Road Map....

1.1: Indian Financial Markets: Where does derivative fall?

1.2: Derivatives History, Meaning and Definition.
1.3: Classification of Derivatives
1.4: Features of Derivatives
1.5: Types of Derivatives
1.6: Players in Derivatives
1.1: Indian Financial Markets:
1.2: Derivatives History, Meaning and Definition

 Derivatives is a product whose value is derived from

the value of the underlying asset
 It is a contract
 It is a hedging instrument, should not be viewed as
an investment instrument
 Underlying asset can be equity, forex, commodity or
any other asset
 Eg. Shares and Indices (Nifty), Dollar /Euro,
Agricultural Commodities like cotton, spices, pulses
etc
1.2.: Where does derivative fall in the financial system?

 Derivatives products are available to hedge risk in

 1. Share Market Investments
 2. Price risk in Commodity Market (Agri / Metal /
Crude)
 3. Transaction risk in Forex Market
 4. Others
 Indian Equity Derivatives Market: A Brief History
May 2000 SEBI granted approval to commence Derivatives Trading in India
…………………….... ………………………………………………………………………………………………………………….
2000 - 2001 Product Launched in
Index Futures (S&P CNX Nifty) June 2000
……………………… ………………………………………………………………………………………………………………….
2001 – 2002 Index Options (Nifty) June 2001
Stock Options July 2001
Stock Futures Nov 2001
……………………… ……………………………………………………………………………………………………………….
2003 – 2004 CNX IT
Interest Rate Futures
……………………… ………………………………………………………………………………………………………………..….
2004 – 2005 • NSE became no. 1 stock exchange in the world in Stock Futures
……………………… ……………………………………………………………………………………………………………………
2005 - 2008 • Bank Nifty, Nifty Junior, CNX100, MCAP
• 275 securities in derivatives segment
• Enhancement of number of strikes for Nifty options based on index
levels
1.3: Classification of Derivatives
1.4: Features of Derivatives

 Hedging

 Price Discovery

 Liquidity Function

 Trading Volumes
1.5: Types of Derivatives
 Forwards
A forward contract is a customized agreement between two
parties to exchange an asset at certain period in future at
today’s pre agreed price
 Futures
A futures contract is an agreement between two parties to
exchange an asset at a certain date at a certain price. Futures
contracts are standardized forward contracts that are traded
on an exchange
 Options
An options contract gives buyer the right, but not the
obligation to buy or sell a specified underlying at a set price
on or before a specified date
 1.6: Players in Derivatives

 Hedgers: Hedgers face risk associated with the price of an asset

they own. They use derivatives to reduce or eliminate risk.

 Speculators: Speculators bet on future movements in the

prices of an asset. Derivatives give them an extra leverage, by
which they can increase both the potential gains and losses.

 Arbitrageurs: Arbitrageurs take advantage of discrepancy

between prices in two different markets.

 Jobbers: Jobbers take advantage from the spread between the

Bid and Ask price.
2.1: Meaning of Forwards
2.2: Features of Forwards
2.3: Players in Forwards
2.4: Limitations of Forwards
2.1: Meaning of Forwards

 Forwards
A forward contract is a customized agreement between
two parties to exchange an asset at certain period in
future at today’s pre agreed price

Eg. On May 1, 2004, Mr. X agrees to buy ten tola of Gold

from Mr. Y on Dec 31, 2004 at Rs 6500/tola

Mr. X has taken a long position and Mr. Y short.

Other details are negotiated bilaterally
2.2: Features of Forwards

 Bilateral contracts

 Customized agreement

 Price known only to the parties

 Delivery settled

 Reversal compulsory with the same counter party

2.3: Players in Forwards

 Hedgers

 Speculators
2.4: Limitations of Forwards

 Lack of centralization of trading

 Illiquidity

 Counter party risk

3.1: Meaning
3.2: Terminologies
3.3: Purpose of Futures
3.4: Payoff Profile
3.5: Trading Strategies
3.1: Meaning

 Futures were designed to solve the problems that

existed in the forward markets

 A futures contract is an agreement between two

parties to exchange an asset at a certain date at a
certain price

 Futures contracts are standardized forward contracts

that are traded on an exchange
contd….

 To facilitate liquidity, exchange specified standard

features for the contract

Quantity and quality of the underlying

Date and month of delivery
Units of price quotation and min. price change
Location and mode of settlement

 Futures can be offset prior to maturity, 99% offset

prior to maturity
 Forwards vs Futures
Forward Future
Traded on OTC Traded on the exchange
Customized Standardized
Illiquid Liquid
No Margins required Margins required
Expiry Settled Daily Settled
Only Delivery Settled Delivery or Cash Settled
No Guarantee Exchange stands Guarantor
Price is only known to the Strike price(s) are public
parties knowledge
3.2: Terminologies

 Spot Price:
Price at which an asset trades in the spot market

 Futures price:
Price at which futures contract trades in the futures
market
contd…

 Contract cycle:
Period over which a contract trades. Derivatives contracts
have one, two and three months expiry cycles. Contracts
expire on last Thursday. New contracts are fired on Friday

 Expiry date:
Date specified on the derivatives contract. It’s the last
Thursday and the last day for the contract to be traded.
Contract will cease to exist from this day
contd…

 Contract size:
Quantity of asset that has to be delivered under one
contract

 Basis:
It is the difference between futures and spot.
Theoretically basis is always positive

 Cost of carry:
It measures the interest cost that is paid to finance the
asset less the income earned on that asset
contd…

 Initial margin:
Amount that must be deposited in the margin account in
order to initiate a futures position

 Mark to Market (MTM):

In futures, at the end of each trading day, the margin
account is adjusted to reflect the investors’ gain or loss
depending upon the futures closing prices. This
adjustment is called MTM
contd…
contd…

 Maintenance Margin:
This is lower than the initial margin. This margin is set to
ensure that the balance in the margin account never
becomes negative.

If the balance falls below maintenance margin, margin

call is made.

Trader is expected to top up the margin account to the

initial margin level
3.3: Purpose of Futures

 Hedging

 Arbitrage

 Jobbing
 Hedging

 Is a mechanism to reduce price risk.

 Price Risk can be Reduced by taking an opposite position

in futures market.

 Hedging can be initiated by Selling Nifty Futures or a

stock ….hedge can be for 20%, 50% or 100% based on
view.

 Ideally 25 – 35% hedge is kept at all times, then based on

view, its increased or decreased.
 Hedging on a scrip
(F&O Segment)

 Mr. X takes a Rs 10 lacs long position in IPCL on May

1, 2004 @ Rs 100 / share

 Take a short position on IPCL futures of Rs 10 lacs

 Hedging on a scrip
(Non F&O Segment)

 Mr. X takes a Rs 10 lacs long position in Zee Tele on

May 1, 2004 @ Rs 100 / share

 Suppose the beta is 1.2

 Take a short position on Index futures of:

Rs 10 lacs x 1.2 = Rs 12 lacs
 Illustration: Hedging of Portfolio

Price as on Investment Weightage Portfolio

Scrip Name Quantity Beta
12.11.08 Amount % Beta

Sun Pharma 84 1185 100000 20.00% 0.59 0.12

Bank of India 366 273 100000 20.00% 0.9 0.18

Tatasteel 541 185 100000 20.00% 0.75 0.15

SCI 1220 82 100000 20.00% 1.13 0.23

Chennai Petro 826 121 100000 20.00% 1.1 0.22

  Total 500000    0.89

Take a short position on Index Futures for Rs 4,47,000/- (0.89 x 5,00,000)

Arbitrage

Arbitrageurs: Arbitrageurs take advantage of

discrepancy between prices in two different
markets.

Eg. Buy L&T in cash market @ Rs. 800/- sell in

future market @ Rs .840/- thereby profit Rs. 40/-
Jobbing

 Jobbing is nothing but taking advantage from the spread

between the Bid and Ask price.

 Eg. Powergrid

Bid Ask
99.90 100.05
99.85 100.10
99.80 100.15
99.75 100.20
99.70 100.25
3.4: Payoff Profile

 A payoff is the likely profit or loss that would accrue

to a market participant with change in the price of
the underlying asset

 Futures have a linear payoff, i.e. the losses as well as

profits for the trader of futures contract are unlimited
Futures – Buyer Payoff
 Payoff for Futures Buyer - Graphical

250

150

50

1,000 1,100 1,200 1,300 1,400 1,500

-50

-150

-250
Futures – Seller Payoff
 Payoff for Futures Seller - Graphical
250

150

50

1,000 1,100 1,200 1,300 1,400 1,500

-50

-150

-250
Futures Pricing - Mathematically

 In equation terminology-

F = S+C = S(1+r)T  
Where,
F = Future Price
S = Spot Price
C = Cost of Carry
r = Rate of Interest
T = Time to expiry
Example

 Spot Nifty (S) = 1250

 Interest rate cost (r)= 10%

 Time to expiration (t) = 1 month

Contd….

F =
S(1+r) t

= 1250 (1+0.10) 1/12

= 1260
3.5: Trading Strategies

 Long

 Short
4.1: Meaning
4.2: Terminologies
4.3: Trading Strategies
4.4: Payoff Profile
4.1: Meaning

 An option is a particular type of contract between two

parties where one person gives the other person the

right to buy or sell a specific asset at a specified price
within a specified time period
4.2: Terminologies

 Index options: Have index as the underlying

 Stock Options: Have stock as the underlying

 Option buyer: Buys the option by paying premium and

gets the right to exercise options on writer/seller

 Option seller: Sells/writes the option and receives the

premium and is hence under obligation to buy/sell asset
if the buyer exercises option
Contd….
 Strike / Exercise price: Price at which the underlying may be
purchased or sold

 Expiry date: It’s last Thursday of the month for options to be

exercised/ traded. Options cease to exist after expiry

 Exercise: Invoke the rights approved to buyer of option

 Assignment: When the buyer of an option exercises his right

to buy / sell, a randomly selected option seller ( at the client
level ) is assigned the obligation to honor the underlying
contract.
Contd….

 European Option
Can be exercised only on the expiration date
e.g. Index options

 American Option
Can be exercised any time on or before the expiration
date
e.g. Stock options
 Open Interest
 The total number of outstanding contracts on a given series
or for a given underlying at a particular point in time.

 Open Interest is the number of contracts which are yet to be

settled.

 Eg.
In the Futures and Options trading.
>> If ‘A’ buys 2 futures from ‘B’, the Open Interest is 2.
>> If ‘B’ in turn buy 4 futures from ‘C’, the open interest is 6.
 ITM
 In the money options
It is an option that will lead to a positive cash flow to
buyer when exercised

Call option is in the money when CMP is higher than

strike

Put option is in the money when CMP is lower than strike

 ATM

 At the money options

It is an option that will lead to a zero cash flow to buyer
when exercised

Options are at the money when CMP is equal to strike

 OTM
 Out of the money options
It is an option that will lead to a negative cash flow to
buyer when exercised, however OTM options can never
be exercised / assigned

Call option is out of money when CMP is lower than

strike

Put option is out of money when CMP is higher than

strike
Contd….
At-The-Money-Strike
In-The-Money Calls Out-The-Money-Calls
950 1050 1150 1250 1350 1450 1550

Spot

950 1050 1150 1250 1350 1450 1550

Out-The-Money-Puts In-The-
Money-Puts
At-The-Money-Strike
 ITM-OTM-ATM

Market Scenario Call Option Put Option

Market Price > Strike Price ITM OTM

Market Price < Strike Price OTM ITM

Market Price = Strike Price ATM ATM

Identifying ITM-OTM-ATM
 Option Premium

 The price that the buyer of an option contract pays to

enter into option contract

 The seller in an option contract receives the premium

 Option Premium comprises of two value viz.

>> Intrinsic Value and
>> Time value
Intrinsic Value

 Intrinsic Value (IV )

Difference between spot and strike
ITM has IV, ATM and OTM have zero IV

 Intrinsic Value tells about the extent to which an option

contract is In the Money at a given point of time.

 Example- If the spot price if Rs. 1000 and strike is Rs. 980
for a call option, then the intrinsic value is taken as Rs. 20
Time Value

 Difference between the premium and intrinsic value

 ITM have both IV and TV, ATM and OTM have only TV
 Longer the expiry more the TV, on expiry TV is 0
 Time value is calculated as the difference between Intrinsic
value and premium.
 Time value of an option contract decreases as the option
contract approaches expiry
 Time value of a contract is measured by THETA
4.3: Trading Strategies
 Buy Bullish

Call

Sell Bearish

Buy Bearish

Put

Sell Bullish
4.4: Payoff Profile

 Losses of the buyer is limited to the premium paid and

profits are unlimited

 For writers/sellers losses are unlimited and profits limited

to the premium received
 Call options – Buy & Sell

 A call option gives the buyer, the right to buy

specified quantity of the underlying asset at a set
strike price on or before expiration date

 The seller(writer) however, has the obligation to sell

the underlying asset if the buyer of the call option
decides to exercise the option to buy
 Buying of a Call Option

View: Bullish

 Buy a one month Nifty Call

 With the Strike of 1250

 Premium of Rs 100
 Payoff Table – Call Buyer

Nifty Spot 1000 1100 1200 1250 1350 1400 1500

Below Below Below At strike Break Above Above

strike strike strike even strike strike

Value of 0 0 0 0 100 150 250

1250 call

Premium -100 -100 -100 -100 -100 -100 -100

paid

Net Profit -100 -100 -100 -100 0 50 150

/ (Loss)
200
Payoff Chart – Call Buyer

150

100

50

0
1,000 1,100 1,200 1,250 1,350 1,450 1,550

-50

-100

-150
The maximum loss for a call option buyer is the premium
paid by him, while maximum gains are unlimited.
 Selling of a Call Option

View: Bearish

 Sell / Write a one month Nifty Call

 With the Strike of 1250

 Premium of Rs 100
 Payoff Table – Call Seller

Nifty Spot 1000 1100 1200 1250 1350 1450 1550

Below Below Below At strike Break Above Above

strike strike strike even strike strike

Value of 0 0 0 0 -100 -200 -300

1250 call

Premium 100 100 100 100 100 100 100

recd

Net Profit 100 100 100 100 0 -100 -200

/ (Loss)
 Payoff Chart – Call Seller
200

150

100

50

0
1,000 1,100 1,200 1,250 1,350 1,450 1,550

-50

-100

-150

-200

-250
The maximum gain for a seller of the call option is
premium
 Put Options – Buy & Sell

 A put option gives the buyer the right to sell specified

quantity of the underlying asset at a set strike price on or
before expiration date.

 The seller (writer) however, has the obligation to buy the

underlying asset if the buyer of the put option decides to
exercise his option to sell.
 Buying of a Put Option

View: Bearish

 Buy a one month Nifty Put

 With the Strike of 1250

 Premium of Rs 100
 Payoff Table – Put Buyer

Nifty Spot 1000 1100 1150 1250 1350 1450 1550

Below Below Break At strike Above Above Above

strike strike even strike strike strike

Value of 250 150 100 0 0 0 0

1250 put

Premium -100 -100 -100 -100 -100 -100 -100

paid

Net Profit 150 50 0 -100 -100 -100 -100

/ (Loss)
 Payoff Chart – Put Buyer
200

150

100

50

0
950 1050 1150 1250 1350 1450 1550

-50

-100

-150 The maximum loss for a buyer of the put option is the
premium paid by him, while maximum gains are unlimited.
 Selling of a Put Option

View: Bullish

 Sell / write a one month Nifty Put

 With the Strike of 1250

 Premium of Rs 100
 Payoff Table – Put Seller

Nifty Spot 1000 1100 1150 1250 1350 1450 1550

Below Below Break At strike Above Above Above

strike strike even strike strike strike

Value of -250 -150 -100 0 0 0 0

1250 put

Premium 100 100 100 100 100 100 100

recd

Net Profit -150 -50 0 100 100 100 100

/ (Loss)
200
Payoff Chart – Put Seller
150

100

50

0
950 1050 1150 1250 1350 1450 1550

-50

-100

-150

-200

-250
The maximum gain for a seller of the put option is premium
Payoff Profile - Summary
Open Interest Analysis - Summary
 PCR

 PCR means Put Call Ratio

 Put Call Ratio means, the Volume of Put Options to the

Volume of Call of Options.

 Put option indicates, the Price of the Stock is going to

fall.

 Call Option buyer anticipates the Stock is going to rise.

 PCR

 When calls are more than Puts, means the anticipation

of market is of a Bullish Sentiment.

 When puts are more than calls, means it is a sentiment

of Bearish Market.

 At the end of the day, when Put to call ratio is taken, the
overall market sentiment can be captured.
PCR Analysis - Summary