An Introduction to Derivatives

A presentation by
Derivative Research
What are derivatives
Derivatives are financial instruments
whose value depend on the value of
other, more basic underlying assets.

Underlying asset can be a commodity,

currency, equity, interest rate,
exchange rate etc.
Derivative Products

Futures
Options
Forward Contracts
A forward contract is a particularly simple derivative.
It is an agreement to buy or sell an asset at a certain
future time for a certain price.
The contract is negotiated privately usually between
two parties.
The quality and quantity of the asset is not
standardized.
The time and place of delivery is not standard.
The parties to the contract assumes counter party
risk.
It is normally not traded on the exchanges.
Futures Contract
Every futures contract is a forward contract.
Futures contracts:
are entered into through exchange, traded on exchange
and clearing corporation/house provides the settlement
guarantee for trades.
are of standard quantity, standard quality.
have standard delivery time and place.
Introduction to futures
Choice of initial product:
Index futures
Options on index
Stock futures
Options on stocks
Introduction to futures
Trading mechanism
Contract design:
Multiplier
Contract size
Tick size
Expiration month and date
Open interest, volume position
Futures – definition
A futures is a legally binding agreement
to buy or sell something in the future at
a price which is determined today.
Pricing
Futures = Spot+Cost of carry –dividend (if any)
Operational Mechanism
Cash settled
Initial Margin (upfront)
Mark-to-Market margin (daily)
Option - definition
option is the right given by the option seller
to the option buyer to buy or sell specific
asset at a specific price on or before a
specific date.
How much does an option
cost?
The premium is the price you pay for
the option.

For buyer of an option

Risk : limited to the amount of premium
paid
Profit potential: unlimited
Option Terminology
Call Option
 Option to buy
Put Option
 Option to sell
Option Buyer
 has the right but not the obligation
Option Writer/Seller
 has the obligation but not the right
Option Terminology
Option Premium
 Price paid by the buyer to acquire the right
Strike Price OR Exercise Price
 Price at which the underlying may be purchased
Expiration Date
 Last date for exercising the option
Exercise Date
 Date on which the option is actually exercised
Types of Options
American Option (options on stocks)
 can be exercised any time on or before the
expiration date
European Option (options on index)
 can be exercised only on the expiration
date (options on index)
Call option
A buyer of call option has the right but not
the obligation to buy the underlying at the
set price by paying the premium upfront.
He can exercise his option on or before
expiry.
Break-even (Call option)
Call= strike +premium +fees

There are two ways you can liquidate your position.

exercise your option
sell back the same option contract you purchased.
Call Buyer V/s Seller
Call Buyer
 Pays premium
 Has right to exercise resulting in a long position in
the underlying
 Time works against buyer
Call Seller
 Collects premium
 Has obligation if assigned resulting in a short
position in the underlying
 Time works in favor of seller
Put option
A buyer of Put option has the right but not
the obligation to sell the underlying at the set
price by paying the premium upfront.
He can exercise his option on or before
expiry.
Break-even (Put option)
Put= strike -premium -fees

There are two ways you can liquidate your position.

exercise your option
sell back the same option contract you
purchased.
Put Buyer V/s Seller
Put Buyer
 Pays premium
 Has right to exercise resulting in a short position
in the underlying
 Time works against buyer
Put Seller
 Collects premium
 Has obligation if assigned resulting in a long
position in the underlying
 Time works in favor of seller
Assignment

• When holder of an option exercises the right,

a randomly selected option seller is obligated
to be assigned into the underlying contract.
Option Valuation
Option Premium = Intrinsic Value
+
Time Value

Option Premium >= 0

Intrinsic Value >= 0
Time Value >= 0
Option Valuation
Intrinsic Value
 Difference between Exercise Price and Spot
Price
 Cannot be negative
 For a Call Option
 St - K
 For a Put Option
 K - St
St = Spot price at time t
Time Value
Amount buyers are willing to pay for the
possibility that, at some time prior to
expiration, the option may become profitable
 Cannot be negative
An at-the-money option has the maximum
time value of any strike price, i.e. more time
value than either an in or out-of-the-money
option.
Strike Prices
In-the-money
 Option with intrinsic value
At-the-money
 Exercise Price = Market Price
Out-of-the-money
 No intrinsic value
 some time value possible
Factors affecting option values
Current Price of the underlying asset (S)
Exercise Price of the option(K)
Interest Rates (Rf)
Time to Expiry (T)
Volatility of prices of the underlying
asset ()
Key Points
• Options can be a very effective tool to take
advantage of a rising or falling underlying. The
following points may be kept in mind while
purchasing options:
• The time value of option premiums decay towards
expiration, so market timing is very important.
• Choose an option month that allows enough time for the
anticipated move in the underlying.
• In-the-money calls are initially more responsive to
underlying price changes than out-of-the-money calls.
• Choose a strike price level that offers a good risk/reward
ratio given the expected price movement.
Trading Strategies
STRATEGIES USING FUTURES
PUT HEDGE

CALL HEDGE

COVERED Call

ARBITRAGE/REVERSE ARBITRAGE
Vertical Spreads
• Buying a call (put) and selling a call
(put) with different strike prices but the
same expiration month.
• Two types of vertical spreads
• Bull Spreads
• Bear Spreads
Debit / Credit Spreads
Debit Spreads entail a net pay-out of
option premium

Credit Spreads entail a net collect of

option premium
Bear Vertical Spreads
Bear Call Spread (Credit Spread)
Bear Put Spread (Debit Spread)
Bear Vertical Spreads
Maximum loss occurs above upper
strike price
Maximum profit occurs below lower
strike price
Breakeven level equals:
 Lower strike plus credit (call spread)
 Upper strike minus debit (put spread)
Bull Vertical Spreads
Bull Call Spread (Debit Spread)
Bull Put Spread (Credit Spread)
Bull Vertical Spreads
Maximum loss occurs below lower strike
price
Maximum profit occurs above upper
strike price
Breakeven level equals:
 Lower strike plus debit (call spread)
 Upper strike minus credit (put spread)
Option Straddles
Consist of buying a put and buying a
call (Long Straddle). Both legs have the
same strike price and same expiration;
OR
Consist of selling a put and selling a call
(Short Straddle). Both legs have the
same strike price and same expiration.
Long Straddles
Maximum loss is equal to net debit, or
total premium paid
Maximum profit is unlimited
Breakeven levels are equal to:
 common strike price plus or minus net
debit
Short Straddles
Maximum profit is equal to net credit
Maximum loss is unlimited
Breakeven levels are equal to:
 common strike price plus or minus net
credit
Long Butterfly
Consist of buying a call option with low
strike (3600) and selling 2 call options
with medium strike (4000) and buying
one more call option with high strike
(4400) price.
The same position can be created with
puts, but it is less common.
Long Butterfly
Maximum profit is limited and equal to
the difference between the lower and
middle strikes minus the net initial debit
( -400 + 2*105 - 10 = -200 ) of
establishing the spread.
Maximum loss is limited to the net initial
debit of establishing the spread.
Short Butterfly
Consist of selling a call option with low
strike (3600) and buying 2 call options
with medium strike (4000) and selling
one more call option with high strike
(4400) price.
The same position can be created with
puts, but it is less common.
Short Butterfly
Maximum profit is equal to the net
credit of the establishing the spread.
Maximum loss is limited to the
difference between the lower and
middle strikes minus the net initial
credit (+400 - 2*105 + 10 = 200 )
3 STEP STRATEGIES
Synthetic Bull Spread

Synthetic Bear Spread

Horizontal Spread
Horizontal Spread is a spread in which
two legs of the spread have different
expiration date but the same strike
prices. This spread may also be called
as time spread or calendar spread.
Thank You