make your 'future' with 'options

8/2/2019 Make Your 'Future' With 'Options'

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MAKE YOUR FUTURE

WITH OPTIONS

PROJECT BY:

NEHA SHAHTYBMS (SEM V), 2001- 2002

DATE OF SUBMISSION: OCTOBER 10, 2001

NARSEE MONJEE COLLEGE OFCOMMERCE AND ECONOMICS

VILE PARLE (WEST),

MUMBAI 400 056


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MAKE YOUR FUTURE

WITH OPTIONS

PROJECT BY:

NEHA SHAH

TYBMS (SEM V), 2001-2002

DATE OF SUBMISSION: OCTOBER 10, 2001

PROJECT GUIDE:Mr. AJAY SHAH

NARSEE MONJEE COLLEGE OFCOMMERCE AND ECONOMICS

VILE PARLE (WEST),

MUMBAI 400 056


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DECLARATION

I Neha Shah of Narsee Monjee College of Commerce and

Economics of TYBMS (Sem V) hereby declare that I have

completed this project on Make Your Future With

Options in the Academic Year 2001 2002. The

information submitted is true and original to the best of my

knowledge.

Signature of Student.


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CERTIFICATE

I Ajay Shah hereby certify that Neha Shah of Narsee

Monjee College of Commerce and Economics of TYBMS

(Sem V) has completed project on Make Your Future With

Options in the academic year 2001 - 2002. The

information submitted is true and original to the best of my

knowledge.

Signature of Project Co-ordinator


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ACKNOWLEDGEMENTS

I would like to thank my project guide Mr. Ajay Shah, a stock

broker dealing in futures and options for his valuable insights into

the real world of futures and options and for guiding me through

the project.

Mr. Alok Nanavaty has helped me a lot by providing me

with the necessary reading material, which was very useful in

assembling the project.

I would like to thank Mr. M.K.Desai, our principal for all

the facilities that he provided me with while I was working on this

project.

I am grateful to our BMS Co-ordinator Mr. Parag Chitale

and Prof. Aashita Mehra for guiding me to proper avenues.

Our librarian Mr.Praveen Vaidya for helping me find

relevant matter from our library.

I thank my family and friends whose constant

encouragement kept me going.


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TABLE OF CONTENTS

SR. NO. CONTENTS PG. NO.1. Executive summary 1

2. Evolution 4

FUTURES3. Basics 10

4. Valuation of Forwards/Futures Contracts 15

5. Futures Market 19

6. Other Futures Contract 27

OPTIONS

7. Basics 298. Types of Options 33

9. Terminology 39

10. Option Pricing 46

11. Risk & Return on Equity Options 54

12. Options Trading Strategies 61

13. Options v/s Futures 88

14. Futures & Options in India 90

15. Bibliography 93

TABLE OF ILLUSTRATIONS

SR. NO. CONTENTS PG. NO.

1. Call Options (Graph) 34

2. Put Options (Graph) 36

3. Call Option at Expiration (Graph) 48


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4. Put Option at Expiration (Graph) 50

5. Call Option Pricing Before Expiration (Graph) 51

6. Put Option Pricing Before Expiration (Graph) 52

7. Risk & Return on Call Option (Graph) 56 / 57

8. Risk & Return on Put Option (Graph) 609. Hedging: Long Stock Long Put (Graph) 64

10. Hedging: Short Stock Long Call (Graph) 65

11. Hedging: Long Stock Short Call (Graph) 67

12. Hedging: Short Stock Short Put (Graph) 68

13. Payoff from Bull Spread (Using Calls) (Table) 69

14. Bull Spread (Using Calls) (Graph) 70

15. Payoff from Bull Spread (Using Puts) (Table) 71

16. Bull Spread (Using Puts) (Graph) 71

17. Payoff from Bear Spread (Using Calls) (Table) 73

18. Bear Spread (Using Calls) (Graph) 74

19. Payoff from Bear Spread (Using Puts) (Table) 75

20. Bear Spread (Using Puts) (Graph) 75

21. Payoff from Butterfly Spread (Table) 77

22. Butterfly Spread (Graph) 78

SR. NO. CONTENTS PG. NO.

23. Payoff from Straddle (Table) 80

24. Straddle (Graph) 80

25. Strip (Graph) 8226. Strap (Graph) 82

27. Payoff from Strangle (Table) 83

28. Strangle (Graph) 83

29. Long Condor (Graph) 85

30. Short Condor (Graph) 85

31. Payoff from Box Spread (Table) 86


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1 EXECUTIVE SUMMARY

A Preview into Futures and Options


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Derivatives occupy a very significant place in the field of finance and are virtually driving

the global financial markets of the day. Futures and options exchanges are an integral part

of virtually all the advanced economies. Many more countries like India are in different

stages of the process of introduction of such trading.

Futures

Futures have revolutionized the global commodities and financial markets ever since their

advent. Futures are only a more developed form of forward trading. A futures contract

involves honouring of a commitment between the buyer and the seller regarding delivery

by the seller of a specified commodity or instrument after a specified period at a specified

price. The price of a futures contract is market related and is linked to the projected spot

price of the underlying asset on the delivery date. The futures market provides economic

and social benefits through their functions of risk management and price discovery.

Options

Option contract helps the investor get returns on his investment while remaining fully

insured against any adverse movement in stock prices. Option is a legal contract in which

the writer of the contract grants to the buyer, the right to purchase from or sell to the writer


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a designated instrument or a scrip at a specified price within a specified period of time. The

writer is legally obligated to perform according to the terms of the option but the buyer is

under no obligation to exercise the option. Broadly, options are of two types i.e. a call

option and a put option. Price of an option depends on factors like stock price, expiration

date, stock volatility, exercise price, etc. The complexities of the corporate risks and their

management gives rise to many solutions through a series of innovative strategies in the

form of combinations of options of different types. Most commonly used are spread

strategies, straddle, strip, strap and condors.


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Introduction of futures and options in India is the beginning of a new era. Both Bombay

Stock Exchange (BSE) and National Stock Exchange (NSE) have introduced trading in

stock index futures and stock options. Trading in stock index futures commenced in June

2000, but trading in stock options began only in July 2001. But however, derivatives

trading in India has not picked up as expected. There are a lot of myths attached to it and

the general lack of awareness among brokers and investors have led to very low volumes in

trading.

However, these are early days and the experience of the world market has proved that

futures and options are going to be the trading instruments in the future.

So come, Make Your Future With Options !!!


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EVOLUTION

Lets peep into the past & see how it a

began


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Investment has been basic to man ever since he discovered commerce. His action to invest

has been motivated by his desire to multiply his acquisitions. As the requirements of mans

life grew in content and quality, the simple commercial transactions of purchase and sale of

a commodity became increasingly complex as his desire to maximize earnings increased.

With the passage of time, man was able to constantly sharpen his investment skills to earn

more by taking more risks.

Risk is the characteristic feature of all commodity and capital markets. Prices of all

commodities whether agricultural like wheat, cotton, rice, coffee or tea, or agricultural

like silver, gold, etc. are subject to fluctuations over time in keeping with prevailing

demand and supply conditions. Producers cannot be sure of the price that their produce will

fetch when they sell them, in the same way as the buyers are not sure what they would have

to pay for their buy. Similarly, prices of shares and debentures or bonds and other securities

are also subject to continuous change. They are constantly exposed to the threat of risk.

This has shaped the markets in Europe and Japan ever since the early seventeenth century.

From spot to forward deals and then on to derivatives, futures, options and other

investment alternatives the modes and instruments have come a long way and vehicles of

investment and speculation acquired innovative forms according to the needs of times.

DERIVATIVES

A derivative instrument, broadly, is a financial contract whose payoff structure is

determined by the value of an underlying commodity, security, interest rate, share price

index, exchange rate, oil price or the like. Thus a derivative instrument derives its value

from some underlying variable. A derivative instrument by itself does not constitute

ownership. It is instead, a promise to convey ownership.

All derivatives are based on some cash products.

The underlying asset of a derivative instrument may be any product of the following type:


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Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rate.

Bonds of different types, including medium to long-term negotiable debt securitiesissued by governments, companies, etc.

Short-term debt securities such as T-bills.

Over-The-Counter (OTC) money market products such as loans or deposits.

However, the most important use of derivatives is in transferring market risk, called

Hedging, which is a protection against losses resulting from unforeseen price or volatility

changes. Thus, derivatives are a very important tool of risk management.

There are many kinds of derivatives including futures, options, interest rate swaps, and

mortgage derivatives.

FORWARD CONTRACT

A deal for the purchase or sale of a commodity, security or other asset can be in the spot of

forward markets. A spot or cash market is most commonly used for trading. In addition to

cash purchase, another way to acquire or sell assets is by entering into a forward contract.

In a forward contract, the buyer agrees to pay cash at a later date when the seller delivers

the goods.

Eg. If a car is booked with the dealer and the delivery matures, the car is delivered after its

price has been paid.

Typically, in a forward contract, the price at which the underlying commodity or assets will

be traded is decided at the time of entering into the contract. The essential idea of entering

into a forward contract is to peg the price and thereby avoid the price risk. Thus, by


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entering into a forward contract, one is assured of the price at which one can buy / sell

goods or other assets.

Forward contracts have been in existence since quiet some time. The organize commodities

exchanges, on which forward contracts are traded, probably started in Japan in the early

18th century, while establishment of the Chicago Board of Trade (CBOT) in 1848 led to the

start of a formal commodities exchange in the USA.

A forward contract is evidently a good means of avoiding price risk, but it entails an

element of risk in that, a party to the contract may not honour its part of the obligation.

Thus, each party faces the risk of default. There is another problem, once a position of buy

or sell is taken in a forward contract an investor cannot retreat except through mutual

consent with the other party or by entering into an identical contract and taking a position

that is reverse of the earlier position. The alternatives are by no means very easy.

FUTURES CONTRACTS

The problems associated with forward contracts lead to the emergence ofFutures

Contracts. A futures contract is a standardized contract between 2 parties where one of the

parties commits to sell and the other to buy a stipulated quantity (and quality, where

applicable) of a commodity, currency, security, index or some other specified item at an

agreed price on or before a given date in the future.

Futures contracts on commodities have been traded for long. In the USA, for instance, such

contracts began trading on the Chicago Board of Trade (CBOT) in the 1860s. However, in

the past 3 decades, financial futures contracts have been evolved. The financial futures,

probably, are a very significant financial innovation. They encompass a variety of

underlying assets securities, stock indices, interest rates and so on. The beginnings of

financial futures were made with the introduction of foreign currency futures contracts on

the International Monetary Markets (IMM) a division of the Chicago Mercantile

Exchange (CME) in May 1972. Subsequently, interest rates futures where the contract


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is on an asset whose price is dependent solely on the level of interest rates were

introduced on the CBOT in October 1975.

A futures contract in treasury bonds is one of the most actively traded futures contracts in

the world. An important development took place in the world of futures contracts in 1982

when stock index futures were introduced in USA. Although some futures contracts on

indices were traded in Europe in the 1970s. It was in America only that a formal beginning

was made when the Kansas City Board of Trade (KCBT) introduced stock index futures

with the value line index serving as the underlying index.

A futures contract on a stock index has been a revolutionary and novel idea because it

represents a contract based not on a readily deliverable physical commodity or currency or

other negotiable instrument. It is instead based on the concept of a mathematically

measurable index that is determined by the market movement of a predetermined set of

equity stocks.

OPTIONS

An option is the right, but not the obligation, to buy or sell a specified amount (and quality)

of a commodity, currency, index, or financial instrument, or to buy or sell a specified

number of underlying futures contracts, at a specified price on or before a given date in the

future. Thus, options, like futures, also provide a mechanism by which one can acquire a

certain commodity or other asset, or take positions in, in order to make profit or cover risk

for a price.

The concept of options is not a new one. In fact, options have been in use for centuries. The

idea of an option existed in ancient Greece and Rome. The Romans wrote options on the

cargoes that were transported by their ships. In the 17 th century, there was an active options

market in Holland.


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Options were traded in UK and US during the 19th century but were mainly confined to the

agricultural commodities. Earlier, they were declared illegal in the UK in 1733 and

remained so until 1860. In USA, options on equity stocks of the companies were available

on the Over-the-Counter (OTC) market only until April 1973.

In spite of the long time that has elapsed since the inception of options, they were, until not

very long ago, looked down upon as mere speculative tools and associated with corrupt

practices. Things changed dramatically in the 1970s when options were transformed from

relative obscurity to a systematically traded asset, which is an integral part of financial

portfolios. The year 1973 witnessed some major developments. Black and Scholes

published a seminal paper explaining the basic principles of options pricing and hedging. In

the same year, the Chicago Board Options exchange (CBOE) was created. It was the first

registered securities exchange dedicated to options trading. While trading in options existed

for long, it experienced a gigantic growth with the creation of this exchange. The listing of

options meant orderly and thicker markets for this kind of securities. Options trading are

now undertaken widely in many countries besides the USA and UK. In fact, options have

become an integral part of the large and developed financial markets.


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FUTURES

3 BASICS

Wondering what Futures trade is allabout?These basic concepts will introduyou

to this unique and importaindustry


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FUTURES THE CONCEPTA futures contract can be defined as a standardized agreement between the buyer and the

seller in terms of which the seller is obligated to deliver a specified asset to the buyer on a

specified date and the buyer is obligated to pay to the seller the then prevailing futures

price in exchange of the delivery of the asset.

The futures contracts represent an improvement in the forward contract in terms of

standardization, performance guarantee and liquidity. Whereas forward contracts are not

standardized, the futures contract are standardized ones, so that

1. the quantity of the commodity or the other asset which could be transferred or

would form the basis of gain/loss on maturity of the contract,

2. the quality of the commodity if a certain commodity is involved and the place

where delivery of the commodity would be made,

3. the date and month of delivery,

4. the units of price quotation,

5. the minimum amount by which the price would change and the price limits of the

days operations, and other relevant details are all specified in a futures contract.

Thus, in a way, it becomes a standard asset, like any other asset to be traded.

Futures contracts are traded on commodity exchanges or on other futures exchanges.

People can buy of sell futures like other commodities. When an investor buys a futures

contract (so that he takes a long position) on an organized futures exchange, he is, in fact,

assuming the right and obligation of taking delivery of the specified underlying item (say

10 quintals of wheat of a specified grade) on a specified date. Similarly, when an investor

sells a contract, to take a short position, one assumes the right and obligation to make

delivery of the underlying asset. While there is a risk of non-performance of a forward

contract, it is not so in case of a futures contract. This is because of the existence of a

clearing house orclearing corporation associated with the futures exchange, which plays a

pivotal role in the trading of futures. Unlike a forward contract, it is not necessary to hold


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on to a futures contract until maturity one can easily close out a position in the futures

contract.

RELATIONSHIP BETWEEN SPOT AND FUTURESPRICE

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

To understand the linkage between spot and futures price, let us consider an example.

--------------------------

Example

If John is certain that the demand-supply position of wheat is such that 3 months from now,

the price of wheat is likely to go up, he should be tempted to buy wheat now and sell the

stock after 3 months at a higher price. For this purpose, he will hire a godown, stock the

inventory, pay interest on the money invested I the stock as well as pay incidental charges

in holding the inventory, like, handling charges, insurance charges, etc., collectively called

the carrying costs. Let us assume that he buys a unit of wheat at Rs. 100 and the carrying

costs aggregates Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot

price of wheat; 3 months from now should be more than Rs. 106. Now if others also have

the same information that the wheat prices are likely to go up beyond the carrying cost, the

number of buyers would increase. As the current demand for wheat increases because of

this information, the current spot price also starts climbing. The current spot price wouldkeep on increasing till the anticipated future spot price becomes equal to current spot price

plus the carrying costs.

As we have already seen, the future spot price tends to equal the current spot price plus the

carrying costs. Suppose the current spot price is Rs. 100 and the carrying costs are Rs. 6.

the predicted futures price, say, 3 months from now is Rs. 110. There would be a tendency


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for the current spot price to rise from Rs. 100 to Rs. 104, as any increase beyond this level

would mean a loss in the transaction.

-------------------------------

Thus, the current spot price would tend towards a level where there is no profit or no loss

situation for both the buyer and seller alike. The conclusion, therefore, is that in a perfectly

predictable and certain market, neither the buyer nor the seller would be interested in

futures trading. If, future spot prices could be forecast with 100% certainty, the very idea of

futures market would vanish. As a corollary, we can say that it is the element of

uncertainty, which gives rise to a futures market.

BASISThe difference between the prevailing spot price of an asset and the futures price is known

as the basis, i.e.

Basis = Spot price Futures 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 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 MarketorInverted 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.


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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 of financial futures I which 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.)

---------------------------

Example

The price of ACC stocks on31st 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 31st 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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4 VALUATION OF FORWARDS

/ FUTURES CONTRACT

Lets see how traders determine afutures fair value


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Let us take a simple example of a fixed deposit in a bank. Rs. 100 deposited in the bank at

a rate of interest of 10% would become Rs. 110 after 1 yr. Based on annual compounding;

the amount will become Rs. 121 after 2 yrs. Thus, we can say that the forward price of the

fixed deposit of Rs. 100 is Rs. 110 after 1 yr. and Rs. 121 after 2 yrs.

As against the usual annual, semi-annual and quarterly compounding, continuous

compounding are used in derivative securities. In terms of annual compounding, the

forward price can be computed through the following formula:

A = P (1 + r / 100)t

Where A is the terminal value of an amount P invested at the rate of interest of r % p.a. for

t years.

Now, if compounding was done twice a year, the amount at the end of 2 years can be

calculated as follows:

Beginning of

period

Principle Interest Amt. at the end

I Halfyear 1000 1000 x 0.05 = 50 1050

II Half-year 1050 1050 x 0.05 = 52.50 1102.50

III Half-year 1102.50 1102.5 x 0.05 = 55.125 1157.6254

IV Half-year 1157.625 1157.625 x 0.05 =

57.881

1215.51

It is observed that with all the inputs being the same, the amount is a little higher when the

frequency of compounding is increased from one to two in each year. With the still greater

compounding frequency, the amount at the end of the 2 yr period would increase. For

instance, for different compounding period at the end of 2 yrs are given below:

Compounding Amount (Rs.)

Quarterly 1218.40

Monthly 1220.39

Weekly 1221.17

Daily 1221.37

In general terms,


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A = P (1 + r / m)m n

where ris the per annum rate of interest, m is the number of compoundings per annum and

n is the number of yrs. For quarterly compounding, for eg. m = 4, while for daily

compounding, m = 365.

To carry the idea further, if the number of compoundings per annum increases more and

more, the time period between successive compoundings would steadily fall. In the

extreme case, the compounding may be thought to be continuous. In such an event, it can

be shown mathematically that the amount may be calculated as follows:

A = Pen r

Where all symbols carry the same meaning as before, and e is a mathematical constantwhose value is 2.7183.

Since the compounding is continuous, the amount is likely to be the largest. To know the

exact amount, we make the following calculation:

A = 1000 x 2.71832 x 0.1

= 1000 x 1.22140

= Rs. 1221.40

In case there is a cash income accruing to the security like dividends, the above formula

will read as follows:

A = (P I) em r

Where I is the present value of the income flow during the tenure of the contract.

-----------------------

Example

Consider a 4 month forward contract on 500 shares with each share priced at Rs. 75.

Dividend @ Rs. 2.50 per share is expected to accrue to the shares in a period of 3

months. The CCRRI is 10% p.a. the value of the forward contract is as follows:

Dividend proceeds = 500 x 2.50 = 1250


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Present value of Dividend = 1250e- (3/12) (0.10)

= 1219.13

Value of forward contract = (500 x 75 1219.13) e(4/12) (0.10)

= 36280.87 x e0.033

= Rs. 37498.11

----------------------------


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FUTURES MARKET

Curious about how trade works?

Come get an insight into the marketin

which youll be dealing


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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.

PURPOSE OF A FUTURES MARKETFutures markets provide flexibility to an otherwise rigid spot market because of their very

concept, which allows a wholistic 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:

1. 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.

2. Price Discovery Function:

The pricing of futures contracts in corporates a set of information based on which the

producers and the consumers can get a fair idea of the future demand and supply


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position of the commodity and consequently the future spot price. This is known as

the price discovery function of future.

3. Advantage to Informed Individuals:Individuals who have superior information in regard to factors like commodity

demand-supply, market behaviour, technology changes, etc., can operate in a futures

markets and impart efficiency to the commoditys price determination process. This,

in turn, leads to a more efficient allocation of resources.

4. 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 a commodity, will need to enter into a transaction which

could protect him in the event of such an adverse change. For eg, a trader who has

imported a consignment of copper and the shipment is to reach within a fortnight 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 honour 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 functions

of risk mgt. and price discovery.

TYPES OF ORDERSMarket Order

When a trader places a buy or sells order at a price, which prevails in the futures pit at the

time, the order is given; it is called a Market Order.


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Limit Order

If the trader specifies a particular price or the price limit within which the order should be

executed, such an order is called a Limit Order. In such orders, the inherent risk is that the

specified price or the band may never be hit during the day and the position may not beclosed out.

Market-If-Touched (MIT) Order

If an order is executed at the best available price after trade occurs at a particular price or at

a price more favourable then the specified price, it is called the Market-if-Touched Order.

Stop Loss Order

When a trader holds a position, either long or short and wants to restrict his downsize, he

would place an order specifying a rate at which the deal could close out. This would insure

him against a run away loss in the event of a drastic adverse price movement. Stop Loss

Orders are normally placed by specifying a range in which the order should be executed

instead of giving a single price order. The risk in the latter case is that the order may not get

executed as in a violent price movement; the specified price may get jumped.

Good Till Cancelled (GTC) Order

In terms of National Stock Exchange (NSE) regulations good till cancelled orders shall be

cancelled at the end of 7 calendar days from the date of entering the order.

THE CLEARING MECHANISMA 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


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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 associations risk.

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


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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:

a) Initial margins on both the buyer as well as the seller.

b) Daily maintenance margins on both.

c) The accounts of the buyer and the seller are marked to the market daily.

MARGINSThe concept of margin here is the same as that for any other trade, i.e. to introduce a

financial stake of the client, to ensure performance of the contract and to cover day to day

adverse fluctuations in the prices of the securities bought. The margin paid by the investor

is kept at the disposal of the clearing house through the brokerage firms. The clearing

house gets the protection against po0ssible business risks through the margins placed with

it in this manner and by the process of marking to market (it means, debiting or crediting

the clients equity accounts with the loss or gains of the day, based on which, margins are

sought or released).

The margin for futures contract has two components


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Initial margin, and

Maintenance margin.

Initial MarginUnlike in an options contract where only the buyer is obligated to perform and not the

seller (writer), in a futures contract both the buyer and the seller are required to perform the

contract. Accordingly, both the buyer and the seller are required to put in the initial

margins. The initial margin is also known as the performance margin and is usually 5 to

155 of the purchase price of the contract. The margin is set by the stock exchange keeping

in view the volume of business and the size of transactions a well as operative risks of the

market in general.

The initial margin is the first line of defense for the clearing house. This protection is

further reinforced by prescribing maintenance margin.

Maintenance Margin

In order to start dealings with a brokerage firm for buying and selling futures, the first

requirement for the investor is to open an account with the firm. This account, called the

equity account, has to be kept separate from any other account including the margin

accounts. Maintenance margin is the margin required to be kept by the investor in the

equity account equal to or more than a specified percentage of the amount kept as initial

margin. Normally, the deposit in the equity account is equal to or more than 75% to 80% of

the initial margin.

In case this requirement is not met, the investor is advised to deposit cash to make up the

shortfall. If the investor does not respond, then the broker will close out the investorsposition by entering a reversing trade in the investors account.

------------------------------

Example


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A buyer buys a futures contract @ Rs. 50 per share for 500 shares from a seller. Both make

a deposit of Rs. 2,500, being 10% of the total investment of Rs. 25.000 towards the initial

margin.

The next day, the stock price rises to Rs. 52 per share. The equity of the buyer

increases to Rs. 3,500 and that of the seller decreases to Rs. 1,500. As the maintenance

margin is required to be maintained at 80% of the initial margin, the buyer and the seller

are required to have a minimum equity of Rs. 2,00 everyday. The buyer has a surplus of

Rs. 1,500 and he has the liberty of withdrawing this sum. The seller, on the other hand, is

short of Rs. 500 and would be called upon to make up the shortfall by depositing cash.

However, if the seller is unable to pay, the broker would enter a reversing trade by

purchasing a future of the same expiration.

--------------------------------

6 OTHER FUTURES CONTRACT

Learn about other choices in Futures


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STOCK INDEX FUTURES


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Stock index futures are drawn on stock market indices and each of these contracts are

characterized by payment of cash on the delivery date of an amount equal to a multiplier

times the difference between:

a) The value of the index at the close of the last trading day of the contract, and

b) The purchase price of the futures contract.

INTEREST RATES FUTURESFutures written on fixed income instruments as the underlying securities are known as

interest rate futures. Predetermined periodical income through the life of such instruments

and principle maturity amount at the end of the instruments life are the usually the features

of such securities. These instruments have become an integral part of all balance portfolios

and accordingly the growth of these securities has grown substantially. But ever since,

interest rates on fixed income instruments have become highly volatile, the need for

suitable hedge against this volatility has risen.

Thus, two prime-movers for the growth of interest rate futures are:

1. the tremendous growth in the fixed income securities, and

2. increased volatility in the interest rates in the market.

In order to hedge against the risks arising as a result of these two factors, interest rate

futures come in handy apart from other hedging instruments like interest-rates swaps.

Interest rate futures can be used to hedge against interest rate risk and to crystallize future

investment yields or future cost of borrowing.


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OPTIONS


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7 BASICSAn introduction to Options involvingthe components of trading


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WHAT IS AN OPTION?Option is a legal contract in which the writer of the contract grants to the buyer, the right to

purchase from or to sell to the writer a designated instrument or a scrip at a specified price

within a specified period of time.

The right to purchase a specified stock is called the call option, while the right to sell a

specified stock is called a put option.

----------------------------

Example

Suppose a writer of an option writes a contract, which conveys or grants to the buyer the

right to bur 100 shares of ITC from him, i.e. from the writer at the rate of Rs. 650 per share.

This option is called a call option and is designated as 100 ITC 650 call.

Similarly, if a writer writes an option which grants to the buyer the right to sell to the writer

100 shares of ITC at Rs. 650 per share, such an option is called a put option and is

designated as 100 ITC 650 put.

It should be noted that in a call option transaction, there is not put option involved. The

writer is writing or selling a call option and the buyer is buying a call option. Similarly, in

the case of a put option transaction there is no call option involved. The writer is writing or

selling a put option and the buyer is buying a put option.

-------------------------------

WHO CAN WRITE AN OPTION?


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Anyone eligible to enter into contract as per the Law of Contract can write an option

irrespective of the fact whether one owns the underlying stock or not.

If the writer of a call option owns the stock that he is obliged to deliver upon exercise of

the call he has written, he is called a covered call writer.

On the other, if the writer of the call option does not own the stock he has written the

option for, he is called an uncovered or naked call writer and the option is called an

uncovered or naked call option.

OBLIGATION OF THE OPTION WRITER AND BUYERThe writer is legally obligated to perform according to the terms of the option. On the other

hand, the buyer of the option has bought a write to exercise the option and is under no

obligation to exercise the option. He can conveniently let the option lapse on the date of

expiration of the option.

The significance of this feature of an option is explained through the following example.

------------------------------

Example

Suppose you buy a 100 ITC 650 Call option contract. During the expiration period, the

stock price does not appreciate enough to cover even the premium paid, i.e., you do not

gain anything by exercising the option. The options contract confers on you the right to

either invoke the contract or let it lapse. Invoking the contract means calling upon the

writer to deliver the stock at the contract price. This would be futile as this stock is

available at equal to or even less than the exercise price in the market. By letting the option

lapse the buyer gets out of the contract, as he is not obligated to perform. However, the

writer or the seller is under the obligation to perform right up to the expiry of the cont6ract

whenever called upon buy the buyer of the option to do so.

---------------------------------


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ESSENTIAL INGREDIENTS OF AN OPTION CONTRACTAn options contract has four essential ingredients:

1. The name of the company on whose stock the option contract has been derived.

2. The quantity of the stock required to be delivered in the case of exercise of the

option.

3. The price, at which the stock would be delivered, or the exercise price or the

strike price.

4. The date when the contract expires, called the expiration date.


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8 TYPES OF OPTIONS

Lets see the kind of Options you cantrade in


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CALL OPTIONSA call option gives the buyer the right to purchase a specified number of shares of a

particular company from the option writer (seller) at a specified price (called the exercise

price) up to the expiry of the option. In other words, the option buyer gets a right to call

upon the option seller to deliver the contracted shares any time up to the expiry of the

option. The contract, thus, is only one-way obligation, i.e. the seller is obligated to deliver

the contracted shares while the buyer has the choice to exercise the option or let the

contract lapse. The buyer is not obligated to perform.

Position Graphs

+ +

b

_ _

(a) Buy a Call (b) Write a Call

(uncovered)

An option buyer starts with a loss equivalent to the premium paid. He has to carry on with

the loss till the stock's market price equals the exercise price as shown in (a). The intrinsic

value of the option up to this point remains zero and thus, runs along the X-axis. As the

stock price increases further, the loss starts reducing and gets wiped out as soon as the

increase equals the premium, represented on the graph by point b, also called the break

even point. The profitability line starts climbing up at an inclination of 45 degrees after

crossing the X-axis at b and from thereon moves into the positive side of the graph. The

Intrinsic Value Lines

Premium { Stock Price

k Intrinsic Value Lines

} PremiumStock Price

k

b


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inclined line beyond the point b indicates that the option acquires intrinsic value and is,

thus referred to as the intrinsic value line.

The position graph in (b) represents the profitability status of the writer who does not own

the stock, i.e., a naked or an uncovered writer. The graph is logically the inverse of that for

the option buyer.

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

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


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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

A put option gives a buyer the right to sell a specified number of shares of a particular

stock to the option writer at a specified price (called the exercise price) any time during the

currency of the option.

Position Graphs

Intrinsic Value Line

Intrinsic Value Lines

+ +

k

b Stock Price } Premium

} Premium b Stock Price

_ k _

(a) Buy a Put (b) Write a Put


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RATIONALE OF BUYING A PUT OPTION

An investor, if he anticipates fall in the price of some stock, has the followingalternatives:

1. 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.

2. 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.

3. 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.

Option Type Buyer of Call Writer of Call


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(Long Position) (Short Position)

Call Right to buy asset Obligation to sell asset

Put Right to sell asset Obligation to buy asset

AMERICAN v/s EUROPEAN OPTIONS

The definitions of options, both call and put, given above apply to the American-style

options. An American option can be exercised by its owner at any time on or before the

expiration date. Besides the American type there are European-style options as well. In

case of European options, the owner can exercise his right only on the expiration date and

not before it. It may be pointed out however, that most of the options traded in the world,

including those in Europe, are of the American style.


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9 TERMINOLOGYGlossary to foster a better

understanding of the Options market


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Before 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.

EXERCISE PRICEThe exercise price (also called the strike price)is the price at which the buyer of a call

option can purchase the stock during the life of the option, or the buyer of the put option

can sell during the life of the option.

Exercise price is that price at which the writer has to deliver the stock to the call option

buyer and buy from the put buyer irrespective of the prevailing market price in case the

latter decides to exercise the option.

EXPIRATION DATEExpiration Date is the date on which the option contract expires, i.e. the last date on which

options contract can be exercised.Options usually have either a monthly and/or quarterly expiration cycle. The maturity

period for an option does not normally exceed nine months.

PREMIUM


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Premium is the price that the buyer of an option, whether call or put, pays to the writer of

the option, for the rights conveyed by the option. 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.

IN-THE-MONEYA call option is In-the-Money if the prevailing stock price (of the underlying asset) is

greater than the exercise price.

AT-THE-MONEYIn case the calls market price is the same as its exercise price, it would bee called at-the-

money orat-the-market.

OUT-OF-THE-MONEYSimilarly, if the market price of the stock is less than the exercise price, it shall be called

out-of-the-money.


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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 VALUEThe premium or the price of an option is made up of two components, namely, intrinsic

value and time value. Intrinsic value is termed asparity 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.

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


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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)]

Example:

Consider the following data calls on a hypothetical stock.

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


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2. 83.50 85 2.50 0 2.50-0=2.50

On

On the

COVERED AND UNCOVERED OPTIONSAn 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.

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 consider to be covered if they have any of the following positions:

Along position in the underlying asset.

An escrow-receipt from a bank.


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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.

MARGIN REQUIREMENTSAs in the case of futures contracts, the performance of contracts is also assured by the

options exchanges (the OCC) the buyer of an option enjoys the right of its performance

exchange, the exchange has, in turn, to make sure that the contract will be honoured. Thus,

for example, if I write a naked call, my broker would need a guarantee in some form that I

would have the necessary funds to be able to deliver the asset, should the buyer of the

option choose to exercise the call, and in turn assure the exchange of the performance of

the contract. For this, margin requirements exist as a form of collateral to ensure that the

writer of a naked call can fulfill the terms of the contract.

Accordingly, the writers of options are required to meet the margin requirements. The

requirements vary depending upon the brokerage firm, the price of the underlying asset, the

price of the option, and whether the option is a call or a put. As a general rule, initial

margins are at least 30% of the stock price when the option is written, plus the intrinsic

value of the option. The amount of margin has an influence on the degree of financial

leverage that the investor has and, consequently, on the returns and risk on the position.


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10 OPTION PRICINGWant to know on what your optionprice depends?


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Before 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.

EXERCISE PRICEThe exercise price (also called the strike price)is the price at which the buyer of a call

option can purchase the stock during the life of the option, or the buyer of the put option

can sell during the life of the option.

Exercise price is that price at which the writer has to deliver the stock to the call option

buyer and buy from the put buyer irrespective of the prevailing market price in case the

latter decides to exercise the option.

EXPIRATION DATEExpiration Date is the date on which the option contract expires, i.e. the last date on which

options contract can be exercised.


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Options usually have either a monthly and/or quarterly expiration cycle. The maturity

period for an option does not normally exceed nine months.

PREMIUMPremium is the price that the buyer of an option, whether call or put, pays to the writer of

the option, for the rights conveyed by the option. 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.

IN-THE-MONEYA call option is In-the-Money if the prevailing stock price (of the underlying asset) is

greater than the exercise price.

AT-THE-MONEYIn case the calls market price is the same as its exercise price, it would bee called at-the-

money orat-the-market.


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OUT-OF-THE-MONEYSimilarly, if the market price of the stock is less than the exercise price, it shall be called

out-of-the-money.

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 VALUEThe premium or the price of an option is made up of two components, namely, intrinsic

value and time value. Intrinsic value is termed asparity 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.

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,


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Intrinsic Value of a put option = max (0, E - S)

TIME VALUETime 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)]

Example:

Consider the following data calls on a hypothetical stock.

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.


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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=2.50

On

On the

COVERED AND UNCOVERED OPTIONSAn 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.

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).


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Covered Call Options / Covered Calls

Call writers are consider 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.

MARGIN REQUIREMENTSAs in the case of futures contracts, the performance of contracts is also assured by the

options exchanges (the OCC) the buyer of an option enjoys the right of its performance

exchange, the exchange has, in turn, to make sure that the contract will be honoured. Thus,

for example, if I write a naked call, my broker would need a guarantee in some form that I

would have the necessary funds to be able to deliver the asset, should the buyer of the

option choose to exercise the call, and in turn assure the exchange of the performance of

the contract. For this, margin requirements exist as a form of collateral to ensure that the

writer of a naked call can fulfill the terms of the contract.

Accordingly, the writers of options are required to meet the margin requirements. The

requirements vary depending upon the brokerage firm, the price of the underlying asset, the

price of the option, and whether the option is a call or a put. As a general rule, initial


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margins are at least 30% of the stock price when the option is written, plus the intrinsic

value of the option. The amount of margin has an influence on the degree of financial

leverage that the investor has and, consequently, on the returns and risk on the position.

RISK & RETURN ON

EQUITY OPTIONS

Lets consider the gains/lossesresulting with long & short

positions in Options


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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 andY, 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


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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 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 atCall Maturity (Rs.)

Investor X Investor Y

90 1000 -1000

100 1000 -1000

110 1000 -1000

120 1000 -1000

130 0 0

140 -1000 1000

150 -2000 2000160 -3000 3000

The profit profile for this contract is indicated below. Figure (a) shows the profit/loss

function for the investorX, the writer of the call, while Figure (b) gives the same for the

other investorY, the buyer of the option.


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(a) For Investor X

(b) For Investor Y

Profit

1500

1000

500

0

500

1000

1500

2000

2500

Loss

90 100 110 120 130 140 150 160

Stock Price

Profit

3000

2500

2000

1500

1000

500

0

500

1000

1500

Loss

90 100 110 120 130 140 150 160

Stock Price


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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 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 stock price, there is no limit on the amount of profit

which can result for the buyer. Being a 'zero-sum' game, a loss (gain) to one party implies

an equal amount of gain (loss) to the other party.

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


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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

Put Maturity (Rs)

Investor X Investor Y

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 theshare happens to be lower than this, the writer would make a loss-and the buyer makes a

gain. For instance, when the price of the share is Rs 100, the gain/loss for each of the

investors may be calculated as shown below.


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Investor X

Option premium received = 7.5 x 100 = Rs. 750

Amount to be paid for shares = 110 x 100 = Rs. 11000Market 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

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, while the Fig. (b) gives the

same for the other investor Y, the buyer of the option. As indicated earlier, the profiles of

the two investors replicate each other.

(a) For investor X

Profit

1500

1000

500

0

500

1000

1500

2000

2500

3000

Loss

90 100 110 120 130 140 150 160

Stock Price


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(b) For Investor Y

Profit

2500

2000

1500

1000

500

0

500

1000

Loss

90 100 110 120 130 140 150

Stock Price

OPTIONS TRADING

STRATEGIESLearn some Strategies which will

profit you in this marketenvironment


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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


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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 AND PUT OPTIONSHedging 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


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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

Share

Price

Exercise

Price

Profit on

Exercise (i)

Profit / Loss on

Share Held (ii)

Net Profit

(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.


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Hedging : Long Stock Long Put

Hedging a Short Position in Stock

Unlike an investor with a long position in stock, a short seller of stockanticipates 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

Profit on Exercise

of PutProfit

50 -40 -

30 -

20 -

10 -

0

10 -

20 -

30 -40 -

Loss

Stock Price

Profit / Loss on Hedging

Profit / Loss onLong Stock

E


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Share

Price

Exercise

Price

Profit on

Exercise (i)

Profit / Loss on

Share Held (ii)

Net Profit

(i) + (ii)

90 105 -4 15 11

95 105 -4 10 6

100 105 -4 5 1105 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.

Hedging : Short Stock Long Call

Profit50 -

40 -

30 -20 -

10 -

0

10 -

20 -

30 -

40 -

Loss

Stock Price

Profit / Loss on Hedging

Profit / Loss on Short StockProfit / Loss on Call Option

E


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HEDGING WITH WRITING CALL AND PUT OPTIONSBoth the strategies discussed above aim at limiting the risk of an underlying

position in an equity stock. Options may also be used for enhancing returns

from the positions in stock. If the common stock is not expected to

experience significant price variations in the short run, then the strategies of

writing calls and puts may be usefully employed for the purpose. As an

example, suppose that you hold shares of a stock which you expect will

experience small changes in the short term, then you may write a call on

these. This is known as writing covered calls. By writing covered call

options, you tend to raise the short-term returns. Of course, you will not

derive any benefit if large price changes occur because then the option will

be exercised or, else, you would have to make a reversing transaction. The

writing of covered calls, i.e., agreeing to sell the stock you have, is a very

conservative strategy.

To illustrate the strategy of writing a covered call, consider an investor who

has bought a share for Rs 100, and who writes a call with an exercise price

of Rs. 105, and receives a premium of Rs. 3. The profit/loss occurring at

some prices of the underlying share is indicated in table below.

Profit / Loss for Selected Share Values: Long Stock Short Call

Share

Price

Exercise

Price

Profit on

Exercise (i)

Profit / Loss on

Share Held (ii)

Net Profit

(i) + (ii)90 105 3 -10 -7

95 105 3 -5 -2

100 105 3 0 3

105 105 3 5 8

110 105 -2 10 8

115 105 -7 15 8


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120 105 -12 20 8

Figure depicts the payoff function for the strategy of writing covered calls.

Hedging : Long Stock Short Call

In a similar way, an investor who shorts stock can hedge by writing a put

option. By undertaking to be the buyer, the investor hopes to reduce the

magnitude of loss that would be occurring from an increase in the stock

price, by limiting the profit that could be made when the stock price

declines. As an example, suppose that you short a share at Rs. 100 and writea put option for Rs. 3, having an exercise price of Rs. 100. Clearly, the buyer

of the put will exercise the option only if the share price does not exceed the

exercise price. The conditional payoffs resulting from some selected values

of the share price are contained in table below.

Profit

50 -40 -

30 -

20 -

10 -

0

10 -

20 -

30 -

40 -

Loss

Stock Price

Profit / Loss onHedging

Profit / Loss on Long Stock

Profit / Loss onCall Option

E


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Profit / Loss for Selected Share Values: Short Stock Short

Put

Share

Price

Exercise

Price

Profit on

Exercise (i)

Profit / Loss on

Share Held (ii)

Net Profit

(i) + (ii)90 100 -7 10 3

95 100 -2 5 3

100 100 3 0 3

105 100 3 -5 -2

110 100 3 -10 -7

115 100 3

make your 'future' with 'options

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