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An Introduction to Derivatives

An Introduction to Derivatives. A presentation by Derivative Research. Why learn or talk about Derivatives. Important Financial instrument – In fact the most widely traded or used financial instrument in currency, commodity and equities market.

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An Introduction to Derivatives

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  1. UNICON

  2. An Introduction to Derivatives A presentation by Derivative Research UNICON

  3. Why learn or talk about Derivatives. • Important Financial instrument – In fact the most widely traded or used financial instrument in currency, commodity and equities market. • Why are they used : - Risk control or hedge against any unforeseen event and leverage. • Good liquidity and ease of entry and exit. UNICON

  4. What are derivatives • Derivatives are financial instruments whose value depend on the value of other, more basic underlying assets. • Underlying asset can be a commodity, currency, equity, interest rate, exchange rate etc. UNICON

  5. Futures Forwards Options Derivative Products UNICON

  6. Futures Contract Futures contracts: • Are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. • Are of standard quantity, standard quality. • Have standard delivery time and place. UNICON

  7. Introduction to futures Choice of initial product: • Index futures • Options on index • Stock futures • Options on stocks UNICON

  8. Introduction to futures • Trading mechanism Contract design: • Price • Lot size • Tick size • Expiration month and date • Open interest, volume position UNICON

  9. Futures – definition • A futures is a legally binding agreement to buy or sell something in the future at a price which is determined today. • Pricing Futures = Spot+Cost of carry –dividend (if any) UNICON

  10. Operational Mechanism • Cash settled • Initial Margin (upfront) • Mark-to-Market margin (daily) UNICON

  11. Option - definition • Option is the right given by the option seller to the option buyer to buy or sell specific asset at a specific price on or before a specific date. UNICON

  12. How much does an option cost? • The premium is the price you pay for the option. For buyer of an option • Risk : limited to the amount of premium paid • Profit potential: unlimited For a seller of an option • Risk – Unlimited. • Profit Potential – limited to the premium recd. UNICON

  13. Option Terminology • Call Option • Option to buy • Put Option • Option to sell • Option Buyer • has the right but not the obligation • Option Writer/Seller • has the obligation but not the right UNICON

  14. Option Terminology • Option Premium • Price paid by the buyer to acquire the right • Strike Price OR Exercise Price • Price at which the underlying may be purchased • Expiration Date • Last date for exercising the option • Exercise Date • Date on which the option is actually exercised UNICON

  15. Strike Prices • In-the-money • Option with intrinsic value • At-the-money • Exercise Price = Market Price • Out-of-the-money • No intrinsic value • some time value possible UNICON

  16. Types of Options • American Option (options on stocks) • can be exercised any time on or before the expiration date • European Option (options on index) • can be exercised only on the expiration date (options on index) UNICON

  17. Call option • A buyer of call option has the right but not the obligation to buy the underlying at the set price by paying the premium upfront. • He can exercise his option on or before expiry. UNICON

  18. Break-even (Call option) • Call= strike +premium +fees There are two ways you can liquidate your position. • exercise your option • sell back the same option contract you purchased. UNICON

  19. Nifty 4000 Call @ 105.20 CMP = Rs. 3935/- Lot Size = 50 UNICON

  20. Call Buyer V/s Seller • Call Buyer • Pays premium • Has right to exercise resulting in a long position in the underlying • Time works against buyer • Call Seller • Collects premium • Has obligation if assigned resulting in a short position in the underlying • Time works in favor of seller UNICON

  21. Put option • A buyer of Put option has the right but not the obligation to sell the underlying at the set price by paying the premium upfront. • He can exercise his option on or before expiry. UNICON

  22. Break-even (Put option) • Put= strike -premium –fees There are two ways you can liquidate your position. • exercise your option • sell back the same option contract you purchased. UNICON

  23. Put Buyer V/s Seller • Put Buyer • Pays premium • Has right to exercise resulting in a short position in the underlying • Time works against buyer • Put Seller • Collects premium • Has obligation if assigned resulting in a long position in the underlying • Time works in favor of seller UNICON

  24. Assignment • When holder of an option exercises the right, a randomly selected option seller is obligated to be assigned into the underlying contract. UNICON

  25. Option Valuation • Option Premium = Intrinsic Value + Time Value Option Premium >= 0 Intrinsic Value >= 0 Time Value >= 0 UNICON

  26. Option Valuation • Intrinsic Value • Difference between Exercise Price and Spot Price • Cannot be negative • For a Call Option • St - K • For a Put Option • K - St St = Spot price at time t K = Strike Price of Option. UNICON

  27. Time Value • Amount buyers are willing to pay for the possibility that, at some time prior to expiration, the option may become profitable • Cannot be negative • An at-the-money option has the maximum time value of any strike price, i.e. more time value than either an in or out-of-the-money option. UNICON

  28. Factors affecting option values • Current Price of the underlying asset (S) • Exercise Price of the option(K) • Interest Rates (Rf) • Time to Expiry (T) • Volatility of prices of the underlying asset (s) UNICON

  29. Key Points • Options can be a very effective tool to take advantage of a rising or falling underlying. The following points may be kept in mind while purchasing options: • The time value of option premiums decay towards expiration, so market timing is very important. • Choose an option month that allows enough time for the anticipated move in the underlying. • In-the-money calls are initially more responsive to underlying price changes than out-of-the-money calls. • Choose a strike price level that offers a good risk/reward ratio given the expected price movement. UNICON

  30. Option Greeks • Delta • Gamma • Vega • Theta • Rho UNICON

  31. Open Interest • Open Interest is an important indicator that can help one in ascertaining the flow of funds. • If the open interest rises with rise in price it is a bullish indication. • If open interest rises and prices fall it is a bearish indication. • If open interest falls and prices rise it is a sign of short covering by bears. • If open interest falls and prices also fall it is a sign of profit booking by bulls or liquidation of positions. UNICON

  32. Put Call Ratio • Put call ratio is an important indicator that can help one in gauging the future direction of the market. • If the Put call ratio rises then there is hope of higher prices in the near future. • If the Put call ratio falls it is a sign of weakness in the market. • Generally put call ratio is read along with volatility. • PCR can be calculated for Open Interest/positions or no of puts and calls traded. • Historically – 1.06 -2.00 is bullish. Above 2 and below 1.06 one may expect a sharp fall. UNICON

  33. VOLATILITY • There are two types of volatility – historic volatility and implied volatility. • Historic volatility is based on historic prices of the futures and implied volatility is based on the volatility calculated from options i.e. volatility implied by premiums in options. • If volatility rises and PCR falls, it has bearish implications. • If volatility falls and PCR rises, it has bullish implications. UNICON

  34. Trading Strategies UNICON

  35. STRATEGIES USING FUTURES • PUT HEDGE • CALL HEDGE • COVERED Call • ARBITRAGE/REVERSE ARBITRAGE UNICON

  36. PUT HEDGE WHEN • Put hedge is used when we are bullish on some stock. • And want to hedge our position if the prices move downwards. HOW • In this strategy we first buy a future and then hedge our position by buying a put immediately. UNICON

  37. Tata Steel Put Hedge Buy Future @ 461 Buy 460 PA @ 16 CMP = Rs. 461/- Lot Size = 675 UNICON

  38. PUT HEDGE • PROBLEMS • Which strike price. • What time. • Premium value. • Reversal of positions • If any important support level is breached (a) We can reduce losses by squaring off the position. (b) Squaring off the future an persisting with the put. UNICON

  39. CALL HEDGE WHEN • Call hedge is used when we are bearish on some stock. • And want to hedge our position if the prices move up. HOW • In this strategy we first sell a future and then hedge our position by buying a call immediately. UNICON

  40. Tata Steel Call Hedge Sell Future @ 450 Buy 460 CA @ 20 CMP = Rs. 449.60/- Lot Size = 600 UNICON

  41. CALL HEDGE • PROBLEMS • Which strike price. • What time. • Premium value. • Reversal of positions • If any important resistance level is breached (a) We can reduce losses by squaring off the position. (b) Squaring off the future an persisting with the call. UNICON

  42. COVERED CALL WHEN • This strategy is used when we are bullish on a stock. • And want to reduce the cost of the future but it limits the profit to the strike price of the call. HOW • In this strategy we first buy a future and sell a call of strike price higher than the future price. UNICON

  43. IFCI Covered Call Buy Future @ 51 Sell 55 CA @ 2.50 CMP = Rs. 51/- Lot Size = 2150 UNICON

  44. Option Spreads • Buying a call (put) and selling a call (put) with different strike prices but the same expiration month. • Two types of spreads • Bull Spreads • Bear Spreads UNICON

  45. Bull Call Spreads • Maximum loss occurs below lower strike price • Maximum profit occurs above upper strike price • Breakeven level equals: • Lower strike plus Premium UNICON

  46. Tata Steel Bull Call Spread Buy 450 CA @ 18.00 Sell 460 CA @ 15.00 CMP = Rs. 382.45/- Lot Size = 400 UNICON

  47. Bear Put Spreads • Maximum loss occurs above upper strike price • Maximum profit occurs below lower strike price • Breakeven level equals: • Upper strike minus Premium UNICON

  48. Reliance Bear Put Spread Buy 1080 PA @ 50.00 Sell 1050 PA @ 40.00 CMP = Rs. 863.35/- Lot Size = 600 UNICON

  49. Option Straddles • Consist of buying a put and buying a call (Long Straddle). Both legs have the same strike price and same expiration; OR • Consist of selling a put and selling a call (Short Straddle). Both legs have the same strike price and same expiration. UNICON

  50. Long Straddles • Maximum loss is equal to net debit, or total premium paid • Maximum profit is unlimited • Breakeven levels are equal to: • common strike price plus or minus total premium paid UNICON

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