
to expiration.
The buyer has the right to buy or sell the asset.
To acquire the right of an option, the buyer of the option must pay a price to the
seller. This is called the option price or the premium.
The exercise price is also called the fixed price, strike price or just the strike and
is determined at the beginning of the transaction. It is the fixed price at which
the holder of the call or put can buy or sell the underlying asset.
Exercising is using this right the option grants you to buy or sell the underlying
asset. The seller may have a potential commitment to buy or sell the asset if the
buyer exercises his right on the option.
The expiration date is the final date that the option holder has to exercise her
right to buy or sell the underlying asset.
Time to expiration is the amount of time from the purchase of the option until
the expiration date. At expiration, the call holder will pay the exercise price and
receive the underlying securities (or an equivalent cash settlement) if the option
expires in the money. (We will discuss the degrees of moneyness later in this
session.) The call seller will deliver the securities at the exercise price and receive
the cash value of those securities or receive equivalent cash settlement in lieu of
delivering the securities.
Defaults on options work the same way as they do with forward contracts.
Defaults on over-the counter option transactions are based on counterparties,
while exchange-traded options use a clearing house.
Example: Call Option
IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call = $3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right
to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the option
on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to the
buyer.

37
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell
IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option on
or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.
Example: Interpreting Diagrams
For the exam, you may be asked interpret diagrams such as the following, which shows the value
of a put option at expiration.
A typical question about this diagram might be:
Q: Ignoring transaction costs, which of the following statements about the value of the put option
at expiration is TRUE?
A. The value of the short position in the put is $4 if the stock price is $76.
B. The value of the long position in the put is $4 if the stock price is $76.
C. The long put has value when the stock price is below the $80 exercise price.
D. The value of the short position in the put is zero for stock prices equaling or exceeding $76.
The correct answer is "C". A put option has positive monetary value when the underlying
instrument has a current price ($76) below the exercise price ($80).

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4. OPTION TRADING
 Buyer of a call:
– Assume purchase of August call option on Swiss francs with strike price of 58½
($0.5850/SF), and a premium of $0.005/SF.
– At all spot rates below the strike price of 58.5, the purchase of the option would
choose not to exercise because it would be cheaper to purchase SF on the open
market.
– At all spot rates above the strike price, the option purchaser would exercise the
option, purchase SF at the strike price and sell them into the market netting a
profit (less the option premium).

39
 Writer of a call:
– What the holder, or buyer of an option loses, the writer gains.
– The maximum profit that the writer of the call option can make is limited to the
premium.
– If the writer wrote the option naked, that is without owning the currency, the
writer would now have to buy the currency at the spot and take the loss delivering
at the strike price.
– The amount of such a loss is unlimited and increases as the underlying currency
rises.
– Even if the writer already owns the currency, the writer will experience an
opportunity loss.

40
 Buyer of a Put:
– The basic terms of this example are similar to those just illustrated with the call.
– The buyer of a put option, however, wants to be able to sell the underlying
currency at the exercise price when the market price of that currency drops (not
rises as in the case of the call option).
– If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the
writer and receive $0.585/SF.
– At any exchange rate above the strike price of 58.5, the buyer of the put would not
exercise the option, and would lose only the $0.05/SF premium.
– The buyer of a put (like the buyer of the call) can never lose more than the
premium paid up front.

41
 Seller (writer) of a put:
– In this case, if the spot price of francs drops below 58.5 cents per franc, the option
will be exercised.
– Below a price of 58.5 cents per franc, the writer will lose more than the premium
received fro writing the option (falling below break-even).
– If the spot price is above $0.585/SF, the option will not be exercised and the
option writer will pocket the entire premium.

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5. BASIC OPTION TERMINOLOGY
Underlying - The specific security / asset on which an options contract is based.
Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or
sell.
Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-
determined price of the underlying asset at which the same can be bought or sold if the option
buyer exercises his right to buy/ sell on or before the expiration day.
Expiration date - The date on which the option expires is known as Expiration Date. On
Expiration date, either the option is exercised or it expires worthless.
Exercise Date - is the date on which the option is actually exercised. In case of European
Options the exercise date is same as the expiration date while in case of American Options, the
options contract may be exercised any day between the purchase of the contract and its
expiration date (see European/ American Option)
Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected
option seller is assigned the obligation to honor the underlying contract, and this process is
termed as Assignment.
Open Interest - The total number of options contracts outstanding in the market at any given
point of time.
Option Holder - is the one who buys an option which can be a call or a put option. He enjoys
the right to buy or sell the underlying asset at a specified price on or before specified time. His
upside potential is unlimited while losses are limited to the Premium paid by him to the option
writer.

43
Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in
case of call option), the underlying asset in case the buyer of the option decides to exercise his
option. His profits are limited to the premium received from the buyer while his downside is
unlimited.
Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying
instrument, e.g., all Sensex Call Options (or) all Sensex Put Options
Option Series - An option series consists of all the options of a given class with the same
expiration date and strike price. E.g. BSXCMAY3600 is an options series, which includes all
Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.
(BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date and
strike Price is 3600)

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6. European vs. American Options and Moneyness
European Option
Europeans Options can only be exercised on the expiry date. European options are typically
valued using the Black-Scholes or Black model formula. This is a simple equation with a closed-
form solution that has become standard in the financial community.
American Option
This is an option that can be exercised at any time up to and including the expiry date. There are
no general formulas for valuing American options, but a choice of models to approximate the
price is available (for example Whaley, binomial options model, Monte Carlo and others),
although there is no consensus on which is preferable.
American options are rarely exercised early. This is because all options have a non-negative time
value and are usually worth more unexercised. Owners who wish to realize the full value of their
options will mostly prefer to sell them rather than exercise them early and sacrifice some of the
time value.
Note that the names of these types of options are in no way related to Europe or the United
States.

45
Moneyness
The concept of moneyness describes whether an option is in-, out-, at-, or in-the-money by
examining the position of strike vs. existing market price of the option's underlying security.
In the Money - Any option that has intrinsic value is in the money. A call option is said
to be in the money when the futures price exceeds the option's strike price. A put is in the
money when the futures price is below the option's strike price. For example, a March
CME euro 90 call option will be in the money if March CME euro futures are above 90,
meaning that the holder has the right to buy these futures at 90, regardless of how much
the price has risen. The further in the money an option, the less time value it will have.
Deep In the Money - These options represent a larger spread between the strike and
market price of an underlying security. Options that are deep in the money generally
trade at or near their actual intrinsic values, calculated by subtracting the strike price from
the underlying asset's market price for a call option (and vice versa for a put option). This
is because options with a significant amount of intrinsic value built in have a very low
chance of expiring worthless. Therefore, the primary value they provide is already priced
into the option in the form of their intrinsic value. As an option moves deeper into the
money, the delta approaches 100% (for call options), which means for every point change
in the underlying asset's price, there will be an equal and simultaneous change in the
price of the option, in the same direction. Thus, investing in the option is similar to
investing in the underlying asset, except the option holder will have the benefits of lower
capital outlay, limited risk, leverage and greater profit potential.
Out of the Money - These options exist when the strike price of a call (put) is above
(below) the underlying asset's market price. (Essentially, it is the inverse of an in the
money option). Options that are out of the money have a high risk of expiring worthless,
but they tend to be relatively inexpensive. As the time value approaches zero at
expiration, out of the money options have a greater potential for total loss if the
underlying stock moves in an adverse direction.
At the Money - These options exist when the strike price of a call or put is equal to the
underlying asset's market price. You can essentially think of at the money as the
breakeven point (excluding transaction costs).

46
Striking The Price
Call Option Put Option
In-the-money
Strike Price less than Spot Price
of underlying asset
Strike Price greater than
Spot Price of underlying
asset
At-the-money
Strike Price equal to Spot Price
of underlying asset
Strike Price equal to Spot
Price of underlying asset
Out-of-the-money
Strike Price greater than Spot
Strike Price less than Spot
Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price
is at significant variance with the underlying asset price.
It is the time value portion of an option‘s premium that is affected by fluctuations in
volatility, interest rates, dividend amounts and the passage of time. There are other factors that
give options value, therefore affecting the premium at which they are traded. Together, all of
these factors determine time value.
Option Premium = Intrinsic Value + Time Value

47
7. Option Pricing & Valuation
 An option whose exercise price is the same as the spot price of the underlying currency is
said to be at-the-money (ATM).
 An option the would be profitable, excluding the cost of the premium, if exercised
immediately is said to be in-the-money (ITM).
 An option that would not be profitable, again excluding the cost of the premium, if
exercised immediately is referred to as out-of-the money (OTM).
Call Put
Intrinsic value max(ST
- X, 0) max(X - ST
, 0)
in the money ST
– X > 0 X – ST
> 0
at the money ST
– X = 0 X – ST
= 0
out of the money ST
– X < 0 X – ST
< 0
Time Value CT
– Int. value PT
– Int. value

48
Forward vs. Options
-$0.90
-$0.75
-$0.60
-$0.45
-$0.30
-$0.15
$0.00
$0.15
$0.30
$0.45
$0.60
$0.75
$0.90
$0.00
$0.10
$0.20
$0.30
$0.40
$0.50
$0.60
$0.70
$0.80
$0.90
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
$1.80
Spot Rate at Expiration
ValueofForward/PutOptionatExpiration.
Value of Forward Sale at Expiration
Value of Put at Expiration

49
8. Factors Affecto the Value of an Option Premium
There are two types of factors that affect the value of the option premium:
Quantifiable Factors:
Underlying stock price,
The strike price of the option,
The volatility of the underlying stock,
The time to expiration and;
The risk free interest rate.
Non-Quantifiable Factors:
Market participants' varying estimates of the underlying asset's future volatility
Individuals' varying estimates of future performance of the underlying asset, based on
fundamental or technical analysis
The effect of supply & demand- both in the options marketplace and in the market for
the underlying asset
The "depth" of the market for that option - the number of transactions and the
contract's trading volume on any given day.
Different pricing models for options
The theoretical option pricing models are used by option traders for calculating the fair
value of an option on the basis of the earlier mentioned influencing factors. An option pricing
model assists the trader in keeping the prices of calls & puts in proper numerical relationship to
each other & helping the trader make bids & offer quickly. The two most popular option pricing
models are:
Black Scholes Model which assumes that percentage change in the price of underlying
follows a normal distribution.
Binomial Model which assumes that percentage change in price of the underlying
follows a binomial distribution.
Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an
option can be known with the help of pricing models and then depending on market conditions
the price is determined by competitive bids and offers in the trading environment.

50
Covered and Naked Calls
A call option position that is covered by an opposite position in the underlying instrument
(for example shares, commodities etc), is called a covered call. Writing covered calls involves
writing call options when the shares that might have to be delivered (if option holder exercises
his right to buy), are already owned.
E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the
call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is no opposite position in the
underlying), since the worst that can happen is that the investor is required to sell shares already
owned at below their market value.
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
Time Decay
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.

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Expiration Day
The expiration date is the last day an option exists. For list-ed stock options, this is the
Saturday following the third Friday of the expiration month. Please note that this is the deadline
by which brokerage firms must submit exercise notices to Stock Exchange Clearing; however,
the exchanges and brokerage firms have rules and procedures regarding deadlines for an option
holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-
off time, is generally on the third Friday of the month, before expiration Saturday, at some time
after the close of the market. Please contact your brokerage firm for specific deadlines. The last
day expiring equity options generally trade is also on the third Friday of the month, before
expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day
earlier, Thursday.
Exercise
If the holder of an American-style option decides to exercise his right to buy (in the case
of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his
brokerage firm to submit an exercise notice to Stock Exchange Clearing. In order to ensure that
an option is exercised on a particular day other than expiration, the holder must notify his broker-
age firm before its exercise cut-off time for accepting exercise instructions on that day.
Note: Various firms may have their own cut-off times for accepting exercise instructions
from customers. These cut-off times may be specific for different classes of options and different
from Stock Exchange Clearing‘s requirements. Cut-off times for exercise at expiration and for
exercise at an earlier date may differ as well.
What’s the Net?
When an investor exercises a call option, the net price paid for the underlying stock on a
per share basis will be the sum of the call‘s strike price plus the premium paid for the call.
Likewise, when an investor who has written a call contract is assigned an exercise notice on that
call, the net price received on a per share basis will be the sum of the call‘s strike price plus the
premium received from the call‘s initial sale.
When an investor exercises a put option, the net price received for the underlying stock
on per share basis will be the sum of the put‘s strike price less the premium paid for the put.
Likewise, when an investor who has written a put contract is assigned an exercise notice on that
put, the net price paid for the underlying stock on per share basis will be the sum of the put‘s
strike price less the premium received from the put‘s initial sale.

52
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.
Option Greeks-Delta, Gamma, Vega, Theta, Rho
The price of an Option depends on certain factors like price and volatility of the underlying,
time to expiry etc. The Option Greeks are the tools that measure the sensitivity of the option
price to the above-mentioned factors. They are often used by professional traders for trading and
managing the risk of large positions in options and stocks. These Option Greeks are:
Delta: is the option Greek that measures the estimated change in option premium/price
for a change in the price of the underlying.
Gamma: measures the estimated change in the Delta of an option for a change in the price
of the underlying
Vega: measures estimated change in the option price for a change in the volatility of the
underlying.
Theta: measures the estimated change in the option price for a change in the time to
option expiry.
Rho: measures the estimated change in the option price for a change in the risk free
interest rates.

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9. How the greeks help in hedging?
Spreading is a risk-management strategy that employs options as the hedging instrument,
rather than stock. Like stock, options have directional risk (deltas). Unlike stock, options carry
gamma, vega, and theta risks as well. Therefore, if a position involves any combination of
gamma, vega, and/or theta risk, this can be reduced or eliminated by adding one or more options
positions. Table 1-1 summarizes the possible hedges and their gamma, vega and theta impact for
each of the six building blocks.
Notice that owning option contracts be they puts or calls, means that you are adding
positive gamma, positive vega, and negative theta. Being short either of these contracts means
acquiring negative gamma, negative vega, and positive theta. This statement points out that as far
as these Greeks are concerned, you get a package deal

54
. Possible Hedging Strategies with the Greeks
Building Block Hedge Hedge Delta Hedge Gamma Hedge Vega Hedge Theta
Long Stock
Positive delta,
no gamma, no
vega, no theta
Sell Call Negative Negative Negative Positive
Sell Stock Negative None None None
Buy Put Negative Positive Positive Negative
Short Stock
Negative delta,
no gamma, no
vega, no theta
Buy Call Positive Positive Positive Negative
Buy Stock Positive None None None
Sell Put Positive Negative Negative Positive
Long Call
Positive delta,
positive gamma,
positive vega,
negative theta
Buy Put Negative Positive Positive Negative
Short Call
Negative delta,
negative gamma,
negative vega,
positive theta
Sell Put Positive Negative Negative Positive
Long Put
Negative delta,
positive gamma,
positive vega,
negative theta
Sell put Positive Negative Negative Positive
Short Put
Positive delta,
negative gamma,
negative vega,
positive theta
Buy put Negative Positive Positive Negative

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10. Benefits of Options Trading
Besides offering flexibility to the buyer in form of right to buy or sell, the major
advantage of options is their versatility. They can be as conservative or as speculative as one's
investment strategy dictates.
Some of the benefits of Options are as under:
High leverage as by investing small amount of capital (in form of premium), one can take
exposure in the underlying asset of much greater value.
Pre-known maximum risk for an option buyer
Large profit potential and limited risk for option buyer
One can protect his equity portfolio from a decline in the market by way of buying a
protective put wherein one buys puts against an existing stock position.
This option position can supply the insurance needed to overcome the uncertainty of the
marketplace. Hence, by paying a relatively small premium (compared to the market value
of the stock), an investor knows that no matter how far the stock drops, it can be sold at
the strike price of the Put anytime until the Put expires.
E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks that the stock is
over-valued and decides to buy a Put option' at a strike price of Rs. 3800/- by paying a premium
of Rs 200/-
If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- by
exercising his put option. Thus, by paying premium of Rs 200,his position is insured in the
underlying stock.

56
Risks of an options buyer
The risk/ loss of an option buyer is limited to the premium that he has paid.
Risks for an Option writer
The risk of an Options Writer is unlimited where his gains are limited to the Premiums
earned. When a physical delivery uncovered call is exercised upon, the writer will have to
purchase the underlying asset and his loss will be the excess of the purchase price over the
exercise price of the call reduced by the premium received for writing the call.
The writer of a put option bears a risk of loss if the value of the underlying asset declines
below the exercise price. The writer of a put bears the risk of a decline in the price of the
underlying asset potentially to zero.
Option writing is a specialized job which is suitable only for the knowledgeable investor who
understands the risks, has the financial capacity and has sufficient liquid assets to meet
applicable margin requirements. The risk of being an option writer may be reduced by the
purchase of other options on the same underlying asset thereby assuming a spread position or by
acquiring other types of hedging positions in the options/ futures and other correlated markets. In
the Indian Derivatives market, SEBI has not created any particular category of options writers.
Any market participant can write options. However, margin requirements are stringent for
options writers.

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11. Stock Index Options
The Stock Index Options are options where the underlying asset is a Stock Index for e.g.
Options on NSE Nifty Index / Options on BSE Sensex etc.
Index Options were first introduced by Chicago Board of Options Exchange in 1983 on
its Index 'S&P 100'. As opposed to options on Individual stocks, index options give an investor
the right to buy or sell the value of an index which represents group of stocks.
Uses of Index Options
Index options enable investors to gain exposure to a broad market, with one trading
decision and frequently with one transaction. To obtain the same level of diversification using
individual stocks or individual equity options, numerous decisions and trades would be
necessary. Since, broad exposure can be gained with one trade, transaction cost is also reduced
by using Index Options. As a percentage of the underlying value, premiums of index options are
usually lower than those of equity options as equity options are more volatile than the Index.
Options on individual stocks
Options contracts where the underlying asset is an equity stock are termed as Options on
stocks. They are mostly American style options cash settled or settled by physical delivery.
Prices are normally quoted in terms of the premium per share, although each contract is
invariably for a larger number of shares, e.g. 100.
Benefits of options in specific stocks to an investor
Options can offer an investor the flexibility one needs for countless investment situations.
An investor can create hedging position or an entirely speculative one, through various
strategies that reflect his tolerance for risk.
Investors of equity stock options will enjoy more leverage than their counterparts who
invest in the underlying stock market itself in form of greater exposure by paying a small
amount as premium.

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Leaps - Long Term Equity Anticipation Securities
(Currently not available in India )
Long-term equity anticipation securities (Leaps) are long-dated put and call options on
common stocks or ADRs. These long-term options provide the holder the right to purchase, in
case of a call, or sell, in case of a put, a specified number of stock shares at a pre-determined
price up to the expiration date of the option, which can be three years in the future.
Exotic Options (Currently not available in India)
Derivatives with more complicated payoffs than the standard European or American calls and
puts are referred to as Exotic Options. Some of the examples of exotic options are as under:
Barrier Options: where the payoff depends on whether the underlying asset's price reaches a
certain level during a certain period of time.
CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Options
where the payout is capped so that it cannot exceed $30.
A Call CAP is automatically exercised on a day when the index closes more than $30 above
the strike price. A put CAP is automatically exercised on a day when the index closes more than
$30 below the cap level.
Binary Options: are options with discontinuous payoffs. A simple example would be an
option which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000
& pays off nothing if it ends up below the strike.
Over-The-Counter Options: are options are those dealt directly between counter-parties
and are completely flexible and customized. There is some standardization for ease of trading in
the busiest markets, but the precise details of each transaction are freely negotiable between
buyer and seller.

59
Options with Options
When an option has value, meaning it is in-the-money, the trader can choose whether to
trade the contract to another individual or exercise the contract and obtain the underlying asset.
The ultimate decision that is made depends upon the individual investor, his or her trading style,
his or her trading needs, and the situation at hand.
Option is a contract which has a market value like any other tradable commodity. Once
an option is bought there are following alternatives that an option holder has:
You can sell an option of the same series as the one you had bought and close out /square
off your position in that option at any time on or before the expiration.
You can exercise the option on the expiration day in case of European Option or; on or
before the expiration day in case of an American option. In case the option is 'Out of
Money' at the time of expiry, it will expire worthless.
#Please note that while options provide the right to acquire the underlying instrument, the owner
must still produce the necessary funds for the asset itself.
In exercising a stock or futures put option, the option holder agrees to sell the
standardized quantity of the underlying asset to the option writer at the predetermined strike
price. Because of their contract, the writer must purchase the asset from the option holder at the
strike price, regardless of the price at which the market is currently trading

60
Placing option orders
Before participating in a market, regardless of which one, it is important that one become
familiar with may of the trading nuances and aspects which apply to that specific market. This is
especially true when trading options. Once these variables are addressed and an option contract
is selected, the trader must then place the order. When placing an option order, a trader must
make certain to supply the following trading instructions to the broker:
1. Whether the option order is a buy or a sell
2. The number of option contracts the trader wishes to transact
3. The proper description of the option, including the specific option contract to be traded,
the correct month and year, and the exercise price
4. The price at which the trader wishes to buy or to sell the option
5. The specific exchange the trader wishes to use to conduct the trade if more than one
exchange lists the option
6. The stop loss level, or the price at which the trader wishes to exit an unprofitable trade
7. The type of option to be executed, that is, an opening purchase, a closing purchase, an
opening sale, or a closing sale
Reading an option price table
Many major newspaper and trading publications today provide option-pricing tables so
traders can track and follow the activity of certain listed options on a day-to-day basis. While the
organization of these price table may differ slightly for stock options, they all usually contain the
security that the option covers, the prior day‘s closing price of the underlying asset, the varying
strike prices and expiration months, the prior day‘s volume and closing prices for each call
option, and the prior day‘s volume and closing prices for each put option. Other option listings,
such as those for indices, also include items such as the net price change of the option from the
previous day‘s closing price and the open interest of the call or put option.

61
When not to buy an option?
It is also important to consider the time or the date at which one should enter the option
market. While these option-buying suggestions are presented in the context of day trading
options, they apply equally as well to option position trading.
When day trading, a trader must give the market adequate time to perform.
Consequently, eliminate day trading within the final hour of trading. If one is position-
trading options, this suggestion should not be a concern.
Avoid trading in an illiquid option market.
Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or
selling options based upon anticipated news (buyouts in particular). Besides bordering
on unethical trading, the information received is more likely to be rumor than correct.
Avoid purchasing options well after the market has established a defined trend – this is
especially true when day trading, as any option premium advantage will have dissipated.
Avoid purchasing way out-of-the-money options when day trading, as any favorable price
movement will have a negligible effect upon premium.
Avoid purchasing call options when the underlying security is up for the day versus the
prior day’s close, unless one intends to take a trend-following stance.
Avoid purchasing put options when the underlying security is down for the day versus the
prior day’s close, unless one intends to take a trend-following stance.
Be careful when holding long option positions beyond Friday’s trading day’s close unless
one is option position trading. Many option theoreticians recalculate their volatility,
delta, and time decay numbers once a week, usually after the close of trading on Fridays
or over the weekend. The resulting adjustments in these values most often have a negative
effect on the value of the long option, which may be acceptable when holding an option
over an extended period of time but is detrimental when day trading.

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12. Quick Snapshot of Options Trading Strategies
Please note:
All or part of your investments using Bullish Strategies has greater risk of loss in falling
market.
Investments using Neutral Strategies have greater risk of loss in volatile markets
Investments using Bearish Strategies have greater risk of loss in rising markets.
BULLISH STRATEGIES
LONG CALLS
For aggressive investors who are bullish about the short-term prospects for a stock, buying calls
can be an excellent way to capture the upside potential with limited inside risk.
COVERED CALLS
For conservative investors, selling calls against a long stock position can be an excellent way to
generate income without assuming the risks associated with uncovered calls. In this case,
investors would sell one call contract for each 100 shares of stock they own.
PROTECTIVE PUT
For investors who want to protect the stocks in their portfolio from falling prices, protective puts
provide a relatively low-cost form of portfolio insurance. In this case, investors would purchase
one put contract for each 100 shares of stock they own.
BULL CALL SPREAD
For bullish investors who want to a nice low risk, limited return strategy without buying or
selling the underlying stock, bull call spreads are a great alternative. This strategy involves
buying and selling the same number of calls at different strike prices to minimize both the cash
outlay and the overall risk.

63
BULL PUT SPREAD
For bullish investors who want a nice low risk, limited return strategy, bull put spreads are
another alternative. Like the bull call spread, the bull put spread involves buying and selling the
same number of put options at different strike prices. Since puts with the higher strike are sold,
the trade is initiated for a credit.
CALL BACK SPREAD
For bullish investors who expect big moves in already volatile stocks, call back spreads are a
great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a
lower strike and buying a greater number of calls at a higher strike price.
NAKED PUT
For bullish investors who are interested in buying a stock at a price below the current market
price, selling naked puts can be an excellent strategy. In this case, however, the risk is substantial
because the writer of the option is obligated to purchase the stock at the strike price regardless of
where the stock is trading.

64
BEARISH STRATEGIES
LONG PUT
For aggressive investors who have a strong feeling that a particular stock is about to move lower,
long puts are an excellent low risk, high reward strategy. Rather than opening yourself to
enormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk is
limited to the initial investment, the profit potential is unlimited.
NAKED PUT
Selling naked calls is a very risky strategy which should be utilized with extreme caution. By
selling calls without owning the underlying stock, you collect the option premium and hope the
stock either stays steady or declines in value. If the stock increases in value this strategy has
unlimited risk.
PUT BACKSPREAD
For aggressive investors who expect big downward moves in already volatile stocks, back
spreads are great strategies. The trade itself involves selling a put at a higher strike and buying a
greater number of puts at a lower strike price. As the stock price moves lower, the profit
potential is unlimited.
BEAR CALL SPREAD
For investors who maintain a generally negative feeling about a stock, bear spreads are a nice
low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near
the current stock price, and buying a higher strike, out-of-the-money call. This spread profits
when the stock price decreases and both calls expire worthless.
BEAR PUT SPREAD
For investors who maintain a generally negative feeling about a stock, bear spreads are another
nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling
another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the
underlying stock decreases.

65
NEUTRAL STRATEGIES
REVERSAL
Primarily used by professional traders, a reversal is an arbitrage strategy that allows traders to
profit when options are underpriced. To put on a reversal, a trader would sell stock and use
options to buy an equivalent position that offsets the short stock.
CONVERSION
Primarily used by professional traders, a conversion is an arbitrage strategy that allows traders to
profit when options are overpriced. To put on a conversion, a trader would
buy stock and use options to sell an equivalent position that offsets the long stock.
THE COLLAR
For bullish investors who want to nice low risk, limited return strategy to use in conjunction with
a long stock position, collars are a great alternative. In this case, the collar is created by
combining covered calls protective puts.
LONG STRADDLE
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a
neutral bias), the long straddle is an excellent strategy. This position involves buying both a put
and a call with the same strike price, expiration, and underlying. The potential loss is limited to
the initial investment. The potential profit is unlimited as the stock moves up or down.
SHORT STRADDLE
For aggressive investors who don't expect much short-term volatility, the short straddle can be a
risky, but profitable strategy. This strategy involves selling a put and a call with the same strike
price, expiration, and underlying. In this case, the profit is limited to the initial credit received by
selling options. The potential loss is unlimited as the market moves up or down.

66
LONG STRANGLE
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a
neutral bias), the long strangle is another excellent strategy. This strategy typically involves
buying out-of-the-money calls and puts with the same strike price, expiration, and underlying.
The potential loss is limited to the initial investment while the potential profit is unlimited as the
market moves up or down.
SHORT STRANGLE
For aggressive investors who don't expect much short-term volatility, the short strangle can be a
risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and
calls with the same strike price, expiration, and underlying. The profit is limited to the credit
received by selling options. The potential loss is unlimited as the market moves up or down.
THE BUTTERFLY
Ideal for investors who prefer limited risk, limited reward strategies. When investors expect
stable prices, they can buy the butterfly by selling two options at the middle strike and buying
one option at the higher and lower strikes. The options, which must be all calls or all puts, must
also have the same expiration and underlying.
RATIO SPREAD
For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited
reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike
and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt
by market movement.
CONDOR
Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body
of the butterfly - two options at the middle strike - and splits between two middle strikes. In this
sense, the condor is basically a butterfly stretched over four strike prices instead of three.

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OPTION TRADING STRATEGY FORMULAS
MARRIED PUT
(Stock Price – Strike Price) + Put Price = Maximum Loss
PROTECTING UNREALIZED PROFIT
(Strike Price – Put Price) – Initial Stock Purchase = Unrealized Profit
COVERED CALL POTENTIAL
(Call Price + Strike Price) – Stock Price = Covered Call Potential
BULL SPREAD (LONG CALL SPREAD)
Difference between Strike Prices – Debit Paid = Maximum Profit
(The debit Paid is the maximum loss.)
BULL SPREAD (SHORT PUT SPREAD)
Difference between Strike Prices – Credit = Maximum Loss
(The credit received is the maximum profit.)

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BEAR SPREAD (LONG PUT SPREAD)
Difference between Strike Prices – Debit Paid = Maximum Profit
(The debit Paid is the maximum loss.)
BEAR SPREAD (SHORT CALL SPREAD)
Difference between Strike Prices – Credit = Maximum Loss
(The credit received is the maximum profit.)
RATIO BULL SPREAD (LONG)
A short call spread plus a long OTM call
RATIO BULL SPREAD (SHORT)
A long call spread plus a short OTM call
RATIO BEAR SPREAD (LONG)
A short put spread plus a long OTM put
RATIO BEAR SPREAD (SHORT)
A long put spread plus a short OTM put

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