The document is a project report submitted by Deepali Dalvi on futures and options contracts. It includes an introduction to derivatives, the history of derivatives and futures markets, an overview of futures and options terminology, and descriptions of different types of derivative contracts such as forwards, futures, calls, puts and options trading strategies. The report also discusses the purpose of futures markets, arbitrage opportunities, clearing mechanisms, differences between futures and forwards, stock index futures, and the NSE's derivatives market. It aims to provide a comprehensive overview of the key concepts relating to futures and options.

1. FUTURES AND OPTIONS
UNIVERSITY OF MUMBAI
M.L. DAHANUKAR COLLEGE OF COMMERCE
VILE PARLE (EAST),
MUMBAI – 400057
A PROJECT ON
FUTURES & OPTIONS
SUBMITTED BY
DEEPALI.N.DALVI
SUBMISSION FOR:
BACHELOR OF MANAGEMENT STUDIES
T.Y.B.M.S
SEMESTER V
UNDER THE GUIDANCE OF
PROF. NACHIKET PATVARDHAN
ACADEMIC YEAR 2009-2010
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DECLARATION
I, DEEPALI.N.DALVI, of M.L. Dahanukar College of Commerce,
T.Y.B.M.S (Semester Vth), hereby declare that I have completed this project on
“FUTURES & OPTIONS” in the academic year 2009-2010
The Information Submitted Is True And Original To The Best Of My Knowledge.
{DEEPALI DALVI}
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Acknowledgement
It gives me pleasure to submit this project to the University of Mumbai as a part of curriculum of
BMS course.
I take this opportunity to express my sincere gratitude to respected Prof. M.Pethe,
The Principal, M.L.Dahanukar College of Commerce and our course coordinator,
Prof. ARCHANA ZINGADE.
My respect and grateful thanks to Prof.NACHIKET PATVARDHAN, for his
valuable assistance in completion of this project.
Last but not the least; I thank to my Family and Friends who have directly or
indirectly helped me in completing my project.
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PREFACE
Futures and Options are the well developed trading instrument in the complex
markets of today.
We will find the futures and options related to almost all types of markets,
E.g.-stocks, finance, metals, agriculture produce etc.
Futures and options have brought various nations of the world commercially nearer
to each other.
Futures and Options shield the manufacturers & farmers from risk of loss due to
unforeseen circumstances so that they can concentrate on their core business of
manufacturing and farming.
Futures and Options are also important for the national economy since it is a very
effective risk management tool.
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TABLE OF CONTENT
Sr. Topic Page
No. No.
1. Introduction 9-10
1.1 History of derivatives 11-12
1.2 Understanding derivatives 13-15
2. Forward contract 16
2.1 History of forward contract 17
3. Futures market 18
3.1 History of futures market 19
3.2 Relationship between spot and futures price 20-23
4. Purpose of futures market 24-25
5. Advantage of Arbitrage 26-30
6. Clearing Mechanism 31-32
7. Types of orders 33-34
8. Futures Terminology 35
9. Difference between Forward and Futures contract 36
10. Options 37
10.1 History 38
11. Option Terminology 39-45
12. Call option 46
12.1 Buying a call 47
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122 Writing a call 48-49
13. Put option 50
13.1 Buying a put 51
13.2 Writing a put 52
14. Advantages and Disadvantages of Options 53-56
15. Risk & Return with equity options 57-63
16. Option Trading Strategies 64-71
17 Margins 72-73
18. Stock Index Futures 74-80
19. NSE’s derivative market 81-83
20. Futures V/S Options 84-85
21. Conclusion 86
22. Bibliography 87
Introduction
Derivatives are defined as financial instruments whose value derived from the prices of one or
more other assets such as equity securities, fixed-income securities, foreign currencies, or
commodities. Derivatives are also a kind of contract between two counterparties to exchange
payments linked to the prices of underlying assets.
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The term Derivative has been defined in Securities Contracts (Regulations) Act, as “A security
derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or
contract for differences or any other form of security. It is a contract which derives its value from
the prices, or index of prices, of underlying securities
The underlying can be :
 Stocks (Equity)
 Agriculture Commodities including grains, coffee beans, etc.
 Precious metals like gold and silver.
 Foreign exchange rate
 Bonds
Short-term debt securities such as T-bills
Derivative can also be defined as a financial instrument that does not constitute ownership, but a
promise to convey ownership.
The most common types of derivatives that ordinary investors are likely to come across are
futures, options, warrants and convertible bonds. Beyond this, the derivatives range is only
limited by the imagination of investment banks. It is likely that any person who has funds
invested an insurance policy or a pension fund that they are investing in, and exposed to,
derivatives-wittingly or unwittingly.
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History
The history of derivatives is surprisingly longer than what most people think. Some texts even
find the existence of the characteristics of derivative contracts in incidents of Mahabharata.
Traces of derivative contracts can even be found in incidents that date back to the ages before
Jesus Christ.
However, the advent of modern day derivative contracts is attributed to the need for farmers to
protect themselves from any decline in the price of their crops due to delayed monsoon, or
overproduction.
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.
These were evidently standardized contracts, which made them much like today's futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized around
1865. From then on, futures contracts have remained more or less in the same form, as we know
them today.
Derivatives have had a long presence in India. The commodity derivative market has been
functioning in India since the nineteenth century with organized trading in cotton through the
establishment of Cotton Trade Association in 1875. Since then contracts on various other
commodities have been introduced as well.
Exchange traded financial derivatives were introduced in India in June 2000 at the two major
stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges.
The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the
launch of index futures on June 12, 2000. The futures contracts are based on the popular
benchmark S&P CNX Nifty Index.
The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE
also became the first exchange to launch trading in options on individual securities from July 2,
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2001. Futures on individual securities were introduced on November 9, 2001. Futures and
Options on individual securities are available on 227 securities stipulated by SEBI.
The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY
JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini
derivative (futures and options) contracts on S&P CNX Nifty index in January 1,2008.
National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in
December 2003, to provide a platform for commodities trading. The derivatives market in India
has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts.
The size of the derivatives market has become important in the last 15 years or so. In 2007 the
total world derivatives market expanded to $516 trillion.
With the opening of the economy to multinationals and the adoption of the liberalized economic
policies, the economy is driven more towards the free market economy. The complex nature of
financial structuring itself involves the utilization of multi currency transactions. It exposes the
clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk,
economic risk and political risk.
.
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UNDERSTANDING DERIVATIVES
The primary objectives of any investor are to maximize returns and minimize risks. Derivatives
are contracts that originated from the need to minimize risk. The word 'derivative' originates
from mathematics and refers to a variable, which has been derived from another variable.
Derivatives are so called because they have no value of their own. They derive their value from
the value of some other asset, which is known as the underlying.
For example, a derivative of the shares of Infosys (underlying), will derive its value from the
share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of
soybean.
Derivatives are specialized contracts which signify an agreement or an option to buy or sell the
underlying asset of the derivate up to a certain time in the future at a prearranged price, the
exercise price.
The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of
commencement of the contract. The value of the contract depends on the expiry period and also
on the price of the underlying asset.
For example, a farmer fears that the price of soybean (underlying), when his crop is ready for
delivery will be lower than his cost of production.
Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the
selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy
the crop at a certain price (exercise price), when the crop is ready in three months time (expiry
period).
In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this
derivative contract will increase as the price of soybean decreases and vice-a-versa.
If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be
more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract
becomes even more valuable.
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This is because the farmer can sell the soybean he has produced at Rs .9000 per ton even though
the market price is much less. Thus, the value of the derivative is dependent on the value of the
underlying.
If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver,
precious stone or for that matter even weather, then the derivative is known as a commodity
derivative.
If the underlying is a financial asset like debt instruments, currency, share price index, equity
shares, etc, the derivative is known as a financial derivative.
Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are
called exchange-traded derivatives. Or they can be customized as per the needs of the user by
negotiating with the other party involved.
Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of
the farmer above, if he thinks that the total production from his land will be around 150 quintals,
he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of
soybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities
exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard
contract on soybean.
The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50
quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives have
some advantages like low transaction costs and no risk of default by the other party, which may
exceed the cost associated with leaving a part of the production uncovered.
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TYPES OF DERIVATIVES:
There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.
Derivatives
Forwards Futures Options Swaps
The most commonly used derivatives contracts are Forward, Futures and Options. Here some
derivatives contracts that have come to be used are covered.
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Forward contract
A forward contract is an agreement to buy or sell an asset on a specified price. One of the
parties to contract assumes a long position and agrees to buy the underlying asset on a certain
specified future date for a specified price. The other party assumes a short position and agrees to
sell the asset on the same date for the same price. Other contract details like delivery date, price,
and quantity are negotiated bilaterally by the parties to the contracts are normally traded outside
the exchanges.
The salient features of forward contract are:-
 They are bilateral contracts and hence exposed to counter-party risk.
 Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
 The contract price is generally not available in public domain.
 On the expiration date, the contract has to be settled by delivery of the asset.
 If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high price being charged.
However forward contracts in certain markets have become very standardized, as in case of foreign
exchange, thereby reducing transaction costs and increasing transactions volume. This process of
standardization reaches its limit in the organized futures market.
The forward price of is commonly contrasted with the spot price, which is the price at which the asset
changes hands on the spot date. The difference between the spot and the forward price is the forward
premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing
party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate
risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying
instrument which is time-sensitive.
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A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very
similar to futures contracts, except they are not marked to market, exchange traded, or defined on
standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin
requirements like futures - such that the parties do not exchange additional property securing the party at
gain and the entire unrealized gain or loss builds up while the contract is open. A forward contract
arrangement might call for the loss party to pledge collateral or additional collateral to better secure the
party at gain.
The following data relates to ABC Ltd’s share prices:
Current price per share Rs. 180
Price per share in the futures market-6 months RS. 195
It is possible to borrow money in the market for securities transactions at the rate of 12% per
annum
Q. 1.Calculation of Theoretical Minimum Price of a 6-month Forward contract
Explain if any arbitraging opportunities exist.
Solution:
Calculation of Theoretical Minimum Price of a 6-month Forward contract
Current share price
Interest rate prevailing in money market for securities transactions
Then,
Theoretical Minimum Price = Rs. 180 + (Rs. 180 * 12/100 *6/12) Rs. 190.80
Arbitraging opportunities
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The current price per share in the futures market-6 months is Rs. 195 and the theoretical
minimum price of 6-months forward is Rs. 190.80. The arbitrage opportunities exist for the ABC
Ltd’s share. An arbitrageur can invest in ABC Ltd’s share shares at Rs.180 by borrowing at 12%
p.a. for 6 months and at same time he can sell the share in the futures market at Rs. 195. On the
expiry date i.e. after 6 months period the arbitrageur can collect Rs. 195 and pay off Rs. 190.80
and can record a profit of Rs. 2.20 (i.e. Rs.195-Rs190.80)
FUTURE CONTRACT
As the name suggests, futures are derivative contracts that give the holder the opportunity to buy
or sell the underlying at a pre-specified price sometime in the future.
Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the future
at a certain price. But unlike forwards contract, the futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contract, the exchange specifies certain
standard features of the contract.
Futures contract is a standardized form with fixed expiry time, contract size and price. A futures
contract may be defined offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way.
It involves an obligation on both the parties i.e. the buyer and the seller to fulfill the terms of the
contract (i.e. these are pre-determined contracts entered today for a date in the future)
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HISTORY OF FUTURES CONTRACT
Merton Miller, the 1990 Nobel laureate had said that ‘financial future represents the most
significant innovation of the last twenty years.’ The first exchange that traded financial
derivatives was launched in Chicago in the year 1972. A division of the Chicago Mercantile
Exchange, it was called the International Monetary Market (IMM) and traded currency futures.
The brain behind this was a man called Leo Melamed, acknowledged as the “father of financial
services” who was then the chairman of the Chicago Mercantile Exchange. Before IMM opened
in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in
millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile
Exchange totaled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar
products at Chicago Mercantile Exchange, Chicago Board of Trade, and the Chicago Board
Options Exchange. By the 1990s, these exchanges were trading futures and options on
everything from Asian and American stock indexes to interest-rate swaps, and their success
transformed Chicago almost overnight into the risk-transfer capital of the world.
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Relationship between Spot and Futures Price
The price of a commodity (here we are not restricting ourselves to equity stock as the underlying
asset) is, among other things, a function of:
Demand and supply position of the commodity
Storability – depending on whether the commodity is perishable or not
Seasonality of the commodity
Basis
In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices normally exceed spot prices.
Basis = Futures Price - Spot Price
In a normal market, the spot price is less than the futures price (which includes the full cost-of-
carry) and accordingly the basis would be negative. Such a market, in which the basis is decided
solely by the cost-of-carry, is known as the Contango Market.
Basis can become positive, i.e. the spot price can exceed the futures price only if there are factors
other than the cost-of-carry to influence the futures price. In case this happens, then basis
become positive and the market under such circumstances is termed as a Backwardation Market
or Inverted Market.
Basis will approach zero towards the expiry of the contract, i.e. the spot and futures prices
converge as the date of expiry of the contract approaches. The process of the basis approaching
zero is called Convergence.
As already explained above, the relationship between futures price and cash price is determined
by the cost-of-carry. However, there might be factors other than cost-of-carry; especially in case
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of financial futures there may be carry returns like dividends, in addition to carrying costs, which
may influence this relationship.
The cost-of-carry model in financial futures, thus, is
Futures price = Spot price + Carrying costs – Returns (dividends, etc.)
The price of ACC stocks on 31st December 2000 was Rs. 220 and the futures price on the same
stock on the same date, for March 2001 was Rs. 230. Other features of the contract and related
information are as follows:
Time of expiration - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03.2001
Face value of the stock - Rs. 10
Based on the above information, the futures price for ACC stock on 31 st December 2000 should
be:
= 220 + (220 x 0.15 x 0.25) – (0.25 x 10)
= Rs. 225.75
Thus, as per the ‘cost of carry’ criteria, the futures price is Rs. 225.75, which is less than the
actual price of Rs. 230 in February 2001. This would give rise to arbitrage opportunities and
consequently the two prices will tend to converge
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Contract specification: S&P CNX Nifty Futures
Underlying index S&P CNX Nifty
Exchange of trading National Stock Exchange of India Limited
Security descriptor N FUTIDX NIFTY
Contract size Permitted lot size shall be 100
(minimum value Rs.2 lakh)
Price bands Not applicable
Trading cycle The futures contracts will have a maximum of
three month trading cycle - the near month
(one), the next month (two) and the far month
(three). New contract will be introduced on the
next trading day following the expiry of near
month contract.
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Expiry day The last Thursday of the expiry month or the
previous trading day if the last Thursday is a
trading holiday.
Settlement basis Mark to market and final settlement will be
cash settled on T+1 basis.
Settlement price Daily settlement price will be the closing price
of the futures contracts for the trading day and
the final settlement price shall be the closing
value of the underlying index on the last
trading day.
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PURPOSE OF FUTURES CONTRACT
As in any other trade, the futures trade has to have a market to facilitate buying and selling. As
the futures markets involve the operation and execution of financial deals of an enormous
magnitude, their efficiency has to be of the highest quantity. Not only the size of the monetary
operation that a futures market handles but also the critical significance it has on the equilibrium
of the commodities / stocks is what makes the operation of the market so crucial.
Futures markets provide flexibility to an otherwise rigid spot market because of their very
concept, which allows a holistic approach to the price mechanism involved in futures contracts.
The future price of a commodity is a function of various commodities related and market related
factors and their inter-play determines the existence of a futures contract and its price. Futures
markets are relevant because of various reasons, some of which are as follows:
Quick and Low Cost Transactions:
Futures contracts can be created quickly at low cost to facilitate exchange of money for goods to
be delivered at future date. Since these low cost instruments lead to a specified delivery of goods
at a specified price on a specified date, it becomes easy for the finance managers to take optimal
decisions in regard to protection, consumption and inventory. The costs involved in entering into
futures contracts is insignificant as compared to the value of commodities being traded
underlying these contracts.
Price Discovery Function:
The pricing of futures contracts incorporates a set of information based on which the producers
and the consumers can get a fair idea of the future demand and supply position of the commodity
and consequently the future spot price. This is known as the ‘price discovery’ function of future.
Advantage to Informed Individuals:
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Individuals, who have superior information in regard to factors like commodity demand-supply,
market behavior, technology changes, etc., can operate in a futures market and impart efficiency
to the commodity’s price determination process. This, in turn, leads to a more efficient allocation
of resources.
Hedging Advantage:
Adverse price changes, which may lead to losses, can be adequately and efficiently hedged
against through futures contract. An individual who is exposed to the risk of an adverse price
change while holding a position, either long or short, will need to enter into a transaction which
could protect him in the event of such an adverse change.
For e.g., a trader who has imported a consignment of copper and the shipment is to reach within
a fortnight, he may sell copper futures if he foresees fall in copper prices. In case copper prices
actually fall, the trader will lose on sale of copper but will recoup through futures. On the
contrary if prices rise, the trader will honors the delivery of the futures contract through the
imported copper stocks already available with him.
Thus, futures markets provide economic as well as social benefits, through their function of risk
management and price discovery.
ADVANTAGE OF ARGITRAGE
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What do you mean by Arbitrage? ….
In economics and finance, arbitrage is the practice of taking advantage of a price differential
between two or more markets: striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market prices. A person who engages in
arbitrage is called an arbitrageur such as a bank or brokerage firm. The term is mainly applied
to trading in financial instruments, such as bonds, stocks, derivatives, commodities and
currencies.
In today’s scenario when markets world over have become highly volatile and choppy because of
Subprime Issue & Credit crises faced by US we very often get to see a gap -up opening or a gap
down opening. However, there is a set of people who enjoy such volatilities. They are waiting
for volatile times in a bull market and are mawkishly waiting for mispricing opportunities to be
created so that they could gain from mispricing in the cash and futures markets. These are the
arbitragers. They have been fast gaining currency in the investment market by providing a steady
performance. Returns from arbitrage funds have been good. These funds are fast gathering
investor attention, especially from the retail segment of the market. The attraction of the
arbitrage fund comes from the fact that there are near risk-free returns to be made here. By its
very definition, arbitrage, means getting risk-free returns by seeking price differentials between
markets. So the returns are risk-free. Now, with the markets getting choppy, the returns are
strong. And even better than many other exiting fixed income investment options.
Modus operandi!!!
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But are arbitrage funds totally risk-free? Before we dwell into this question, knowing how an
astute arbitrage works is important. Earlier, the arbitrager would sit across two monitors, one
having prices of stocks listed on the National Stock Exchange and the other the Bombay Stock
Exchange. The idea was to spot price differences between these markets.
Buy in one and simultaneously sell in the other to gain from the difference. However, with
markets getting sharper and the security transaction tax (STT) coming in, the transaction costs
having risen, the pricing advantage has been nullified to a great extent. The price differential is
now very narrow and one would require huge amounts to really gain, so this type of arbitrage is
not all that attractive now.
The game now takes place in the spot (cash) and the futures market. Volatile prices and overall
excitement-led activity often create strong pricing mismatches between the spot and futures
market.
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Suppose the stock price of XYZ company is now is quoting at Rs 100. And the quotation of price
in the futures segment in the derivatives market is Rs 110. In such a case, the arbitrager can make
risk-free profit by selling a futures contract of XYZ at Rs 110 and at the same time buying an
equivalent number of shares in the cash market at Rs 100. So this is the first leg of the
transaction which involves selling a futures contract and buying in the cash segment.
Now after waiting for a month, or the contract expiration period, on the settlement day, it is
obvious that the future and the cash price tend to converge. At this time, the arbitrager will
reverse the position. Sell in the cash market and buy a futures contract of the same security. This
is the second leg of the transaction.
There could be two possibilities in such a situation. One, the share price has risen substantially in
the holding period, and has now become Rs 200. In that case, the arbitrager makes money on the
profit on the sale of Rs 100 share at Rs 200 and a loss on the sale of the futures contract. And if
the price declines to Rs 50, then the arbitrager will gain from the sale of the derivatives contract
and take a loss on the sale of the shares in the spot market. Either ways, there is a gain. There are
other gains to be made while rolling the contract over and taking advantage of further mispricing
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Whenever the futures price deviates substantially from its
fair value, arbitrage opportunities arise!!!
Arbitrage - Overpriced futures: buy spot, sell futures
If you notice that futures on a security that you have been observing seem overpriced, how can
you cash in on this opportunity to earn risk less profits? Say for instance, ACC Ltd. trades at
Rs.1000. One–month ACC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you
can make risk less profit by entering into the following set of transactions.
On day one, borrow funds; buy the security on the cash/spot market at 1000.
Simultaneously, sell the futures on the security at 1025.
Take delivery of the security purchased and hold the security for a month.
On the futures expiration date, the spot and the futures price converge. Now unwind the position.
Say the security closes at Rs.1015. Sell the security.
Futures position expires with profit of Rs.10.
The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position.
Return the borrowed funds.
When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the
security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is
termed as cash–and–carry arbitrage.
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Arbitrage - Underpriced futures: buy futures, sell spot
It could be the case that you notice the futures on a security you hold seem underpriced. How can
you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at
Rs.1000. One–month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you
can make riskless profit by entering into the following set of transactions.
On day one, sell the security in the cash/spot market at 1000.
Make delivery of the security.
Simultaneously, buy the futures on the security at 965.
On the futures expiration date, the spot and the futures price converge. Now unwind the position.
Say the security closes at Rs.975. Buy back the security.
The futures position expires with a profit of Rs.10.
The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.
If the returns you get by investing in riskless instruments is more than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash–and–carry and
reverse cash–and–carry, we will see increased volumes and lower spreads in both the cash as
well as the derivatives market.
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CLEARING MECHANISM
A clearing house is an inseparable part of a futures exchange. This exchange acts as a seller for
the buyer and a buyer for the seller in the process of execution of a futures contract.
For example, the moment the buyer and the seller agree to enter into a contract, the clearing
house steps in and bifurcates the transaction, such that,
Buyer buys from the clearing house, and
Seller sells to the clearing house.
Thus, the buyer and the seller do not get into the contract directly; in other words, there is no
counter party risk. The idea is to secure the interest of both. In order to achieve this, the clearing
house has to be solvent enough. This solvency is achieved through imposing on its members,
cash margins and/or bank guarantees or other collaterals, which are encashable fast. The clearing
house monitors the solvency of its members by specifying solvency norms.
The solvency requirements normally imposed by the clearing house on their members are
broadly as follows.
1. Capital Adequacy
Capital adequacy norms are imposed on the clearing members to ensure that only financially
sound firms could become members. The extent of capital adequacy has to be market specific
and would vary accordingly.
2. Net Position Limits
Such limits are imposed to contain the exposure threshold of each member. The sum total of
these limits, in effect, is the exposure limit of the clearing association as a whole and the net
position limits are meant to diversify the association’s risk.
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32. FUTURES AND OPTIONS
3. Daily Price Limits
These limits set up the upper and the lower limits for the futures price on a particular day and
incase these limits are touched the trading in those futures is stopped for the day.
4. Customer Margins
In order to avoid unhealthy competition among clearing members in reducing margins to attract
customers, a mandatory minimum margin is obtained by the members from the customers. Such
a step insures the market against serious liquidity crisis arising out of possible defaults by the
clearing members owing to insufficient margin retention.
In order to secure their own interest as well as that of the entire system responsible for the
smooth functioning of the market, comprising the stock exchanges, clearing houses and the
banks involved, the members collect margins from their clients as may be stipulated by the stock
exchanges from time to time. The members pass on the margins to the clearing house on the net
basis i.e. at a stipulated percentage of the net purchases and sale position while they collect the
margins from clients on gross basis, i.e. separately on purchases and sales.
The stock exchanges impose margins as follows:
Initial margins on both the buyer as well as the seller.
Daily maintenance margins on both.
The accounts of the buyer and the seller are marked to the market daily.
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33. FUTURES AND OPTIONS
TYPES OF ORDERS
The system allows the trading members to enter orders with various conditions attached to them
as per their requirements. These conditions are broadly divided into the following categories:
• Time conditions
• Price conditions
• Other conditions
Several combinations of the above are allowed thereby providing enormous flexibility to the
users. The order types and conditions are summarized below.
Time conditions
– Day order: A day order, as the name suggests is an order which is valid for the day on which it
is entered. If the order is not executed during the day, the system cancels the order automatically
at the end of the day.
– Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as
the order is released into the system, failing which the order is cancelled from the system. Partial
match is possible for the order, and the unmatched portion of the order is cancelled immediately.
Price condition
-Stop–loss: This facility allows the user to release an order into the system, after the market price
of the security reaches or crosses a threshold price.
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34. FUTURES AND OPTIONS
E.g. if for stop–loss buy order, the trigger is 1027.00, the limit price is 1030.00 and the
market(last traded) price is 1023.00, then this order is released into the system once the
market price reaches or exceeds 1027.00. This order is added to the regular lot book with
time of triggering as the time stamp, as a limit order of 1030.00. For the stop–loss sell
order, the trigger price has to be greater than the limit price.
Other conditions
– Market price: Market orders are orders for which no price is specified at the time the order is
entered (i.e. price is market price). For such orders, the system determines the price.
– Trigger price: Price at which an order gets triggered from the stop–loss book.
– Limit price: Price of the orders after triggering from stop–loss book.
– Pro: Pro means that the orders are entered on the trading member’s own account.
– Cli: Cli means that the trading member enters the orders on behalf of a client.
For both the futures and the options market, while entering orders on the trading system,
members are required to identify orders as being proprietary or client orders. Proprietary orders
should be identified as ‘Pro’ and those of clients should be identified as ‘Cli’. Apart from this, in
the case of ‘Cli’ trades, the client account number should also be provided.
The futures market is a zero sum game i.e. the total number of long in any contract always equals
the total number of short in any contract. The total number of outstanding contracts (long/short)
at any point in time is called the “Open interest”. This Open interest figure is a good indicator
of the liquidity in every contract. Based
on studies carried out in international exchanges, it is found that open interest is maximum in
near month expiry contracts
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35. FUTURES AND OPTIONS
Futures Terminology
Spot price:- The price at which an asset trades in the spot market is called spot price
Futures price: - The price at which the futures contract trades in the futures market.
Contract cycle: - The period over which a contract trades. The index futures contracts on the
NSE have one-month, two months and three –month’s expiry cycles which expire on the last
Thursday of the month. Thus a January expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a three-month expiry
is introduced for trading.
Expiry date :- It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
Contract size: - The amount of asset that has to be delivered under one contract. For instance,
the contract size on NSE’s futures market is 200 Nifties.
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36. FUTURES AND OPTIONS
Basis: - in the context of financial futures, basis can be defined as the futures price minus the
spot price. There will be a different basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: - the relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest that
is paid to finance the asset less the income earned on the asset.
Differences between Forward and Futures Contracts
FEATURE FORWARD CONTRACT FUTURE CONTRACT
Operational Traded directly between two parties Traded on the exchanges.
Mechanism (not traded on the exchanges).
Contract Differ from trade to trade. Contracts are standardized contracts.
Specifications
Counter-party risk Exists. Exists. However, assumed by the clearing
corp., which becomes the counter party to
all the trades or unconditionally
guarantees their settlement.
Liquidation Profile Low, as contracts are tailor made High, as contracts are standardized
contracts catering to the needs of the exchange traded contracts.
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37. FUTURES AND OPTIONS
needs of the parties.
Price discovery Not efficient, as markets are scattered. Efficient, as markets are centralized and
all buyers and sellers come to a common
platform to discover the price.
Examples Currency market in India. Commodities, futures, Index Futures and
Individual stock Futures in India.
OPTIONS
“ An option is a contractual agreement that gives the option buyer the right, but not the
obligation, to purchase (in the case of a call option) or to sell( in case of put option) a specified
instrument at a specified price at any time of the option buyer’s choosing by or before a fixed
date in the future. Upon exercise of the right by the option holder, an option seller is obliged to
deliver the specified instrument at the specified price.”
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right. In
contrast, in a forward or futures contract, the two parties have committed themselves in doing
something. Whereas it costs nothing (except margin requirements) to enter into a futures
contract, the purchase of an option requires an up-front payment.
There are two basic types of options, call options and put options.
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38. FUTURES AND OPTIONS
Call option: A call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.
HISTORY OF OPTIONS CONTRACT
Although options have existed for a long time, they were traded OTC, without much
technology of valuation. The first trading in options began in Europe and US as early as the
seventeenth century. It was only in the early 1990s that a group of firm’s setup what was known
as the put and call Brokers and Dealers Association with the aim of providing a mechanism for
bringing buyers and sellers together. If someone wanted to buy an option, he or she would
contact one of the member firms. The firm would then attempt to find a seller or writer of the
option either from its own clients or those of the other member firms. If no seller could be found,
the firm would undertake o write the option itself in return for a price.
This market however suffered from two deficiencies. First, there was a secondary market and
second, there was no mechanism to guarantee that the writer of the option would honor the
contract.
In 1973, Black, Merton and Scholes invented the framed Back-Scholes formula. In April 1973,
CBOE was setup specifically for the purpose of trading options. The market for options
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39. FUTURES AND OPTIONS
developed so rapidly that by early 80’s , the number of shares underline the option contract sold
each day exceeded the daily volume of shares traded on the NYSE. Since then has been no
looking back.
Option Terminology
Before going into the concepts and mechanics of options trading, we need to be familiar with the
basic terminology as they are repeatedly used in case of options.
Index options: - These options have the index as the underline. Some options are European
while other is American. Like index futures contracts, index options are also cash settled.
Stock options: - Stock options are options on individual stocks. Options currently trade on over
500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the
specific price.
Buyer of an option: The buyer of an option is the one who by paying the option premium buys
right but not the obligation to exercise his option on the seller / writer.
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40. FUTURES AND OPTIONS
Writer of an option: The writer of a call/per option is the one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer exercises on him.
Option price/premium: Option price is the price which the option buyer pays to the option
seller. It is also referred to as the option premium. - To acquire an option, the speculator must
pay option money, the amount of which depends on the share being dealt in. the more volatile
the share the higher the cost of the option. It may, however, normally be somewhere within the
range of 5-10 percent.
The premium of the option is a function of variables, such as:
Current stock price,
Strike price,
Time to expiration,
Volatility of stock, and
Interest rates.
The buyer pays the premium to the seller, which belongs to the seller whether the option is
exercised, or not. If the owner of an option decided not to exercise the option, the option expires
and becomes worthless. The premium becomes the profit of the option writer, while if the option
is exercised; the premium gets adjusted against the loss that the writer incurs upon such exercise
Striking price: - The fixed price at which the option may be exercised, known as the ‘striking
price’ is based on the current quoted prices.
With a call option the striking price is the higher quoted price plus a further small sum called the
contango to recompense the option dealer.
With a put option the striking price is usually the current lower quoted price. There is no
contango money.
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41. FUTURES AND OPTIONS
Declaration day: - At the end of the period the holder either abandons his/her option or claims
right under it. The time for doing this is the ‘declaration day’ which is the second last day in the
account before the final account day on which completion of the option may take place
Limiting risk: - Options are expensive and in order to be profitable requires a fairly sharp short-
term price movement. The costs to be covered are the jobber’s turn, the option money, the
broker’s commission, and in the case of a call option the contango in the striking price. They do
however; substantially reduce the speculator’s risk of loss.
Traded options: - If the options dealing is introduced in the stock exchanges, they will be
publicly traded like any other quoted stocks. Greater flexibility is available to the holder of
traded options than with the options which are not traded in stock exchanges.
Double options: - As well as call and put options it is also possible to obtain a double option
which is a combination of both. The holder has the right either to buy or sell the shares subject to
the option at the striking price which in this case will probably be around the middle of the
current quoted prices. The option money is exactly twice that of the current quoted prices.
Gearing: - Percentage wise the price movements of a traded option are of more than those of the
underlying share. The holder of an option is then exposed to a higher risk but on the other hand
could reap greater rewards in relation to the amount of his/her investment.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive
cash flow to the holder if it were exercised immediately. A call option on the index is said to be
In-the-money when the current index stands at a level higher than the strike price (i.e. spot price
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42. FUTURES AND OPTIONS
> strike price). If the index is much higher than the strike price, the call is said to be deep ITM.
In the case of a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-money when the current
index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to
negative cash flow it were exercised immediately. A call option on the index is out-of-the-money
when the current index stands at a level which is less than the strike price (i.e. spot price < strike
price). If the index is much lower than the strike price, the call is said to be deep OTM. In the
case of a put, the put is OTM if the index is above the strike price.
These concepts are tabulated below, wherein S indicates the present value of the stock and E is
the exercise price.
Condition Call option Put option
S>E In-the-Money Out-of-the-Money
S<E Out-of-the-Money In-the-Money
S=E At-the-Money At-the-Money
Intrinsic Value:-The premium or the price of an option is made up of two components, namely,
intrinsic value and time value. Intrinsic value is termed as parity value.
For an option, the intrinsic value refers to the amount by which it is in money if it is in-the-
money. Therefore, an option, which is out-of-the-money or at-the-money, has zero intrinsic
value.
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43. FUTURES AND OPTIONS
For a call option, which is in-the-money, then, the intrinsic value is the excess of stock price (S)
over the exercise price (E), while it is zero if the option is other than in-the-money.
Symbolically,
Intrinsic Value of a call option = max (0, S – E)
In case, of an in-the-money put option, however, the intrinsic value is the amount by which the
exercise price exceeds the stock price, and zero otherwise. Thus,
Intrinsic Value of a put option = max (0, E - S)
Time Value: - Time value is also termed as premium over parity. The time value of an option is
the difference between the premium of the option and the intrinsic value of the option. For, a call
or a put option, which is at-the-money or out-of-the-money, the entire premium about is the time
value. For an in-the-money option time value may or may not exist. In case, of a call which is in-
the-money, the time value exists if the call price, C, is greater than the intrinsic value, S – E.
Generally, other things being equal, the longer the time of a call to maturity, the greater will be
the time value.
This is also true for the put options. An in-the-money put option has a time value if its premium
exceeds the intrinsic value, E – S. Like for call options, put options, which are at-the-money or
out-of-the-money, have their entire premium as the time value. Accordingly,
Time value of a call = C – [max (0, S - E)]
Time value of a put = C – [max (0, E - S)]
Consider the following data calls on a hypothetical stock.
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44. FUTURES AND OPTIONS
Option Exercise Stocks Call Option Classification
Price (Rs) Price (Rs) Price (Rs)
1. 80 83.50 6.75 In-the-money
2. 85 83.50 2.50 Out-the-money
We may show how the market price of the two calls can be divided between intrinsic and
time values.
Option S E C Intrinsic Value Time Value
Max (0, S-E) C-max (0, S-E)
1. 83.50 80 6.75 3.50 6.75-3.50=3.25
2. 83.50 85 2.50 0 2.50-0=2
Covered & Uncovered Options
An option contract is considered covered if the writer owns the underlying asset or has another
offsetting option position. In the absence of one of these conditions, the writer is exposed to the
risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at
an unfavorable price.
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45. FUTURES AND OPTIONS
The call writer may have to purchase the underlying asset at a price that is higher than he strike
price. The put writer may have to buy the asset from the holder at a price that creates a loss.
When they face such a risk writers are said to be uncovered (or naked).
Covered Call Options / Covered Calls
Call writers are considering to be covered if they have any of the following positions:
Along position in the underlying asset.
An escrow-receipt from a bank.
A security that is convertible into requisite number of shares of the underlying security.
A warrant exercisable for requisite number of shares of the underlying security.
A long position in a call on the same security that has the same or the lower strike price and that
expires at the same time or later than the option being written.
Covered Put
There is only one way for put writer to be covered. They must own a put on the same underlying
asset with the same or later expiration month and the higher strike price than the option being
written.
We will consider some of the following examples to understand the above discussed
concepts better:-
Suppose there is a call option at a strike of Rs.176 and is selling at a premium of Rs.18. At what
price will it break even for the buyer of the option Mr. Ramesh?
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46. FUTURES AND OPTIONS
For Mr. Rajesh to recover the option premium of Rs.18, the spot will have to rise to 176 + 18.
So answer to this will be Rs 194/-
Suppose ACC stock currently sells at Rs.120/-. The put option to sell the stock sells at Rs.134
costs Rs.18. The time value of the option in this case will be?????
It will be Rs4/-
Suppose the spot value of Nifty is 2140. An investor Mr. Murti buys a one month nifty 2157 call
option for a premium of Rs.7. In this case what will such an option be called????
It will be called as Out of the money
Essential Ingredients of an Option Contract
An options contract has four essential ingredients:
The name of the company on whose stock the option contract has been derived.
The quantity of the stock required to be delivered in the case of exercise of the option.
The price, at which the stock would be delivered, or the exercise price or the strike price.
The date when the contract expires, called the expiration date.
Call option
A call option give the buyer the right but not the obligation to buy a given quantity of a
underlying asset, a given price known as ‘exercise price’ on or given future date called a
‘maturity date’ or expiry date’. A call option gives the buyer the rights to buy a fixed number of
shares/commodities in particular securities at the exercised price up to the date of expiration the
contract. The seller of an option is known as the ‘writer’. Unlike the buyer, the writer has no
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47. FUTURES AND OPTIONS
choice regarding the fulfillment of the obligations under the contract. If the buyer wants to
exercise his rights, the writer must comply. For this asymmetry of privilege, the buyer must pay
the writer the option price which is known as premium. The rights and obligations of the buyer
and writer of a call option are explained below
CALL OPTION
BUYER OR HOLDER SELLER OR WRITER
GOING LONG GOING LONG
PAYS TOTAL RECEIVES TOTAL
PREMIUM PREMIUM
HE HAS THE RIGHT BUT NOT THE HE IS OBLIGATED TO SELL ON DEMAND,
OBLIGATION TO BUY 100 SHARES OF THE UNDERLYNG STOCK OF 100 SHARES
THE UNDERLYING STOCK AT STRIKE AT SRIKE PRICE WHEN THE
PRICE. BUYER/HOLDER EXERCISES CALL OPTION.
Buying a call
The buyer of a call option pays the premium in return for the right to buy the underlying asset at
the exercise price. If at the expiry date of the option, the underlying asset price is above the
exercise price, the buyer will exercise the option, pay the exercise price and receives the asset.
This may then be sold in the market at spot price and makes profit. Alternatively, the option may
be sold immediately prior to expiry to realize a similar profit because at expiry, its value must be
sold immediately prior to expiry to realize a similar profit because at expiry, its value must be
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48. FUTURES AND OPTIONS
equal to the difference between the exercise price and market price of the underlying asset. If the
asset price is below the exercise price, the option will be abandoned by the buyer and his loss
will be equal to the premium paid on the purchase of call option.
Intrinsic Value Lines
Premium { Stock Price
k
Writing a call
The call option writer receives the premium as consideration for bearing the risk of having to
deliver the underlying asset is return for being paid the exercise price. If at the expiry, the asset
price is above the exercise price, the writer will incur loss because he will have to buy the asset
at market price in order to deliver it to the option buyer in exchange for the lower exercise price.
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49. FUTURES AND OPTIONS
If the asset price is below the exercise price, the call option will not be exercised and the writer
will make the profit equal to the option premium
k
} Premium b
Stock Price
Intrinsic Value Lines
Rationale of Buying Call Options
There are broadly three reasons why an investor could buy a call option instead of buying the
stock outright. These are as follows:
1. Return on Investment
An investor anticipates that a stock is shortly going to appreciate from Rs. 300 to Rs. 400 per
share and buying 100 shares of the stock would involve an investment of Rs. 30,000. However,
a call option on the stock is available at a premium of Rs. 20. Let us assume that the stock's
share actually goes up to Rs. 400 within the currency of the option. The investor thus makes a
profit of Rs. 80 per share (400 (300+20)]. His investment was only to the extent of premium
paid, i.e. Rs. 20 per share. Thus, the investor got an appreciation of 400% on his investment.
Had he bought the stock outright, the investor would have made Rs. 100 per share on an
investment of Rs. 300, i.e. 33%. This should be sufficient motivation for the investor to go in f6r
call options on the stock as against outright buying of the stock.
2. Hedging
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50. FUTURES AND OPTIONS
Trading with the objective of reducing or controlling risk is called HEDGING. An investor,
having short sold a stock, can protect himself by buying a call option. In the event of an increase
in the stock's price, he would at least have the commitment of the option writer to deliver the
stock at the exercise price, whenever he is to effect delivery for the stock, sold short. The
maximum loss the investor may be exposed to would be limited to the premium paid on the call
option. Options can thus be used as a handy tool for hedging.
3. Arbitrage
Arbitrage involves buying at a lower price and selling- at a higher price, if it so exists. As in any
other trade, options arbitrage provides an opportunity to earn money by exploiting the pricing
inefficiencies, which may exist within a market or between two markets or two products and as a
result tends to bring perfection to the market.
PUT OPTION
The put option gives the buyer the right, but not the obligation, to sell a given quantity of the
underlying asset at a given price on or before a given date. The put option gives the right to sell
the underlying asset at exercise price up to date of the contract. The seller of the put option is
known as ‘writer’. He has no choice regarding the fulfillment of the obligation under the
contract. If the buyer wants to exercise his put option, the writer must purchase at exercise price.
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51. FUTURES AND OPTIONS
For this asymmetry of privilege, the buyer of put option must take the writer, the option price
called as ‘premium’. The rights and obligations of the buyer and writer of a put are explained in
below figure,
PUT OPTION
BUYER OR HOLDER SELLER OR WRITER
GOING LONG GOING LONG
PAYS TOTAL RECEIVES TOTAL
PREMIUM PREMIUM
HE HAS THE RIGHT BUT NOT THE HE IS OBLIGATED TO BUY ON DEMAND,
OBLIGATION TO SELL 100 SHARES OF THE UNDERLYNG STOCK OF 100 SHARES
THE UNDERLYING STOCK AT STRIKE AT SRIKE PRICE WHEN THE
PRICE. BUYER/HOLDER EXERCISES PUT OPTION.
Buying a Put
The buyer of the put option pays the option premium for the right to sell underlying asset at the
exercised price. If at expiry the asset prices are below the exercised price, the buyer will exercise
the option, gives the asset and receive the exercised price. If the asset is above the exercise price,
the put option will be abandoned and the buyer will incur loss equal to the option premium.
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52. FUTURES AND OPTIONS
WRITING A PUT
The put writer receives the premium for bearing the risk of having to take the underlying asset at
the exercised price. If the market price of the asset is below the exercise price at expiry, the
writer will incur a loss because he will have to pay the exercise price but will only be able to
resell the asset at the lower market price. If the asset is above the exercise price at expiry, the
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53. FUTURES AND OPTIONS
buyer will abandon the put option and the writer will make a profit equal to the option premium
received.
Rationale of Buying a Put Option
An investor, if he anticipates fall in the price of some stock, has the following alternatives:
Sell the stock short, i.e. enter a sales transaction without owning the stock. In the event of a fall
in the stock price, he can buy the stock at a lower price and can deliver the stock sold to the
buyer, thus making profit equal to the fall in the price. However, in case the stock price
appreciates instead of declining, the investor would be exposed to unlimited loss.
Write a call option without owning the stock, i.e. writing a naked call option. Writing such an
option is similar to selling short, the only difference being that the loss in the event of
appreciation in the stock price would be curtailed to the extent of the premium received on
writing the call option, which may not be sufficient attraction.
Purchase a put option. The purchase of a put option is the most desirable policy as compared to
either going short or writing a naked call option. The first reason is that the investment in buying
a put option is restricted to the premium as against a larger sum required for going short. Thus,
as in the case of a call option, the return on investment on buying a put option is much higher as
compared to going short on the stock. Secondly, in the event of increase in the stock price, the
loss to the put option buyer is restricted to the premium paid.
Advantages of options
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54. FUTURES AND OPTIONS
• There is limited risk for many options strategies. The trader can lose the entire premium,
but that amount is known when the position is initiated.
• There are no margin calls for many strategies.
• Options offer a wide range of strategies for a variety of conditions.
• Options offer a way to add to futures positions without spending any more money or
premiums. Thus, the option trader has more leverage.
• With a forward and futures contract, the investor is committed to a future transaction;
with an option, he enjoys the right to go ahead but he walk away from the deal if he so
desires.
• The options have certain favorable characteristics. They limit the downside of risk
without limiting the upside. It is quite obvious that there is a price which has to be paid
for this one way but which is known as ‘option premium’. Those who sell options must
charge a premium high enough to cover their losses when options are exercised at prices
that are much better than the existing market price; options have become the fastest
growing derivative in the currency markets.
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55. FUTURES AND OPTIONS
Disadvantages of options
• The trader pays a premium to enter a market when buying options. When volatility is
high, premiums can be very expensive. The trade is paying for time, so premium
becomes an eroding asset. On the other side, options sellers can receive price premium,
but they have margin requirements.
• Currently, there is more liquidity in future contracts than there are in most options
contracts. Entry and exit from some markets can be difficult. Even if the positions entered
with a limit order, existing can be a problem, unless the option is in the money. Of
course, the option buyer can exercise the option, receive a futures position, then liquidate
the futures. There are more complex factors affecting premium prices for options,
volatility and time to expiration are more important than price movement.
• Many options contracts expire weeks before the underlying futures. This can be an
occasional often occurs close to the final trading day of futures. However, this should not
be construed to mean that commercials cannot use the options to hedge.
• Option premiums don’t move tick for tick with the futures (unless they’re deep in the
money). Thus can be frustrating to have the market move in your direction, yet lose
premium value.
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56. FUTURES AND OPTIONS
In May beginning Mr. Vicky decide that shares in X Ltd. will rise over the next month or so. The
current price is Rs. 100 and he hopes that the shares will be at Rs.150 by the end of July.
When no options are traded
If Mr. Vicky buys the shares, say 100 shares for Rs 10000 and he is correct in his expectations
his shares will be worth Rs 15000 within three months showing a profit of Rs 5000, 50% of the
amount invested less expenses.
The risk attached in this investment, is, he need an investment of Rs 10000for purchase of 100
shares in X Ltd. And if the amount is invested, there is a risk of price drop on different factors
like collapse of X Ltd. fall of shares market index, slump in the market.etc. then he will loose his
money, when his expectations go wrong.
When options are traded
1. When an option is traded, he could buy an option on the share, say at Rs. 10 premium.
2. This option would give him the right to buy a share in X Ltd for Rs 100 at any time over the
next three months.
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57. FUTURES AND OPTIONS
3. if X Ltd’s share price remains at Rs. 100 he have no option with no value and so he will lose
Rs. 10 premium per share that he has paid and his total extent of Rs.1000( 100 shares *Rs. 10).
4. If the share price goes up to Rs.150 then his option has value worth exercising. The increase in
share price from Rs.100 to Rs.150 per share amounting to total increase in Rs.5000 on 100
shares and his net return is RS. 4000 on an investment of Rs. 1000 and he earns a profit 400% on
his investment by purchasing an option instead of shares in X Ltd.
5. If the price rose to over Rs 100. And the option was exercised, then he would be required to
part with his shares in X Ltd at Rs. 100 per share or buy them for onward delivery at the
prevailing market price. However, he would gets Rs. 10 premium as well. So he would get Rs.
10 premium as well, so he would locally be getting Rs. 100 on shares and this Rs. 10 would limit
the paper loss in his portfolio if the X Ltd share price falls.
57

58. FUTURES AND OPTIONS
RISK AND RETURN WITH EQUITY OPTIONS
We will now see the risk and return associated with equity stock options.
Call Options
Consider a call option on a certain share; say ABC Suppose the contract is made between two
investors X and Y, who take, respectively, the short and long positions. The other details are
given below:
Exercise price = Rs 120
Expiration month = March, 2001
Size of contract = 100 shares
Date of entering into contract =January 5, 2001
Price of share on the date of contract = Rs 124.50
Price of option on the date of contract = Rs 10
At the time of entering in to the contract, Investor X writes a contract and receives Rs. 1000 (=
10 x 100) Investor Y takes a long position and pays Rs 1000 for it.
On the date of maturity, the profit or loss to each investor would depend upon the price of the
share ABC prevailing on that day. The buyer would obviously not call upon the call writer to
sell shares if the price happens to be lower than Rs 120 per share. Only when the price exceeds
Rs 120 per share will a call be made. Having paid Rs 10 per share for buying an option, the
58

59. FUTURES AND OPTIONS
buyer can make a profit only in case the share price would be at a point higher than Rs 120 + Rs
10 = Rs 130. At a price equal to Rs 130 a break-even point is reached. The profit/loss made by
each of the investors for some selected values of the share price of ABC is indicated below.
Profit / Loss Profile for the Investors - Call Option
Possible Price of ABC at Investor X Investor Y
Call Maturity (Rs.)
90 1000 -1000
100 1000 -1000
110 1000 -1000
120 1000 -1000
130 0 0
140 -1000 1000
150 -2000 2000
160 -3000 3000
59

60. FUTURES AND OPTIONS
The profit profile for this contract is indicated below. Figure (a) shows the profit/loss function
for the investor X, the writer of the call, while Figure (b) gives the same for the other investor Y,
the buyer of the option.
(a) For Investor X
Profit
1500 –
Stock Price
1000 –
90 100 110 120 130 140 150 160
500 –
0
500 –
(b) For Investor Y
Profit
1000 –
3000
1500 –
2500
2000 –
2000
2500 –
Stock Price
90 100 110 120 130 140 150 160
1500 –
Loss
1000 –
60
500 –

61. 0–
FUTURES AND OPTIONS
500 –
It is evident that the call writer's profit is limited to the amount of call premium but, theoretically,
there is no limit to the losses if the stock price continues to increase and the writer does not make
1000 –
a closing transaction by purchasing an identical call. The situation is exactly opposite for the call
buyer for whom the loss is limited to the amount of premium paid. However, depending on the
stock1500 – there is no limit on the amount of profit which can result for the buyer. Being a
price,
'zero-sum' game, a loss (gain) to one party implies an equal amount of gain (loss) to the other
party.Loss
Put Options
In a put option, since the investor with a long position has a right to sell the stock and the writer
is obliged to buy it at the will of the buyer, the profit profile is different from the one in a call
option where the rights and obligations are different.
Consider a put option contract on a certain share, PQP, Suppose, two investors X and Y enter
into a contract and take short and long positions respectively. The other details are given below:
Exercise price = Rs I 10
Expiration month = March, 2001
Size of contract= I 00 shares
Date of entering into contract =January 6, 2001
Share price on the date of contract = Rs 1 12
Price of put option on the date of contract = Rs 7.50
61

62. FUTURES AND OPTIONS
Now, as the contract is entered into, the writer of the option, X will receive Rs 750 (=7.50 x 100)
from the buyer, Y At the time of maturity, the gain/loss to each party depends on the ruling price
of the share. If the price of the share is Rs 110 or greater than that, the option will not be
exercised, so that the writer pockets the amount of put premium-the maximum profit which can
accrue to a seller. At the same time, it represents the maximum loss that the buyer is exposed to.
If the price of the share falls below the exercise price, a loss would result to the writer and a gain
to the buyer. The maximum loss that the writer may theoretically be exposed to is limited by the
amount of the exercise price.
Thus, if the value of the underlying share falls to zero, the loss to the writer is equal to Rs. 110 –
Rs. 7.50 = Rs. 102.50 per share. The profit/loss for some selected values share are given below.
Possible Price of PQR at Investor X Investor Y
Investor X
Investor Y
Put Maturity (Rs)
80 -2250 2250
90 -1250 1250
100 -250 250
110 750 -750
120 750 -750
130 750 -750
140 750 -750
150 750 -750
The break-even share price would be Rs 102.50 (= Rs 110 Rs 7.50). If the price of the share
happens to be lower than this, the writer would make a loss-and the buyer makes a gain. For
62

63. FUTURES AND OPTIONS
instance, when the price of the share is Rs 100, the gain/loss for each of the investors may be
calculated as shown below.
Investor X
Option premium received = 7.5 x 100 = Rs. 750
Amount to be paid for shares = 110 x 100 = Rs. 11000
Market value of the shares = 100 x 100 = Rs. 10000
Net Profit (Loss) = 750 - 11000 + 10000 = (Rs. 250)
Investor Y
Option premium paid = 7.5 x 100 = Rs. 750
Amount to be received for shares = 110 x 100 = Rs. 11000
Market value of the shares = 100 x 100 = Rs. 10000
Net profit (loss) = -750 + 11000 - 10000 = Rs. 250
Profit
1500 –
The profile of profit/loss for each of the investors is given in Figures below. Fig. (a) shows the
profit/loss function for the investor X the writer of the put, Stock Price Fig. (b) gives the same for
while the
1000 –
the other investor Y, the buyer of the option. 150 160
90 100 110 120 130 140
As indicated earlier, the profiles of the two
investors replicate each other.
500 –
(a) For investor X
0
500 –
63
1000 –

64. 1500 –
FUTURES AND OPTIONS
2000 –
2500 –
3000 –
Loss
(b) For Investor Y
Profit
2500 –
2000 –
Stock Price
90 100 110 120 130 140 150
1500 –
1000 –
Option Trading Strategies
500 –
0–
64
500 –

65. 1000 –
FUTURES AND OPTIONS
Loss
We have considered above the profit/loss resulting to the investors with long and short positions
in the call and put options. It is important to note that an investor need not take positions in
naked options only or in a single option alone. In fact, a number of trading strategies involving
options may be employed by the investors. Options may be used on their own, in conjunction
with the futures contracts, or in a strategy using the underlying instrument (equity stock, for
example). One of the attractions of options is that they could be used for creating a very wide
range of payoff functions. We now discuss some of the commonly used strategies.
To begin with, we may consider investment in a single stock option. The payoffs associated with
a long or short call, and a long or short put option has already been discussed. A long call is
used when one expects that the market would rise. The more bullish market sentiment or
perception, the more out-of-the money option should one buy. For the option buyer in this
strategy, the loss is limited to the premium payable while the profit is potentially unlimited. On
the other hand, the writer of a call has a mirror image position along the break-even line. The
writer writes a call with the belief or expectation that the market would not show an upward
trend.
In case of the put option, a long put would gain value as the underlying asset, the equity share
price or the market index, declines. Accordingly, a put is bought when a decline is expected in
the market. The loss for a put buyer is limited to the amount paid for the option if the market
ends above the option exercise price. The writer of a put option would get the maximum profit
equal to the premium amount but would be exposed to loss should the market collapse. The
maximum loss to the writer of a put option on an equity hare could be equal to the exercise price
(since the stock price cannot be negative).
Thus, while selling of options may be used as a legitimate means of generating premium income
and bought in the expectation of making profit from the likely bullish / bearish market
sentiments, they may or may not be used alone. They may, however, be combined in several
Ways without taking positions in the underlying assets or they might be used in conjunction with
the underlying assets for purposes of hedging, which we describe in the next section.
Hedging using Call & Put Options
65

66. FUTURES AND OPTIONS
Hedging represents a strategy by which an attempt is made to limit the losses in one position by
simultaneously taking a second offsetting position. The offsetting position may be in the same or
a different security. In most cases, the hedges are not perfect because they cannot eliminate all
losses. Typically, a hedge strategy strives to prevent large losses without significantly reducing
the gains.
Very often, options in equities are employed to hedge a long o short position in the underlying
common stock. Such options are called covered options in contrast to the uncovered or naked
options, discussed earlier.
Hedging a Long Position in Stock
An investor buying a common stock expects that its price would increase. However, there is a
risk that the price may in fact fall. In such a case, a hedge could be formed by buying a put i.e.,
buying the right to sell. Consider an investor who buys a share for Rs. 100. To guard against the
risk of loss from a fall in its price, he buys a put for Rs. 16 for an exercise price of, say, Rs. 110.
He would, obviously, exercise the option only if the price of the share were to be less than Rs.
110. Table below gives the profit/loss for some selected values of the share price on maturity of
the option. For instance, at a share price of Rs. 70, the put will be exercised and the resulting
profit would be Rs. 24, equal to Rs. 110 – Rs. 70, or Rs 40 minus the put premium of Rs. 16.
With a loss of Rs. 30 incurred for the reason of holding the share, the net loss equals to Rs. 6.
Profit / Loss for Selected Share Values: Long Stock Long Put
66

67. FUTURES AND OPTIONS
Share Exercise Profit on Profit / Loss on Net Profit
Price Price Exercise (i) Share Held (ii) (i) + (ii)
70 110 24 -30 -6
80 110 14 -20 -6
90 110 4 -10 -6
100 110 -6 0 -6
110 110 -16 10 -6
120 110 -16 20 4
130 110 -16 30 14
140 110 -16 40 24
The profits resulting from the strategy of holding a long position in stock and long put are shown
in the figure below.
Hedging: Long Stock Long Put
Profit on Exercise
Profit Profit / Loss on Hedging
of Put
50 -
40 -
30 -
E
20 -
10 -
Stock Price
0
10 -
20 - Profit / Loss on
Hedging a Short30 -
Position in Stock
Long Stock
40 -
Loss 67

68. FUTURES AND OPTIONS
Unlike an investor with a long position in stock, a short seller of stock anticipates a decline in
stock price. By shorting the stock now and buying it at a lower price in the future, the investor
intends to make a profit. Any price increase can bring losses because of an obligation to purchase
at a later date. To minimize the risk involved, the investor can buy a call option with an exercise
price equal to or close to the selling price of the stock.
Let us suppose, an investor shorts a share at Rs. 100 and buys a call option for Rs. 4 with a strike
price of Rs. 105. The conditional payoffs resulting from some selected prices of the share are
shown in a table below.
Profit / Loss for Selected Share Values: Short Stock Long Call
Share Exercise Profit on Profit / Loss on Net Profit
Price Price Exercise (i) Share Held (ii) (i) + (ii)
90 105 -4 15 11
95 105 -4 10 6
100 105 -4 5 1
105 105 -4 0 -4
110 105 1 -5 -4
115 105 6 -10 -4
120 105 11 -15 -4
The payoff function associated with this policy is shown below
68