Sub: Derivatives and Risk Management Case Study No.

Title: Futures and Options

Aniket, an entrepreneur, with the profits earned through his venture, decided to make investments.
Originally, most of his investments were in mutual funds, and when the Indian market was doing well,
he was getting a high return on these investments. He was not satisfied with this investment
performance and decided to trade on derivatives. Since options sounded very complicated, he went on
to trade in futures.

Even though he did not know much about futures, he formulated a simple rule. He would take a long
position in the futures on a single stock, which he believed would increase in price. Then he would close
the position if the future prices move up, so that he can make at least INR 1000 and take the profits. In
case the price does not increase as expected, he would close the position after two days and take
whatever be the result, even it is a loss.

From 2004 to 2007, this worked when the market was doing well and most stocks were increasing in
prices. However, when the market started doing poorly from the middle of 2008, this strategy resulted
in huge losses and at one point of time, he had lost more than INR 1.5 million in a month

In early 2009, Aniket’s brother Raj, who lives in the USA and is a professor of finance, visited
Aniket.When Aniket explained his predicament, Raj told Aniket that he should have gone into options
rather than futures, as futures were comparatively more risky and can lead to huge losses.

Aniket had a number of questions for Raj and raj told him that all these questions can be answered by
his students who take his course on derivatives.

Discussion Questions

i) Why is trading in futures more risky when compared to trading in options?

ii) In the case of futures, Aniket need to post a margin. Does he need to post a margin in the case of
options?

iii) In the case of futures, Aniket has a strategy of closing the position whenever he makes INR 1000, Can
he also do the same with options?

iv) Aniket enter into a long November futures contract at INR 1250.He also enter into an options
contract to buy ICICI bank shares at INR 1250. The option price is INR 70.On November 28, ICICI bank
shares sell at INR 1300.What will be Aniket’s gain or loss from futures? What will be his gain or loss from
options?
v)In case the ICICI Bank announces a stock split of 5:2, that is for every two shares currently owned, five
new shares will be issued. Will the options contract remain the same or will it change? How will option
terms change?