products in derivatives market

PRODUCTS IN DERIVATIVES MARKET

A PROJECT REPORT ON


BY JASMEET SINGH

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I. Derivatives markets, products and participants

1. Introduction

Derivatives have been associated with a number of high-profile corporate events that roiled the global financial markets over the past two decades. To some critics, derivatives have played an important role in the near collapses or bankruptcies of Barings Bank in 1995, Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in and American International Group (AIG) in 2008. Warren Buffet even viewed derivatives as time bombs for the economic system and called them financial weapons of mass destruction (Berkshire Hathaway Inc (2002)). But derivatives, if “properly” handled, can bring substantial economic benefits. These Instruments help economic agents to improve their management of market and credit risks.

The key differences of these markets will be highlighted. Section 6 reviews some recent credit events and to what extent counterparty risk has played a role.

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2. ORIGIN OF FINANCIAL DERIVATIVES

Financial derivatives have emerged as one of the biggest markets of the world during the past

two decades. A rapid change in technology has increased the processing power of computers and

has made them a key vehicle for information processing in financial markets. Globalization of

financial markets has forced several countries to change laws and introduce innovative financial

contracts which have made it easier for the participants to undertake derivatives transactions.

Early forward contracts in the US addressed merchants’ concerns about ensuring that there were

buyers and sellers for commodities. ‘Credit risk’, however remained a serious problem. To deal

with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT)

in 1848. The primary intention of the CBOT was to provide a centralized location (which would

be known in advance) for buyers and sellers to negotiate forward contracts. In 1865, the CBOT

went one step further and listed the first ‘exchange traded” derivatives contract in the US. These

contracts were called ‘futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of

CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile

Exchange (CME).

The CBOT and the CME remain the two largest organized futures exchanges, indeed the two

largest “financial” exchanges of any kind in the world today. The first exchange-traded financial

derivatives emerged in 1970’s due to the collapse of fixed exchange rate system and adoption of

floating exchange rate systems. As the system broke down currency volatility became a crucial

problem for most countries. To help participants in foreign exchange markets hedge their risks

under the new floating exchange rate system. Foreign currency futures were introduced in 1972

at the Chicago Mercantile Exchange.

In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange

(CBOE) to facilitate the trade of options on selected stocks. The first stock index futures contract

was traded at Kansas City Board of Trade. Currently the most popular stock index futures

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3. Some concepts basic and Growth of Derivatives Market

The Oxford dictionary defines a derivative as something derived or obtained from another, coming from a source; not original. In the field of financial economics, a derivative security is generally referred to a financial contract whose value is derived from the value of an underlying asset or simply underlying.There are a wide range of financial assets that have been used as underlying, including equities or equity index, fixed-income instruments, foreign Currencies, commodities, credit events and even other derivative securities. Depending on the types of underlying, the values of the derivative contracts can be derived from the corresponding equity prices, interest rates, exchange rates, commodity prices and the probabilities of certain credit events.

The derivative market growth is spectacular. In order to understand modern day finance you must at least have an idea about what derivatives are and how they function. Monitoring certain derivatives markets can be crucial in understanding market risk which has a direct effect on equities as equities are usually the last to respond to market developments in terms of other securities. For investors who do not have a large capital base or tons of money to invest with, understanding current market risk is vital. We may not have the cash/liquidity to ride out spouts of deflationary markets. Seeing your stock position down over 50% can be disheartening. Above is a chart of the growth in the derivatives market.

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II. Major types of derivatives

There are five main types of derivatives contracts: forwards; futures, options warrants and swaps. This section discusses the basics of these five types of derivatives with the help of some specific examples of these instruments.

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1. Forwards and futures contracts

Forward and futures contracts are usually discussed together as they share a similar feature: a forward or futures contract is an agreement to buy or sell a specified quantity of an asset at a specified price with delivery at a specified date in the future. But there are important differences in the ways these contracts are transacted. First, participants trading futures can realise gains and losses on a daily basis while forwards transaction requires cash settlement at delivery. Second, futures contracts are standardised while forwards are customised to meet the special needs of the two parties involved (counterparties). Third, unlike futures contracts which are settled through established clearing house, forwards are settled between the counterparties. Fourth, because of being exchange-traded, futures are regulated whereas forwards, which are mostly over-the-counter (OTC) contracts, and loosely regulated (at least in the run up to the global financial crisis).

This importance of exchange-traded versus OTC instruments will be discussed further in later section.

2. Options contracts

Options contracts can be either standardized or customized. There are two types of option: call and put options. Call option contracts give the purchaser the right to buy a specified quantity of a commodity or financial asset at a particular price (the exercise price) on or before a certain future date (the expiration date). Similarly, put option contracts give the buyer the right to sell a specified quantity of an asset at a particular price on a before a certain future date. These definitions are based on the so-called American-style option. And for a European style option, the contract can only be exercised on the expiration date.

In options transaction, the purchaser pays the seller – the writer of the options – an amount for the right to buy or sell. This amount is known as the option premium. Note that an important difference between options contracts and futures and forwards contracts is that options do not require the purchaser to buy or sell the underlying asset under all circumstances. In the event that options are not exercised at expiration, the purchaser simply loses the premium paid. If the options are exercised, however, the option writer will be liable for covering the costs of any changes in the value of the underlying that benefit the purchasers.

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3. Swaps Swaps are agreements between two counterparties to exchange a series of cash payments for a stated period of time. The periodic payments can be charged on fixed or floating interest rates, depending on contract terms. The calculation of these payments is based on an agreed-upon amount, called the notional principal amount or simply the notional.

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III . FORWARDS

1. Meaning

A forward contract is a private transaction - a futures contract is not. Futures contracts are reported to the future's exchange, the clearing house and at least one regulatory agency. The price is recorded and available from pricing services.

Forwards have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. Mark to market is the process of converting daily gains and losses into actual cash gains and losses each night. As one party loses on the trade the other party gains, and the clearing house moves the payments for the counterparty through this process.

Forwards are basically unregulated, while future contract are regulated at the federal

government level. The regulation is there to ensure that no manipulation occurs, that trades are

reported in a timely manner and that the professionals in the market are qualified and honest.

What are forward deals?

A forward deal is a contract where the buyer and seller agree to buy or sell an asset or currency at a spot rate for a specified date in the future (usually up to 60 days). Forward contracts are conducted as a way to cover (hedge) future movements in exchange rates. Margin spreads are higher than in Day Trading but no renewal fees are charged. Forward deals with easy-forex® are only offered in some world regions.

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In Global Financial Markets, for many years, options have been a means of conveying rights from one party to another at a specified price on or before a specific date. Options to buy and sell are commonly executed in real estate and equipment transactions, just as they have been for years in the securities markets. There are two types of option agreements: CALLS and PUTS.

A CALL OPTION is a contract that conveys to the owner the right, but not the obligation, to purchase a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.

A PUT OPTION is a contract that conveys to the owner the right, but not obligation, to sell a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.

Consequently, if the market in a security were expected to advance, a trader would purchase a call and, conversely, if the market in a security were expected to decline, a trader would purchase a put. With the advent of listed options, the inconvenience and difficulties originally associated with transacting options have been greatly diminished.

Exchange-traded options have many benefits including flexibility, leverage, limited risk for buyers employing these strategies, and contract performance guaranteed by Stock Exchanges. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income. Options give you options. You’re not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own financial situation, stock market outlook and risk tolerance.

Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your broker can help you select an appropriate options strategy. The strategies presented do not cover all, or even a significant number, of the possible strategies utilizing options. These are the most basic strategies, however, and will serve well as building blocks for more complex strategies.

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Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure section coming later in this document which outlines the purposes and risks thereof. Further, if you have only limited or no experience with options, or have only a limited understanding of the terms of option contracts and basic option pricing theory, you should examine closely another industry document.

Options are currently traded on the following Indian exchanges: The Stock Exchange, Mumbai (BSE) and National Stock Exchange (NSE). Like trading in stocks, an option trading is regulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly markets for the Purchase and sale of standardized options. It must be noted that, despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position.

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2. Settlement of forward contracts

Forward Markets and Contracts: Settlement Procedures The differences between long and short positions in forward markets are as follows:

The long position holder is the buyer of the contract and the short position holder is the seller of the contract.

The long position will take the delivery of the asset and pay the seller of the asset the contract value, while the seller is obligated to deliver the asset versus the cash value of the contract at the origination date of this transaction.

When it comes to default, both parties are at risk because typically no cash is exchanged at the beginning of the transaction. However, some transactions do require that one or both sides put up some form of collateral to protect them from the defaulted party.

Procedures for Settling a Forward Contract at Expiration

A forward contact at expiration can be settled in one of two ways:

1. Physical Delivery - Refers to an option or futures contract that requires the actual underlying asset to be delivered on the specified delivery date, rather than being traded out with offsetting contracts. Most derivatives are not actually exercised, but are traded out before their delivery dates. However, physical delivery still occurs with some trades: it is most common with commodities, but can also occur with other financial instruments. Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly after the last day of trading, the regulated exchange's clearing organization will report a purchase and sale of the underlying asset at the previous day's settlement price (also referred to as the "invoice price"). Traders who hold a short position in a physically settled security futures contract to expiration are required to make delivery of the underlying asset. Those who already own the assets may tender them to the appropriate clearing organization. Traders who do not own assets are obligated to purchase them at the current price.

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2. Exchanges specify the conditions of delivery for the contracts they cover. Acceptable locations for delivery (in the case of commodities or energies) and requirements as to the quality, grade or nature of the underlying asset to be delivered are regulated by the exchanges. For example, only certain Treasury bonds may be delivered under the Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may be delivered under the Coffee, Sugar and Cocoa Exchange's coffee future. In many commodity or energy markets, parties want to settle futures by delivery, but exchange rules are too restrictive for their needs. For example, the New York Mercantile Exchange requires that natural gas be delivered only at the Henry Hub in Louisiana, a location that may not be convenient for all futures traders.

3. Cash Settlement - Refers to an option or futures contract that requires the counterparties to the contract to net out the cash difference in the value of their positions. The appropriate party receives the cash difference. In the case of cash settlement, no actual assets are delivered at the expiration of a futures contract. Instead, traders must settle any open positions by making or receiving a cash payment based on the difference between the final settlement price and the previous day's settlement price. Under normal circumstances, the final settlement price for a cash-settled contract will reflect the opening price for the underlying asset. Once this payment is made, neither the buyer nor the seller of the futures contract has any further obligations on the contract.

Example: Settling a Forward ContractLet's return to our sailboat example from the first part of this section. Assume that at the end of 12 months you are a bit ambivalent about sailing. In this case, you could settle your forward contract with John in one of two ways:

1. Physical Delivery - John delivers that sailboat to you and you pay him $150,000, as agreed.

2. Cash Settlement - John sends you a check for $35,000. (The difference between your contract's purchase price of $150,000 and the sail boat's current market value of $165,000.)

The same options are available if the current market price is lower than the forward contract's settlement price. If John's sailboat decreases in value to $135,000, you could simply pay John $15,000 to settle the contract, or you could pay him $150,000 and take physical possession of the boat. (You would still suffer a $15,000 loss when you sold the boat for the current price of $135,000.)

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3. KEY FEATURES OF FORWARD CONTRACTS

A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. Key features of forward contracts are:

Highly customized - Counterparties can determine and define the terms and features to fit their specific needs, including when delivery will take place and the exact identity of the underlying asset.

All parties are exposed to counterparty default risk - This is the risk that the other party may not make the required delivery or payment.

Transactions take place in large, private and largely unregulated markets consisting of banks, investment banks, government and corporations.

Underlying assets can be a stocks, bonds, foreign currencies, commodities or some combination thereof. The underlying asset could even be interest rates.

They tend to be held to maturity and have little or no market liquidity. Any commitment between two parties to trade an asset in the future is a forward contract.

Example

Let's assume that you have just taken up sailing and like it so well that you expect you might buy

your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to

upgrade to a newer, larger model in 12 months. You and John could enter into a forward contract

in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in 12 months

for that price. In this scenario, as the buyer, you have entered a long forward contract.

Conversely, John, the seller will have the short forward contract. At the end of one year, you find

that the current market valuation of John's sailboat is $165,000. Because John is obliged to sell

his boat to you for only $150,000, you will have effectively made a profit of $15,000. (You can

buy the boat from John for $150,000 and immediately sell it for $165,000.) John, unfortunately,

has lost $15,000 in potential proceeds from the transaction.

Like all forward contracts, in this example, no money exchanged hands when the contract was

negotiated and the initial value of the contract was zero.

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4. Default Risk in Forward Contract

A drawback of forward contracts is that they are subject to default risk. Regardless

of whether the contract is for physical or cash settlement, there exists a potential

for one party to default, i.e. not honor the contract. It could be either the buyer or

the seller. This results in the other party suffering a loss. This risk of making

losses due to any of the two parties defaulting is known as counter party risk.

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VI. FUTURES

1. Introduction

A futures contract is an agreement between a buyer and a seller that calls for the seller to deliver to the buyer a specified quantity and grade of an identified commodity or security , at a fixed date in the future , at a price agreed to when the contract is first entered into. All futures contracts have to be bought and sold on designated contract markets known as futures exchanges.

A financial futures contract is an exchange traded contract for the delivery of standardised amounts of the underlying financial instrument at a future date. The price for the financial instrument is agreed on the day the contract is bought or sold and gains or losses are incurred as a result of subsequent price fluctuations. Unlike 1forward contracts, futures contracts are readily tradeable , reflecting the standardisation of contract terms.

The purchase or sale of a futures contract is, therefore, a commitment to make or take delivery of a specific financial instrument, at a predetermined date in the future, for which the price is established at the time of the initial transaction. Transactions are actually entered into in the futures exchange either through the “open outcry” method on the exchange floor or through a screen-based trading system.

Contracts are standardised which means that participants can buy and sell them freely on the futures exchange with precise knowledge of the contracts being traded.

The contract specifies both the type of the financial instrument and its ‘quality’ in terms of such matters as coupon rate and maturity. The instruments specified must be delivered at or during a specified month in the future (known as delivery date) - usually in a cycle of March, June, September and December. Exact delivery details vary according to the nature of the instrument or indicator. For contracts based on stock-market indices, no physical delivery can take place, and settlement is based on a cash payment calculated on movement of the index.

Although contracts are traded between the buyer and the seller on the exchange floor, each has an obligation not to the other, but to the clearing house. This feature ensures that futures markets are free of credit risk.

Participants may offset equal numbers of bought and sold contracts of the same type and delivery month and thereby close out a position without actually communicating the original counterparty..

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2. Evolution of futures markets -

The modern day futures markets originated in the USA in the 19th century to facilitate the grain trade. Much of their early history is directly linked to the city of Chicago and the needs of farmers and grain merchants. Forward pricing was regularised for only a few specific commodities by the Chicago Board Of Trade in 1848. Formal futures trading was subsequently established in 1865, at the time of the American Civil War and at a time when the prices of staple commodities such as cotton and grain would fluctuate dramatically and often quite unpredictably.

The result of all this wild fluctuations in prices was that the producers, mainly farmers, had no idea what was a fair price to accept for their goods. The buyers and processors, on the other hand had no control over their expenditures. All parties could see the benefits of having a contractual agreement wherein future commodities prices could be fixed. Thus, the mechanism of a futures contract was created and formalised specifically for the purpose of eliminating price risk.

In 1960, 4 million contracts changed hands during the year on all futures exchanges in USA. In 1990, nearly 280 million contracts were traded, more each week than in all of 1960. In the last decade alone, they have jumped from 98 million to 400 million contracts. Trading in foreign exchange futures began in 1972 and in treasury bill futures in 1977. The introduction of stock-index futures in 1982 completed the transformation.

The changing nature of futures has brought in new types of market participants. Today, the largest and most prestigious financial institutions such as banks, mutual funds, pension funds, insurance companies and other endowment funds all over the world use futures as a tool in their investment strategy. Futures markets have become an integral part of how these institutions manage their risks and portfolio of assets.

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3. Classification of Futures Contracts:

In a futures contract there are two parties:

1. The long position, or buyer, agrees to purchase the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Buyers benefit from price increases.

2. The short position, or seller, agrees to sell the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Sellers benefit from price decreases.

Prices change daily in the marketplace and are marked to market on a daily basis.

At expiration, the buyer takes delivery of the underlying from the seller or the parties can agree to make cash settlement.

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KEY FEATURES OF FUTURE CONTRACTS

Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

Terms and conditions are standardized. Trading takes place on a formal exchange wherein the exchange provides a place to

engage in these transactions and sets a mechanism for the parties to trade these contracts.

There is no default risk because the exchange acts as a counterparty, guaranteeing delivery and payment by use of a clearing house.

The clearing house protects itself from default by requiring its counterparties to settle gains and losses or mark to market their positions on a daily basis.

Futures are highly standardized, have deep liquidity in their markets and trade on an exchange.

An investor can offset his or her future position by engaging in an opposite transaction before the stated maturity of the contract.

Example: Future ContractsLet's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for his next crop, while McDonald's is trying to secure a buying price in order to determine how much to charge for a Big Mac next year. The farmer and the corporation can enter into a futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in December at a price of $3.50 per bushel. The contract locks in a price for both parties. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.

Most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. For example, let's suppose that at the expiration date in December there is a blight that decimates the tomato crop and the spot price rises to $5.50 a bushel. McDonald's has a gain of $2 per bushel on its futures contract but it still has to buy tomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offset against the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10 million is offset against the higher price for which he can now sell his tomatoes.

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Margin MoneyIn the stock market, a margin is a loan that is made to the investor. It helps the investor to reduce the amount of her own cash that she uses to purchase securities. This creates leverage for the investor, causing gains and losses to be amplified. The loan must be paid back with interest.

Margin % = Market Value of the stock - Market value of the debt divided by the market value of the stock

An initial margin loan in the U.S can be as much as 50%. The market value of the securities minus the amount borrowed can often be less than 50%, but the investor must keep a balance of 25-30% of the total market value of the securities in the margin account as a maintenance margin.

A margin in the futures market is the amount of cash an investor must put up to open an account to start trading. This cash amount is the initial margin requirement and it is not a loan. It acts as a down payment on the underlying asset and helps ensure that both parties fulfill their obligations. Both buyers and sellers must put up payments.

Initial MarginThis is the initial amount of cash that must be deposited in the account to start trading contracts. It acts as a down payment for the delivery of the contract and ensures that the parties honor their obligations.

Maintenance MarginThis is the balance a trader must maintain in his or her account as the balance changes due to price fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If the balance in the trader's account drops below this margin, the trader is required to deposit enough funds or securities to bring the account back up to the initial margin requirement. Such a demand is referred to as a margin call. The trader can close his position in this case but he is still responsible for the loss incurred. However, if he closes his position, he is no longer at risk of the position losing additional funds.

Futures (which are exchange-traded) and forwards (which are traded OTC) treat margin accounts differently. When a trader posts collateral to secure an OTC derivative obligation such as a forward, the trader legally still owns the collateral. With futures contracts, money transferred from a margin account to an exchange as a margin payment legally changes hands. A deposit in a margin account at a broker is collateral. It legally still belongs to the client, but the broker can take possession of it any time to satisfy obligations arising from the client's futures positions

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Variation MarginThis is the amount of cash or collateral that brings the account up to the initial margin amount once it drops below the maintenance margin.

Settlement PriceSettlement price is established by the appropriate exchange settlement committee at the close of each trading session. It is the official price that will be used by the clearing house to determine net gains or losses, margin requirements and the next day's price limits. Most often, the settlement price represents the average price of the last few trades that occur on the day. It is the official price set by the clearing house and it helps to process the day's gains and loses in marking to market the accounts. However, each exchange may have its own particular methodology. For example, on NYMEX (the New York Mercantile Exchange) and COMEX (The New York Commodity Exchange) settlement price calculations depend of the level of trading activity. In contract months with significant activity, the settlement price is derived by calculating the weighted average of the prices at which trades were conducted during the closing range, a brief period at the end of the day. Contract months with little or no trading activity on a given day are settled based on the spread relationships to the closest active contract month, while on the Tokyo Financial Exchange settlement price is calculated as the theoretical value based on the expected volatility for each series set by the exchange.

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4. TYPES OF FUTURES CONTRACT

The different types of futures contracts are:

1. Commodity futures - These contracts relate to delivery of an underlying commodity. These are the oldest known futures contracts and are traded in almost every country. Oilseeds, cotton, grain, potato, gold, silver and copper are some of the commodities covered by futures contracts.

2. Foreign exchange futures - These are futures contracts in which the underlying asset is a particular currency. These contracts are traded most frequently in the forex markets of the world primarily to hedge against unfavourable changes in currency rates.

3. Treasury bill futures - These futures contracts are based on the underlying Treasury bill instruments. Specific futures contracts exist for specific duration of treasury bills. E.g. - 91 day, 182 day, and 364 day T-bill futures.

4. Futures on securities - These contracts are based on a specific underlying individual security or share.

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5. Economic benefits of futures markets

Price Discovery –

The heart of the futures exchanges is the trading pit where buyers and sellers meet each day to conduct business. Each trader who enters the trading pits bring with him specific market information such as supply and demand figures, current exchange rates, inflation rates, weather forecasts, etc., that contributes to ongoing price discovery function. As trades between buyers and sellers are executed, the fair market value (price) of a given commodity or security is discovered and these prices are disseminated instantaneously to businesses throughout the world. Futures prices are viewed by businessmen and traders as leading price indicators.

Price Risk Management –

The second economic function provided by futures markets is price risk management, the most common method being hedging. In it’s simplest form, hedging is the practice of offsetting the price risk inherent in any cash market position by an equal and opposite position in the futures markets. Hedgers use futures markets as buffers protect the business from adverse price changes that could negatively impact the bottom line profitability of the business.

Benefits for the prudent financial manager Today’s widespread use of futures has surprised veteran financial managers who believed they were risky products. However, just the opposite has been proven true - major institutional investors, faced with unprecedented changes in prices, have realised it was imprudent not to use futures to manage cashmarket price risks.

Fund managers have seen that using futures often improves the rate of return and the overall performance of the portfolio. By including futures in their investment strategies, fund managers may be able to reduce higher transaction costs, which they normally experience in the cash markets.

The key benefits of using futures for the prudent financial manager are -

Lower transaction costs. Ease of execution. Lower market impact costs (since bid-ask spreads reduce due to greater liquidity). Negligible counterparty default risk (since all transactions are through clearing house).

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Stock index future contract and its advantages

A stock-index futures contract is a contract to buy or sell the face value of the underlying stock index; where the face value is defined as being the value of the index multiplied by a specified monetary amount (called the multiplier).

This product makes it possible to equate the value of a stock index with that of a specific basket of shares having the following specifications :-

The total value of the shares must match the monetary value of the index. The shares selected must correspond to the set of shares used to create the index. The amount of each holding must be in proportion to the market capitalization of each of the

companies included in the index.The profit or loss from a stock-index futures contract that is settled on delivery is the

difference between the value of the index at delivery date and the value on the date of entering into the contract. It is important to emphasise that the delivery at settlement date cannot be in underlying stocks of the index, but must be in cash. The futures index at expiration is set equal to the cash index on that day.

Advantages:

1. Actual Purchase Of Securities Not Involved - Stock index futures permit investment in the stock market without the trouble and expense involved in buying the individual securities.

2. High Leverage Due To Margin System - Operating under a margining system, stock-index futures allow full participation in market moves without significant commitment of capital. The margin levels allow leverage of between 10 to 40 times.

3. Lower Transaction Costs - The transaction costs are typically 60 - 75 % lower than those for physical share transactions.

4. Hedging Of Share Portfolio - Portfolio managers for large share portfolios can hedge the value of their investment against adverse fluctuations without having to alter the composition of the portfolio periodically.

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Impact of stock-index futures on cash markets

Since the introduction of stock-index futures in USA in 1982, the trading of these products has become very popular worldwide. The stock-index futures have outpaced the traditional cash markets in terms of volumes traded and popularity. One of the reasons for the success of stock-index futures is its ability to provide a new dimension to trading for a whole spectrum of traders from long-term investors to aggressive speculators

Introduction of trading in stock-index futures would increase volume in the underlying secondary markets in India. The trading in stock-index futures would also make the markets more complete than before. Therefore, there is ample evidence to support the introduction of futures trading in India

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Effects of the futures markets on spot market -

Researchers have argued that futures contracts have a beneficial impact on the markets for reasons like completion of otherwise incomplete markets, expansion of information available to market participants and the pooling of risk across securities and investors. On the other hand, it has been claimed by some, mainly market observers and policy makers, that futures contracts encourage speculation in the underlying assets market, with all its deleterious side effects, which are accentuated by the rapid advances and disseminations, information processing, trading technology and architecture of the markets.

The most widespread argument is that futures markets are inherently more volatile than cash markets, presumably because their participants are more highly leveraged and speculatively oriented than cash market investors. It is feared that such excess volatility may spill over from the futures markets by risk arbitrage and portfolio insurance. This fear stems from the belief that futures markets bring with them uninformed or irrational speculators, who trade in the cash market as well as the futures markets. It is argued that such speculators drive the prices up or down in quest for short-run “bandwagon” profits(Stein, 1961)1 . Economists have analysed these arguments and have concluded that it would take a considerable number of speculators to destabilse cash markets.

Influence of Programmed trading on Share price volatility

Programmed trading may increase the volatility of an index computed from the prices of the last trade in each share. An analysis of the effects of programmed trading on the volatility of the S&P 500 index found that fluctuations in the last trade prices due to switching between the bid and ask prices had led to a considerable increase in the spot volatility(Harris, Soriano’s and Shapiro, 1990)

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6. TRADE PROCESS

In electronic trading, customers (who have been pre-approved by a brokerage for electronic trading) send buy or sell orders directly from their computers to an electronic marketplace offered by the relevant exchange. There are no brokers involved in the process. Traders see the various bids and offers on their computers. The trade is executed by the traders lifting bids or hitting offers on their computer screens. The trading pit is, in essence, the trading screen and the electronic market participants replace the brokers standing in the pit. Electronic trading offers much greater insight into pricing because the top five current bids and offers are posted on the trading screen for all market participants to see. Computers handle all trading activity - the software identifies matches of bids and offers and generally fills orders according to a first-in, first-out (FIFO) process. Dissemination of information is also faster on electronic trades. Trades made on CME® Globex®, for example, happen in milliseconds and are instantaneously broadcast to the public. In open outcry trading, however, it can take from a few seconds to minutes to execute a trade.

Price LimitThis is the amount a futures contract's price can move in one day. Price limits are usually set in absolute dollar amounts - the limit could be $5, for example. This would mean that the price of the contract could not increase or decrease by more than $5 in a single day.

Limit MoveA limit move occurs when a transaction takes place that would exceed the price limit. This freezes the price at the price limit.

Limit UpThe maximum amount by which the price of a futures contract may advance in one trading day. Some markets close trading of these contracts when the limit up is reached, others allow trading to resume if the price moves away from the day's limit. If there is a major event affecting the market's sentiment toward a particular commodity, it may take several trading days before the contract price fully reflects this change. On each trading day, the trading limit will be reached before the market's equilibrium contract price is met.

Limit DownThis is when the price decreases and is stuck at the lower price limit. The maximum amount by which the price of a commodity futures contract may decline in one trading day. Some markets close trading of contracts when the limit down is reached, others allow trading to resume if the price moves away from the day's limit. If there is a major event affecting the market's sentiment toward a particular commodity, it may take several trading days before the contract price fully reflects this change. On each trading day, the trading limit will be reached before the market's equilibrium contract price is met.

Locked LimitOccurs when the trading price of a futures contract arrives at the exchange's predetermined limit price. At the lock limit, trades above or below the lock price are not executed. For example, if a futures contract has a lock limit of $5, as soon as the contract trades at $5 the contract would no

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longer be permitted to trade above this price if the market is on an uptrend, and the contract would no longer be permitted to trade below this price if the market is on a downtrend. The main reason for these limits is to prevent investors from substantial losses that can occur as a result of the volatility found in futures markets.

Futures - Marking to Market Process

Futures contracts are “marked to market” daily.

Generates cash flows to (or from) holders of foreign currency futures from (or to) the clearing house.

At the initiation of the trade, a price is set and money is deposited in the account. At the end of the day, a settlement price is determined by the clearing house. The account

is then adjusted accordingly, either in a positive or negative manner, with funds either being drawn from or added to the account based on the difference in the initial price and the settlement price.

The next day, the settlement price is used as the base price. As the market prices change through the next day, a new settlement price will be

determined at the end of the day. Again, the account will be adjusted by the difference in the new settlement price and the previous night's price in the appropriate manner.

If the account falls below the maintenance margin, the investor will be required to add additional funds into the account to keep the position open or allow it to be closed out. If the position is closed out the investor is still responsible for paying for his losses. This process continues until the position is closed out.

Mechanics:

Buy a futures contract this morning at the price of f0,T

At the end of the day, the new price is f1,T

The change in your futures account will be:

[f1,T - f0,T] x Contract Face Value = Cash Flow

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V. Futures vs. Forwards

Futures differ from forwards in several instances:

1. A forward contract is a private transaction - a futures contract is not. Futures contracts are reported to the future's exchange, the clearing house and at least one regulatory agency. The price is recorded and available from pricing services.

2. A future takes place on an organized exchange where the all of the contract's terms and conditions, except price, are formalized. Forwards are customized to meet the user's special needs. The future's standardization helps to create liquidity in the marketplace enabling participants to close out positions before expiration.

3. Forwards have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. Mark to market is the process of converting daily gains and losses into actual cash gains and losses each night. As one party loses on the trade the other party gains, and the clearing house moves the payments for the counterparty through this process.

4. Forwards are basically unregulated, while future contract are regulated at the federal government level. The regulation is there to ensure that no manipulation occurs, that trades are reported in a timely manner and that the professionals in the market are qualified and honest.

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Difference between Forward & Future Contract

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Futures vs. Forwards

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V. OPTIONS

1. HISTORY

Ancient Origins

Although it isn’t known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights—at a very low cost—to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price. Early Options in America

In America, options appeared on the scene around the same time as stocks. In the early 19thCentury, call and put contracts—known as “privileges”—were not traded on an exchange. Because the terms differed for each contract, there wasn’t much in the way of a secondary market. Instead, it was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific calls and puts in newspaper ads.

Chicago Board of Trade

In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade (CBOT) explored opportunities for diversification into the option market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing.

To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide two-sided markets. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price.

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Chicago Board Options Exchange (CBOE)

After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, 1973. The CBOE’s first home was actually a smoker’s lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year. Along the way, the new exchange achieved several important milestones.

As the number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts.

Exchange Traded Options

There are a variety of different types of options (e.g., stock options, index options). Once the basic principles are understood, they can easily be applied to the other financial instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by their company in a number of important ways.

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2. Meaning

WHAT IS AN OPTION?

We all know many opportunities exist in trading today. Everywhere you turn, someone is waiting to inform you of the tremendous profits to be realized in the stock and futures markets. However, many people are unaware of the derivative trading possibilities that are available within and across several different markets. Option trading is just one of the many ways to participate in these secondary markets. And contrary to popular belief, this potential trading arena is not limited strictly to the practice of selling or writing options.

Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one’s portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading.

One of the primary advantages of option trading is that option contracts enable a trade to be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual cost. And since an option’s price mirrors that of the underlying asset at the very least, any favorable return in the asset will be met with a greater percentage return in the option provides limited risk and unlimited reward.

With options, the buyer can only lose what was paid for the option contract, which is a fraction of what the actual cost of the asset would be. However, the profit potential is unlimited because the option holder possesses a contract that performs in sync with the asset itself. If the outlook is positive for the security, so too will the outlook be for that asset’s underlying options. Options also provide their owners with numerous trading alternatives. Options can be customized and combined with other options and even other investments to take advantage of any possible price dislocation within the market. They enable the trader or investor to acquire a position that is appropriate for any type of market outlook that he or she may have, be it bullish, bearish, choppy, or silent.

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CALL and PUT

Call: gives the holder the right to buy

Put: gives the holder the right to sell

An option is common form of a derivative. It's a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or OTC. They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets). There are two main types of options: calls and puts:

Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ''writing'' an option.

Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers - those who hold a "long" - put are either speculative buyers looking for leverage or "insurance" buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a "short" expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlyer is at or above the option's strike price at expiration. The maximum loss is unlimited for an uncovered put writer.

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http://www.investopedia.com/terms/p/put.asp

http://www.investopedia.com/terms/c/calloption.asp


The Options Game

Call Option Put Option

Option buyer or option holder

Buys the right to buy the underlying asset at the specified price

Buys the right to sell the underlying asset at the specified price

Option seller or option writer

Has the obligation to sell the underlying asset (to the option holder) at the specified price

Has the obligation to buy the underlying asset (from the option holder) at the specified price

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3. BASICS OF OPTIONS

Both put and call options have three basic characteristics: exercise price, expiration date and time to expiration.

The buyer has the right to buy or sell the asset. To acquire the right of an option, the buyer of the option must pay a price to the

seller. This is called the option price or the premium. The exercise price is also called the fixed price, strike price or just the strike and

is determined at the beginning of the transaction. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset.

Exercising is using this right the option grants you to buy or sell the underlying asset. The seller may have a potential commitment to buy or sell the asset if the buyer exercises his right on the option.

The expiration date is the final date that the option holder has to exercise her right to buy or sell the underlying asset.

Time to expiration is the amount of time from the purchase of the option until the expiration date. At expiration, the call holder will pay the exercise price and receive the underlying securities (or an equivalent cash settlement) if the option expires in the money. (We will discuss the degrees of moneyness later in this session.) The call seller will deliver the securities at the exercise price and receive the cash value of those securities or receive equivalent cash settlement in lieu of delivering the securities.

Defaults on options work the same way as they do with forward contracts. Defaults on over-the counter option transactions are based on counterparties, while exchange-traded options use a clearing house.

Example: Call OptionIBM is trading at 100 today. (June 1, 2005)

The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call = $3

In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to the buyer.

Example: Put OptionIBM is trading at 100 today (June 1, 2005)

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Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00

In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option on or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.

Example: Interpreting Diagrams For the exam, you may be asked interpret diagrams such as the following, which shows the value of a put option at expiration.

A typical question about this diagram might be:

Q: Ignoring transaction costs, which of the following statements about the value of the put option at expiration is TRUE?

A. The value of the short position in the put is $4 if the stock price is $76.

B. The value of the long position in the put is $4 if the stock price is $76.

C. The long put has value when the stock price is below the $80 exercise price.

D. The value of the short position in the put is zero for stock prices equaling or exceeding $76.

The correct answer is "C". A put option has positive monetary value when the underlying instrument has a current price ($76) below the exercise price ($80).

4. OPTION TRADING

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Buyer of a call:

– Assume purchase of August call option on Swiss francs with strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF.

– At all spot rates below the strike price of 58.5, the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market.

– At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium).

Writer of a call:

– What the holder, or buyer of an option loses, the writer gains.

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– The maximum profit that the writer of the call option can make is limited to the premium.

– If the writer wrote the option naked, that is without owning the currency, the writer would now have to buy the currency at the spot and take the loss delivering at the strike price.

– The amount of such a loss is unlimited and increases as the underlying currency rises.

– Even if the writer already owns the currency, the writer will experience an opportunity loss.

Buyer of a Put:

– The basic terms of this example are similar to those just illustrated with the call.

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– The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option).

– If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and receive $0.585/SF.

– At any exchange rate above the strike price of 58.5, the buyer of the put would not exercise the option, and would lose only the $0.05/SF premium.

– The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front.

Seller (writer) of a put:

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– In this case, if the spot price of francs drops below 58.5 cents per franc, the option will be exercised.

– Below a price of 58.5 cents per franc, the writer will lose more than the premium received fro writing the option (falling below break-even).

– If the spot price is above $0.585/SF, the option will not be exercised and the option writer will pocket the entire premium.

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5. BASIC OPTION TERMINOLOGY

Underlying - The specific security / asset on which an options contract is based.

Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell.

Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.

Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.

Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option)

Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.

Open Interest - The total number of options contracts outstanding in the market at any given point of time.

Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.

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Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.

Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options

Option Series - An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series, which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.

(BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date and strike Price is 3600)

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6. European vs. American Options and Moneyness

European Option

Europeans Options can only be exercised on the expiry date. European options are typically valued using the Black-Scholes or Black model formula. This is a simple equation with a closed-form solution that has become standard in the financial community.

American Option

This is an option that can be exercised at any time up to and including the expiry date. There are no general formulas for valuing American options, but a choice of models to approximate the price is available (for example Whaley, binomial options model, Monte Carlo and others), although there is no consensus on which is preferable.

American options are rarely exercised early. This is because all options have a non-negative time value and are usually worth more unexercised. Owners who wish to realize the full value of their options will mostly prefer to sell them rather than exercise them early and sacrifice some of the time value.

Note that the names of these types of options are in no way related to Europe or the United States.

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http://www.investopedia.com/terms/a/americanoption.asp

http://www.investopedia.com/terms/e/europeanoption.asp


Moneyness

The concept of moneyness describes whether an option is in-, out-, at-, or in-the-money by examining the position of strike vs. existing market price of the option's underlying security.

In the Money - Any option that has intrinsic value is in the money. A call option is said to be in the money when the futures price exceeds the option's strike price. A put is in the money when the futures price is below the option's strike price. For example, a March CME euro 90 call option will be in the money if March CME euro futures are above 90, meaning that the holder has the right to buy these futures at 90, regardless of how much the price has risen. The further in the money an option, the less time value it will have.

Deep In the Money - These options represent a larger spread between the strike and market price of an underlying security. Options that are deep in the money generally trade at or near their actual intrinsic values, calculated by subtracting the strike price from the underlying asset's market price for a call option (and vice versa for a put option). This is because options with a significant amount of intrinsic value built in have a very low chance of expiring worthless. Therefore, the primary value they provide is already priced into the option in the form of their intrinsic value. As an option moves deeper into the money, the delta approaches 100% (for call options), which means for every point change in the underlying asset's price, there will be an equal and simultaneous change in the price of the option, in the same direction. Thus, investing in the option is similar to investing in the underlying asset, except the option holder will have the benefits of lower capital outlay, limited risk, leverage and greater profit potential.

Out of the Money - These options exist when the strike price of a call (put) is above (below) the underlying asset's market price. (Essentially, it is the inverse of an in the money option). Options that are out of the money have a high risk of expiring worthless, but they tend to be relatively inexpensive. As the time value approaches zero at expiration, out of the money options have a greater potential for total loss if the underlying stock moves in an adverse direction.

At the Money - These options exist when the strike price of a call or put is equal to the underlying asset's market price. You can essentially think of at the money as the breakeven point (excluding transaction costs).

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http://www.investopedia.com/terms/o/outofthemoney.asp

http://www.investopedia.com/terms/d/deepinthemoney.asp

http://www.investopedia.com/terms/i/inthemoney.asp


Striking The Price

Call Option Put Option

In-the-money

Strike Price less than Spot Price of underlying asset

Strike Price greater than Spot Price of underlying asset

At-the-money

Strike Price equal to Spot Price of underlying asset

Strike Price equal to Spot Price of underlying asset

Out-of-the-money

Strike Price greater than Spot Price of underlying asset

Strike Price less than Spot Price of underlying asset

Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.

It is the time value portion of an option’s premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value.

Option Premium = Intrinsic Value + Time Value

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7. Option Pricing & Valuation

An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).

An option the would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM).

An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM).

Call Put

Intrinsic value max(ST - X, 0) max(X - ST, 0)

in the money ST – X > 0 X – ST > 0

at the money ST – X = 0 X – ST = 0

out of the money ST – X < 0 X – ST < 0

Time Value CT – Int. value PT – Int. value

Forward vs. Options

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48

-$0.90

-$0.75

-$0.60

-$0.45

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$0.45

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Spot Rate at Expiration

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Value of Forward Sale at Expiration

Value of Put at Expiration


8. Factors Affecto the Value of an Option Premium

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:

Underlying stock price, The strike price of the option, The volatility of the underlying stock, The time to expiration and; The risk free interest rate.

Non-Quantifiable Factors:

Market participants' varying estimates of the underlying asset's future volatility Individuals' varying estimates of future performance of the underlying asset, based on

fundamental or technical analysis The effect of supply & demand- both in the options marketplace and in the market for

the underlying asset The "depth" of the market for that option - the number of transactions and the

contract's trading volume on any given day.

Different pricing models for options

The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are:

Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.

Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution.

Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and offers in the trading environment.

Covered and Naked Calls

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A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call. Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.

E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.

Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value.

Intrinsic Value of an option

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

Time DecayGenerally, the longer the time remaining until an option’s expiration, the higher its

premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Expiration DayThe expiration date is the last day an option exists. For list-ed stock options, this is the

Saturday following the third Friday of the expiration month. Please note that this is the deadline

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by which brokerage firms must submit exercise notices to Stock Exchange Clearing; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.

ExerciseIf the holder of an American-style option decides to exercise his right to buy (in the case

of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to Stock Exchange Clearing. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his broker-age firm before its exercise cut-off time for accepting exercise instructions on that day.

Note: Various firms may have their own cut-off times for accepting exercise instructions from customers. These cut-off times may be specific for different classes of options and different from Stock Exchange Clearing’s requirements. Cut-off times for exercise at expiration and for exercise at an earlier date may differ as well.

What’s the Net?When an investor exercises a call option, the net price paid for the underlying stock on a

per share basis will be the sum of the call’s strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on a per share basis will be the sum of the call’s strike price plus the premium received from the call’s initial sale.

When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put’s strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put’s strike price less the premium received from the put’s initial sale.

Volatility

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Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Option Greeks-Delta, Gamma, Vega, Theta, Rho

The price of an Option depends on certain factors like price and volatility of the underlying, time to expiry etc. The Option Greeks are the tools that measure the sensitivity of the option price to the above-mentioned factors. They are often used by professional traders for trading and managing the risk of large positions in options and stocks. These Option Greeks are:

Delta: is the option Greek that measures the estimated change in option premium/price for a change in the price of the underlying.

Gamma: measures the estimated change in the Delta of an option for a change in the price of the underlying

Vega: measures estimated change in the option price for a change in the volatility of the underlying.

Theta: measures the estimated change in the option price for a change in the time to option expiry.

Rho: measures the estimated change in the option price for a change in the risk free interest rates.

9. How the greeks help in hedging?Spreading is a risk-management strategy that employs options as the hedging instrument,

rather than stock. Like stock, options have directional risk (deltas). Unlike stock, options carry gamma, vega, and theta risks as well. Therefore, if a position involves any combination of

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gamma, vega, and/or theta risk, this can be reduced or eliminated by adding one or more options positions. Table 1-1 summarizes the possible hedges and their gamma, vega and theta impact for each of the six building blocks.

Notice that owning option contracts be they puts or calls, means that you are adding positive gamma, positive vega, and negative theta. Being short either of these contracts means acquiring negative gamma, negative vega, and positive theta. This statement points out that as far as these Greeks are concerned, you get a package deal

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. Possible Hedging Strategies with the Greeks

Building Block Hedge Hedge Delta Hedge Gamma Hedge Vega Hedge Theta

Long StockPositive delta, no gamma, no vega, no theta

Sell Call Negative Negative Negative PositiveSell Stock Negative None None NoneBuy Put Negative Positive Positive Negative

Short StockNegative delta, no gamma, no vega, no theta

Buy Call Positive Positive Positive NegativeBuy Stock Positive None None NoneSell Put Positive Negative Negative Positive

Long CallPositive delta, positive gamma, positive vega, negative theta

Sell Call Negative Negative Negative PositiveBuy Put Negative Positive Positive NegativeSell Stock Negative None None None

Short CallNegative delta, negative gamma, negative vega, positive theta

Buy Call Positive Positive Positive NegativeSell Put Positive Negative Negative PositiveBuy Stock Positive None None None

Long PutNegative delta, positive gamma, positive vega, negative theta

Sell put Positive Negative Negative PositiveBuy Call Positive Positive Positive NegativeBuy Stock Positive None None None

Short PutPositive delta, negative gamma, negative vega, positive theta

Buy put Negative Positive Positive NegativeSell Call Negative Negative Negative PositiveSell Stock Negative None None None

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10. Benefits of Options Trading

Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. They can be as conservative or as speculative as one's investment strategy dictates.

Some of the benefits of Options are as under:

High leverage as by investing small amount of capital (in form of premium), one can take exposure in the underlying asset of much greater value.

Pre-known maximum risk for an option buyer Large profit potential and limited risk for option buyer One can protect his equity portfolio from a decline in the market by way of buying a

protective put wherein one buys puts against an existing stock position. This option position can supply the insurance needed to overcome the uncertainty of the

marketplace. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the Put anytime until the Put expires.

E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks that the stock is over-valued and decides to buy a Put option' at a strike price of Rs. 3800/- by paying a premium of Rs 200/-

If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- by exercising his put option. Thus, by paying premium of Rs 200,his position is insured in the underlying stock.

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Risks of an options buyer

The risk/ loss of an option buyer is limited to the premium that he has paid.

Risks for an Option writer

The risk of an Options Writer is unlimited where his gains are limited to the Premiums earned. When a physical delivery uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.

The writer of a put option bears a risk of loss if the value of the underlying asset declines below the exercise price. The writer of a put bears the risk of a decline in the price of the underlying asset potentially to zero.

Option writing is a specialized job which is suitable only for the knowledgeable investor who understands the risks, has the financial capacity and has sufficient liquid assets to meet applicable margin requirements. The risk of being an option writer may be reduced by the purchase of other options on the same underlying asset thereby assuming a spread position or by acquiring other types of hedging positions in the options/ futures and other correlated markets. In the Indian Derivatives market, SEBI has not created any particular category of options writers. Any market participant can write options. However, margin requirements are stringent for options writers.

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11. Stock Index Options

The Stock Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty Index / Options on BSE Sensex etc.

Index Options were first introduced by Chicago Board of Options Exchange in 1983 on its Index 'S&P 100'. As opposed to options on Individual stocks, index options give an investor the right to buy or sell the value of an index which represents group of stocks.

Uses of Index Options

Index options enable investors to gain exposure to a broad market, with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stocks or individual equity options, numerous decisions and trades would be necessary. Since, broad exposure can be gained with one trade, transaction cost is also reduced by using Index Options. As a percentage of the underlying value, premiums of index options are usually lower than those of equity options as equity options are more volatile than the Index.

Options on individual stocks

Options contracts where the underlying asset is an equity stock are termed as Options on stocks. They are mostly American style options cash settled or settled by physical delivery. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g. 100.

Benefits of options in specific stocks to an investor

Options can offer an investor the flexibility one needs for countless investment situations. An investor can create hedging position or an entirely speculative one, through various strategies that reflect his tolerance for risk.

Investors of equity stock options will enjoy more leverage than their counterparts who invest in the underlying stock market itself in form of greater exposure by paying a small amount as premium.

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Leaps - Long Term Equity Anticipation Securities

(Currently not available in India )

Long-term equity anticipation securities (Leaps) are long-dated put and call options on common stocks or ADRs. These long-term options provide the holder the right to purchase, in case of a call, or sell, in case of a put, a specified number of stock shares at a pre-determined price up to the expiration date of the option, which can be three years in the future.

Exotic Options (Currently not available in India)

Derivatives with more complicated payoffs than the standard European or American calls and puts are referred to as Exotic Options. Some of the examples of exotic options are as under:

Barrier Options: where the payoff depends on whether the underlying asset's price reaches a certain level during a certain period of time.

CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Options where the payout is capped so that it cannot exceed $30.

A Call CAP is automatically exercised on a day when the index closes more than $30 above the strike price. A put CAP is automatically exercised on a day when the index closes more than $30 below the cap level.

Binary Options: are options with discontinuous payoffs. A simple example would be an option which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000 & pays off nothing if it ends up below the strike.

Over-The-Counter Options: are options are those dealt directly between counter-parties and are completely flexible and customized. There is some standardization for ease of trading in the busiest markets, but the precise details of each transaction are freely negotiable between buyer and seller.

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Options with Options

When an option has value, meaning it is in-the-money, the trader can choose whether to trade the contract to another individual or exercise the contract and obtain the underlying asset. The ultimate decision that is made depends upon the individual investor, his or her trading style, his or her trading needs, and the situation at hand.

Option is a contract which has a market value like any other tradable commodity. Once an option is bought there are following alternatives that an option holder has:

You can sell an option of the same series as the one you had bought and close out /square off your position in that option at any time on or before the expiration.

You can exercise the option on the expiration day in case of European Option or; on or before the expiration day in case of an American option. In case the option is 'Out of Money' at the time of expiry, it will expire worthless.

#Please note that while options provide the right to acquire the underlying instrument, the owner must still produce the necessary funds for the asset itself.

In exercising a stock or futures put option, the option holder agrees to sell the standardized quantity of the underlying asset to the option writer at the predetermined strike price. Because of their contract, the writer must purchase the asset from the option holder at the strike price, regardless of the price at which the market is currently trading

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Placing option ordersBefore participating in a market, regardless of which one, it is important that one become

familiar with may of the trading nuances and aspects which apply to that specific market. This is especially true when trading options. Once these variables are addressed and an option contract is selected, the trader must then place the order. When placing an option order, a trader must make certain to supply the following trading instructions to the broker:

1. Whether the option order is a buy or a sell

2. The number of option contracts the trader wishes to transact

3. The proper description of the option, including the specific option contract to be traded, the correct month and year, and the exercise price

4. The price at which the trader wishes to buy or to sell the option

5. The specific exchange the trader wishes to use to conduct the trade if more than one exchange lists the option

6. The stop loss level, or the price at which the trader wishes to exit an unprofitable trade

7. The type of option to be executed, that is, an opening purchase, a closing purchase, an opening sale, or a closing sale

Reading an option price tableMany major newspaper and trading publications today provide option-pricing tables so

traders can track and follow the activity of certain listed options on a day-to-day basis. While the organization of these price table may differ slightly for stock options, they all usually contain the security that the option covers, the prior day’s closing price of the underlying asset, the varying strike prices and expiration months, the prior day’s volume and closing prices for each call option, and the prior day’s volume and closing prices for each put option. Other option listings, such as those for indices, also include items such as the net price change of the option from the previous day’s closing price and the open interest of the call or put option.

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When not to buy an option?

It is also important to consider the time or the date at which one should enter the option market. While these option-buying suggestions are presented in the context of day trading options, they apply equally as well to option position trading.

When day trading, a trader must give the market adequate time to perform. Consequently, eliminate day trading within the final hour of trading. If one is position-trading options, this suggestion should not be a concern.

Avoid trading in an illiquid option market.

Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyouts in particular). Besides bordering on unethical trading, the information received is more likely to be rumor than correct.

Avoid purchasing options well after the market has established a defined trend – this is especially true when day trading, as any option premium advantage will have dissipated.

Avoid purchasing way out-of-the-money options when day trading, as any favorable price movement will have a negligible effect upon premium.

Avoid purchasing call options when the underlying security is up for the day versus the prior day’s close, unless one intends to take a trend-following stance.

Avoid purchasing put options when the underlying security is down for the day versus the prior day’s close, unless one intends to take a trend-following stance.

Be careful when holding long option positions beyond Friday’s trading day’s close unless one is option position trading. Many option theoreticians recalculate their volatility, delta, and time decay numbers once a week, usually after the close of trading on Fridays or over the weekend. The resulting adjustments in these values most often have a negative effect on the value of the long option, which may be acceptable when holding an option over an extended period of time but is detrimental when day trading.

12. Quick Snapshot of Options Trading Strategies

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Please note:

All or part of your investments using Bullish Strategies has greater risk of loss in falling market.

Investments using Neutral Strategies have greater risk of loss in volatile markets Investments using Bearish Strategies have greater risk of loss in rising markets.

BULLISH STRATEGIESLONG CALLS

For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited inside risk.

COVERED CALLS

For conservative investors, selling calls against a long stock position can be an excellent way to generate income without assuming the risks associated with uncovered calls. In this case, investors would sell one call contract for each 100 shares of stock they own.

PROTECTIVE PUT

For investors who want to protect the stocks in their portfolio from falling prices, protective puts provide a relatively low-cost form of portfolio insurance. In this case, investors would purchase one put contract for each 100 shares of stock they own.

BULL CALL SPREAD

For bullish investors who want to a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize both the cash outlay and the overall risk.

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BULL PUT SPREAD

For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike are sold, the trade is initiated for a credit.

CALL BACK SPREAD

For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price.

NAKED PUT

For bullish investors who are interested in buying a stock at a price below the current market price, selling naked puts can be an excellent strategy. In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading.

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BEARISH STRATEGIESLONG PUT

For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk is limited to the initial investment, the profit potential is unlimited.

NAKED PUT

Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.

PUT BACKSPREAD

For aggressive investors who expect big downward moves in already volatile stocks, back spreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price. As the stock price moves lower, the profit potential is unlimited.

BEAR CALL SPREAD

For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless.

BEAR PUT SPREAD

For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases.

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NEUTRAL STRATEGIES REVERSAL

Primarily used by professional traders, a reversal is an arbitrage strategy that allows traders to profit when options are underpriced. To put on a reversal, a trader would sell stock and use options to buy an equivalent position that offsets the short stock.

CONVERSION

Primarily used by professional traders, a conversion is an arbitrage strategy that allows traders to profit when options are overpriced. To put on a conversion, a trader would

buy stock and use options to sell an equivalent position that offsets the long stock.

THE COLLAR

For bullish investors who want to nice low risk, limited return strategy to use in conjunction with a long stock position, collars are a great alternative. In this case, the collar is created by combining covered calls protective puts.

LONG STRADDLE

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down.

SHORT STRADDLE

For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down.

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LONG STRANGLE

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down.

SHORT STRANGLE

For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down.

THE BUTTERFLY

Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying.

RATIO SPREAD

For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt by market movement.

CONDOR

Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

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OPTION TRADING STRATEGY FORMULAS

MARRIED PUT(Stock Price – Strike Price) + Put Price = Maximum Loss

PROTECTING UNREALIZED PROFIT(Strike Price – Put Price) – Initial Stock Purchase = Unrealized Profit

COVERED CALL POTENTIAL(Call Price + Strike Price) – Stock Price = Covered Call Potential

BULL SPREAD (LONG CALL SPREAD)

Difference between Strike Prices – Debit Paid = Maximum Profit

(The debit Paid is the maximum loss.)

BULL SPREAD (SHORT PUT SPREAD)

Difference between Strike Prices – Credit = Maximum Loss

(The credit received is the maximum profit.)

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BEAR SPREAD (LONG PUT SPREAD)

Difference between Strike Prices – Debit Paid = Maximum Profit

(The debit Paid is the maximum loss.)

BEAR SPREAD (SHORT CALL SPREAD)

Difference between Strike Prices – Credit = Maximum Loss

(The credit received is the maximum profit.)

RATIO BULL SPREAD (LONG)

A short call spread plus a long OTM call

RATIO BULL SPREAD (SHORT)

A long call spread plus a short OTM call

RATIO BEAR SPREAD (LONG)

A short put spread plus a long OTM put

RATIO BEAR SPREAD (SHORT)

A long put spread plus a short OTM put

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LONG STRADDLEStrike Price – (Call Price + Put Price) = Low Break-even Point

Strike Price + (Call Price + Put Price) = High Break-even Point

SHORT STRADDLEStrike Price – (Call Price + Put Price) = Low Break-even Point

Strike Price + (Call Price + Put Price) = High Break-even Point

LONG STRANGLEOTM Put Strike Price – (OTM Call Price + OTM Put Price) = Low Break-even Point

OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point

SHORT STRANGLEOTM Put Strike Price – (OTM Call Price + OTM Put Price) = Low Break-even Point

OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point

LONG BUTTERFLYBuy One + Sell Two + Buy One = Total Debit

SHORT BUTTERFLYSell One + Buy Two + Sell One = Total Credit

LONG IRON BUTTERFLYSell ATM Straddle – Buy OTM Strangle = Receive a credit

SHORT IRON BUTTERFLYBuy ATM Straddle – Sell OTM Strangle = Total Debit

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LONG CONDORBuy One + Sell One + Sell One + Buy One = Total Debit paid

SHORT CONDORSell One + Buy One + Buy One + Sell One = Credit received

RISK COLLAR / FENCE (RISK CONVERSION)

Long Underlying Security = Purchasing OTM Put + Selling the OTM call

RISK COLLAR / FENCE (RISK REVERSAL)

Short Underlying Security = Purchasing OTM Call + Selling the OTM Put

INTRINSIC AND PREMIUM FORMULAS

The intrinsic value of an option corresponds to the relationship between the option’s strike price and the current price of the underlying asset. The intrinsic value is the amount that an option is in-the-money (ITM). Out-of-the-money (OTM) options have no intrinsic value.

CALL INTRINSIC VALUECurrent Stock Price – Strike Price = Call Intrinsic Value

PUT INTRINSIC VALUEStrike Price – Current Stock Price = Put Intrinsic Value

CALL PREMIUM VALUE

Call Option Price – Call Intrinsic Value = Call Premium Value

PUT PREMIUM VALUEPut Option Price – Put Intrinsic Value = Put Premium Value

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In the option markets, the players fall into four categories:

The Exchanges Financial Institution Market Makers Individual (Retail) Investors

What follows is a brief overview of each group along with insights into their trading objectives and strategies.

The Exchanges

The exchange is a place where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments. Since 1973 when the Chicago Board Options Exchange first began trading options, a number of other players have emerged. At first, the exchanges each maintained separate listings and therefore didn't trade the same contracts. In recent years this has changed.

Financial Institutions

Financial institutions are professional investment management companies that typically fall into several main categories: mutual funds, hedge funds, insurance companies, stock funds. In each case, these money managers control large portfolios of stocks, options, and other financial instruments. Although individual strategies differ, institutions share the same goal—to outperform the market. In a very real sense, their livelihood depends on performance because the investors who make up any fund tend to be a fickle group. When fund don’t perform, investors are often quick to move money in search of higher returns.

Market Makers

Market makers are big-time traders on the exchanges who create liquidity by providing two-sided markets. In each counter, the competition between market makers keeps the spread between the bid and the offer relatively narrow. Nevertheless, it’s the spread that partially compensates market makers for the risk of willingly taking either side of a trade.

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For market makers, the ideal situation would be to “scalp” every trade. More often than not, however, market makers don’t benefit from an endless flow of perfectly offsetting trades to scalp.

Any or all of these techniques may be employed by the same market maker depending on trading conditions.

Day Traders Premium Sellers Spread Traders Theoretical Traders

Individual (Retail)

As option volume increases, the role of individual investors becomes more important because they account for over 90% of the volume. That's especially impressive when you consider that option volume in February 2000 was 56.2 million contracts—an astounding 85% increase over February 1999

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Delta Effects

When the Underlying Security…

Increase in Value Decrease in Value

The Long Call will…. Increase in Value Decrease in Value

The Short Call will…. Decrease in Value Increase in Value

The Long Put will…. Decrease in Value Increase in Value

The Short Put will…. Increase in Value Decrease in Value

Position Hedges

Option Position Hedge Position

Long Call – Increases in value as the underlying increases in value

Short Underlying

Short Call

Long Put

Short Call – Decreases in value as the underlying increases in value

Long Underlying

Long Call

Short Put

Long Put – Decreases in value as the underlying increases in value

Long Underlying

Short Put

Long Call

Short Put – Increases in value as the underlying decreases in value

Short Underlying

Long Put

Short Call

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Varying Market Conditions

As market conditions change the values of…

Rise in price of the underlying…

Interest rates Rise…

Volatility Rise…

Passage of time…

Dividends Rise…

Long Underlying

Increase No effect No effect No effect Increase

Short Underlying

Decrease No effect No effect No effect Decrease

Long Call Increase Increase Increase Decrease Decrease

Short Call Decrease Decrease Decrease Increase Increase

Long Put Decrease Decrease Increase Decrease Increase

Short Put Increase Increase Decrease Increase Decrease

Knowing the risks involved with options trading is the first step to successful trading while hedging these risks to create a profitable position is the second step. We have learned that there are different ways to hedge each trade, providing a market maker with the important task of determining the best hedge possible for each trade he or she executes.

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Effects of Theta

As Time Moves Forward…

Underlying Security Value remains constant

Long Call Decrease in Value

Short Call Increase in Value

Long Put Decrease in Value

Short Put Increase in Value

Interest rate risk (rho risk) is negligible to most traders. Its impact can be substantial if a position contains a large amount of long or short stock or long-term options. Decreasing the stock position, replacing stock with options is the most efficient way to reduce rho risk. Remember, longer-term options are more interest rate sensitive.

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VI. SWAPS

1. MEANING

A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a cash-settled contract between two parties to exchange (or "swap") cash flow streams. As long as the present value of the streams is equal, swaps can entail almost any type of future cash flow. They are most often used to change the character of an asset or liability without actually having to liquidate that asset or liability. For example, an investor holding common stock can exchange the returns from that investment for lower risk fixed income cash flows - without having to liquidate his equity position.

The difference between a forward contract and a swap is that a swap involves a series of payments in the future, whereas a forward has a single future payment.

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http://www.investopedia.com/terms/s/swap.asp


Two of the most basic swaps are:

Interest Rate Swap - This is a contract to exchange cash flow streams that might be associated with some fixed income obligations. The most popular interest rate swaps are fixed-for-floating swaps, under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan.

Currency Swap - This is similar to an interest rate swap except that the cash flows are in different currencies. Currency swaps can be used to exploit inefficiencies in international debt markets. For example, assume that a corporation needs to borrow $1O million euros and the best rate it can negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a comparable loan. The corporation could take the U.S. loan and then find a third party willing to swap it into an equivalent euro loan. By doing so, the firm would obtain its euros at more favorable terms.

Cash flow streams are often structured so that payments are synchronized, or occur on the same dates. This allows cash flows to be netted against each other (so long as the cash flows are in the same currency.

The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

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http://www.investopedia.com/terms/c/currencyswap.asp

http://www.investopedia.com/terms/i/interestrateswap.asp

http://en.wikipedia.org/wiki/Speculation

http://en.wikipedia.org/wiki/Interest_rate_risk

http://en.wikipedia.org/wiki/Hedge_(finance)

http://en.wikipedia.org/wiki/Collateral_(finance)

http://en.wikipedia.org/wiki/Option_(finance)

http://en.wikipedia.org/wiki/Forward_contract

http://en.wikipedia.org/wiki/Futures_contract

http://en.wikipedia.org/wiki/Notional_principal_amount

http://www.investopedia.com/terms/f/fixed_floatswap.asp

http://www.investopedia.com/terms/f/fixed_floatswap.asp


A swap bank is a generic term used to describe a financial institution that facilitates swaps between counterparties.

The swap bank serves as either a broker or a dealer.

A broker matches counterparties but does not assume any of the risk of the swap. The swap broker receives a commission for this service.

Today most swap banks serve as dealers or market makers. As a market maker, the swap bank stands willing to accept either side of a currency swap.

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2. Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.

Interest rate swapsThe most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage

Commodity swapsA commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

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http://en.wikipedia.org/wiki/Petroleum#Crude_oil

http://en.wikipedia.org/wiki/Comparative_advantage

http://en.wikipedia.org/wiki/Equity_swap

http://en.wikipedia.org/wiki/Commodity_swap

http://en.wikipedia.org/wiki/Interest_rate_swap



Currency swapsA currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.

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Since all swap rates are derived from the yield curve in each major currency, the fixed-to-floating-rate interest rate swap existing in each currency allows firms to swap across currencies.

The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency.

The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated.

Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows (a significant reason for this being cost).

Currency Swaps

http://en.wikipedia.org/wiki/Comparative_advantage


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Example of a Currency Swap

Company A

Swap Bank

i$=8%

i$=8%i£=1

1%

i£=12%

i$=9.4%

CompanyB

i£=12%

$ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%

The swap bank makes money too:

1.4% of $16 million

financed with 1% of £10

million per year for 5

years.At S0 = 1.60 $/£, that is a gain of $64,000 per year for 5 years.

The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.


Credit default swapsA credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.[1]

A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset

A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.

An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.

A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes.

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http://en.wikipedia.org/wiki/Amortising_swap

http://en.wikipedia.org/wiki/Bond_duration

http://en.wikipedia.org/wiki/Variance_swap

http://en.wikipedia.org/wiki/Underlying

http://en.wikipedia.org/wiki/Asset

http://en.wikipedia.org/wiki/Total_return_swap

http://en.wikipedia.org/wiki/Swap_(finance)#cite_note-hull-1

http://en.wikipedia.org/wiki/Money

http://en.wikipedia.org/wiki/Insurance_premium

http://en.wikipedia.org/wiki/Buyer

http://en.wikipedia.org/wiki/Insurance

http://en.wikipedia.org/wiki/Bankruptcy

http://en.wikipedia.org/wiki/Restructuring

http://en.wikipedia.org/wiki/Credit_event

http://en.wikipedia.org/wiki/Default_(finance)

http://en.wikipedia.org/wiki/Loan

http://en.wikipedia.org/wiki/Bond_(finance)


A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future.

An Accrediting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.

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VII. KEY INGREDIENTS TO PERFORMING YOUR BEST

PASSIONYou must be passionate about what you are doing and having fun. Passion first, then performance.

CONFIDENCETop performance comes from having a high degree of confidence. You must have the confidence that you can take control and face adversity. You must also be confident that you will have a favorable outcome over time.

CONCENTRATIONPeak performance comes from exceptional CONCENTRATION. You must concentrate on the process, though, not the outcome. A sprinter who is in the lead is thinking about the wind on their face, how relaxed their arms are, feeling the perfect stride…they are totally in the moment. The person who does NOT have the edge is thinking, “Oh, that runner is pulling ahead of me…I don’t know if I have enough wind to catch the leader…” They are tense and tight because they are thinking about the outcome, not the process.

RESILIENCYGreat performances come from being able to rebound quickly and forget about mistakes.

CHALLENGEGreat performance comes from pushing yourself and trying to overcome limitations. Staying in the safe zone becomes a monkey on your back. Challenge yourself to take that hard trade. Manage it. If it does not work out, so what…your risk was limited and you can pat yourself on the back for taking the hard trade in the first place.

SEE AND DO ... DON'T THINK!Great performance comes from turning off the brain and becoming automatic. This is being in the Zone …in the groove. You can’t overanalyze the markets during the trading day.

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RELAXATIONWhen you are relaxed, your reflexes and timing are superior because you are loose.

POSITIVE SELF TALKThere are some concrete tools to break the cycle and bust out of the slump? The number one tool for starters is POSITIVE SELF TALK. We all talk to ourselves in our own head. Be aware of the things you are saying to yourself.

DESIREThe most successful players are the ones who have a burning desire to win

DEFY FAILURE!Don't check out of the game. Never give up!

CONSISTENCYImprove your consistency. Stay active, stay involved, and keep your feet moving.

PATIENCEBe patient. Do not force a trade that isn't there. Wait for the play to set up.

MANAGEMENTWhen you get a good trade, go for it. Manage it. Trail a stop. Don't be too eager to get out.

FLEXIBILITYBe flexible - if what you are doing isn't working, change what you are doing!

CONFIDENCEWhen down, get a little rhythm and confidence going. Don't worry about being too ambitious.

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CONCENTRATIONStay with your game. Don't let outside distractions bother you. They take energy and break your concentration.

KNOW YOURSELFMatch your particular strengths to the type of market conditions.

CLEAN UP YOUR ACTHate making stupid mistakes and unforced errors. This includes not getting out of a bad trade when you know you are wrong.

STAY POSITIVEMany players will play their best game when they are coming from behind.

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Time Tested Trading Rules to be a Master Trader

Plan your trades. Trade your plan.

Keep records of your trading results.

Keep a positive attitude, no matter how much you lose.

Don't take the market home.

Continually set higher trading goals.

Successful traders buy into bad news and sell into good news.

Successful traders are not afraid to buy high and sell low.

Successful traders have a well-scheduled planned time for studying the markets.

Successful traders isolate themselves from the opinions of others.

Continually strive for patience, perseverance, determination, and rational action.

Limit your losses - use stops!

Never cancel a stop loss order after you have placed it!

Place the stop at the time you make your trade.

Never get into the market because you are anxious because of waiting.

Avoid getting in or out of the market too often.

Losses make the trader studious - not profits. Take advantage of every loss to improve your knowledge of market action.

The most difficult task in speculation is not prediction but self-control. Successful trading is difficult and frustrating.

You are the most important element in the equation for success.

Always discipline yourself by following a pre-determined set of rules.

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Remember that a bear market will give back in one month what a bull market has taken three months to build.

Don't ever allow a big winning trade to turn into a loser. Stop yourself out if the market moves against you 20% from your peak profit point.

You must have a program, you must know your program, and you must follow your program.

Expect and accept losses gracefully. Those who brood over losses always miss the next opportunity, which more than likely will be profitable.

Split your profits right down the middle and never risk more than 50% of them again in the market.

The key to successful trading knows you and your stress point.

Dream big dreams and think tall. Very few people set goals too high.

A man becomes what he thinks about all day long.

Accept failure as a step towards victory.

Have you taken a loss? Forget it quickly. Have you taken a profit?

One cannot do anything about yesterday. When one door closes, another door opens. The greater opportunity always lies through the open door.

The deepest secret for the trader is to subordinate his will to the will of the market. The market is truth as it reflects all forces that bear upon it. As long as he recognizes this he is safe. When he ignores this, he is lost and doomed.

It's much easier to put on a trade than to take it off.

If a market doesn't do what you think it should do, get out.

In the world of money, which is a world shaped by human behavior, nobody has the foggiest notion of what will happen in the future. Mark that word - Nobody! Thus the successful trader does not base moves on what supposedly will happen but reacts instead to what does happen.

When the ship starts to sink, don't pray - jump!

VIII. CONCLUSION

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This project concludes that FORWARD, FUTURES, OPTIONS and SWAPS

products in derivatives are powerful and innovative product which transfers the

risk from those who do not want to take it at a price to those who are capable of

and expert in managing risk. Hedger, Speculator and Arbitrageurs are the people

who are prepared to deal with the risk.

Financial institution are very sensitive to the risk exposer measures so they look

Forward to derivatives market and use various innovative products like Forward,

Future, Options and Swaps.

Indian derivatives market is strongly routed through the stock exchanges and

commodities market derivatives. Future traders deal through the stock exchanges

in a standardize manner. NSE India is the Pioneer of derivatives product in India.

Derivatives are important tools which help in growth of Indian Capital Markets.

SEBI on time to time issue various guidelines to all the dealers of derivatives to

bring transparency in the working.

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IX. BIBLIOGRAPHY

www.investopdeia.com

www.wikipedia.com

www.managementparadise.com

www.bseinida.com

www.nse.com

www.alpari.com

www.economywatch.com

www.newyorkfed.org

http://www.namansec.com/knowledge_center/derivatives.htm

http://www.emathzone.com/tutorials/basic-statistics/continuous-random-variable.html

http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/managing-risk-options-strategies-long-short-call-put-positions.asp

http://www.sdgm.com/Support/Glossary.aspx

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http://www.sdgm.com/Support/Glossary.aspx





http://www.namansec.com/knowledge_center/derivatives.htm

http://www.newyorkfed.org/

http://www.economywatch.com/

http://www.alpari.com/

http://www.nse.com/

http://www.bseinida.com/

http://www.managementparadise.com/

http://www.wikipedia.com/

http://www.investopdeia.com/


X. Analysis

Survey Questions

1} Education and qualification of investor who investing in derivative market?

Under Graduate 6

Graduate 10

Post graduate 23

Professional 11

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2} Income range of investor who invest in derivative market ?

Income range Number Of Result

Below 1,50,000 01

1,50,000 - 3,00,000 09

3,00,000 – 5,00,000 14

Above 5,00,000 16

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3} Why people do not invest in derivative market ?

Results Number of result

Lack of knowledge and understanding 27

Increase speculation 02

Risky and highly leveraged 17

Counter party risk 04

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4] What is the purpose of investing in derivative market ?

Purpose of investment Number of result

Hedge their fund 27

Risk control 9

More stable 1

Direct investment without holding & buying asset

13

5} You participate in derivative market as?

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Participation as Number of result

Investor 23

Speculator 02

Broker / Dealer 08

Hedger 17

6} From where you prefer to take advice before investing in derivative market ?

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Advice from

Number of result

Brokers 15

Research analyst 7

Websites 2

News network 23

Others 3

7} In which of the following would you like to participate ?

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Participate in Number of result

Stock index future 19

Stock index option 13

Future on individual stock 06

Currency future 09

Options on individual stock 03

10. .How are derivatives settled in India?

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Derivative transactions are currently settled in cash.

11. Are the risks involved in derivative trading more than trading in the spot market?

Yes, sometimes the investors can lose huge amounts within a short span of time in

derivatives much more than possible losses in the cash market given similar

invested amounts.

12. When one make profits will in Future contracts?

If you have bought Futures and the price goes up, you will make profits.

If you have sold Futures and the price goes down, you will make profits.

13. What is the derivatives scenario in India?

Derivative instruments are highly traded in India since its inception in June 2000

on NSE. If you see the amount of contracts traded in the exchanges it is

continuously on a uproll from the past.

14. What are the things which are important while trading in derivatives

It is very important for individuals to know that derivatives are highly leveraged

instruments, it can also prove highly risky instrument as the losses are also high in

derivatives. So proper research and risk management strategy must be adopted

before trading in derivative instruments.

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products in derivatives market

Business