CONTENTS
? Derivatives – an overview
? Futures contract
? Hedging in futures
? Speculating in futures
? Arbitrage in futures
? Options
? Options strategies
? Derivatives products
? Open interest
? Futures price = spot price + cost of carry
DERIVATIVES
The word “DERIVATIVES” is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc.
Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.
Derivatives is derived from the following products:
A. Shares
B. Debuntures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivatives having same views about the market. In short it is like a INSURANCE market where investors cover their risk for a particular position.
Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.
Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks.
Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities.
The first product which was launched by BSE and NSE in the derivatives market was index futures
BACKGROUND
Consider a hypothetical situation in which ABC trading company has to import a raw material for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk through the use of derivatives
DEFINATIONS
According to JOHN C. HUL “ A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.”
According to ROBERT L. MCDONALD “A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-
A Derivative includes: –
a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
b. contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.
INTRODUCTION TO FUTURE MARKET
Futures markets were designed to solve the problems that exit in forward markets. A futures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. There is a multilateral contract between the buyer and seller for a underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.
PURPOSE
The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk.
It is a derivative instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market
It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be launched even in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons
EXAMPLE
The current market price of INFOSYS COMPANY is Rs.1650.
There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares.
Suppose the stock rises to 2200.
Profit
20
2200
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the buyer is 500.
Unlimited loss for the buyer because the buyer is bearish in the market
Suppose the stock falls to Rs.1400
Profit
20
10
0
1400 1500 1600 1700 1800 1900
-10
-20
Loss
Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is 250.
Unlimited loss for the seller because the seller is bullish in the market.
Finally, Futures contracts try to “bet” what the value of an index or commodity will be at some date in the future. Futures are often used by mutual funds and large institutions to hedge their positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in proportion to the total value of contract
MARGIN
Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract value.
PURPOSE
The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations.
TYPES OF MARGIN
INITIAL MARGIN:
It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a traders futures position, the initial margin is returned to the trader.
OBJECTIVE
The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction.
MAINTENANCE MARGIN:
It is the minimum margin required to hold a position. Normally the maintenance is lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call to top up the margin account to the initial level before trading commencing on the next level.
ILLUSTRATION
On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%. The lot size of nifty futures =200.suppose on MAY 16th
The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the market. The profit for the buyer will be 10,000 [(1350-1300)*200]
Loss for the seller will be 10,000[(1300-1350)]
Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer)
Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller)
Suppose on may 17th nifty futures settled at 1400.
Profit of buyer will be 10,000[(1450-1350)*200]
Loss of seller will be 10,000[(1350-1400)*200]
Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer)
Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller)
As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600 While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call.
Now the nifty futures settled at Rs.1390.
Loss for Buyer will be 2,000 [(1390-1400)*200]
Profit for Seller will be 2,000 [(1390-1400)*200]
Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer)
Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller)
Therefore in this way each account each account is credited or debited according to the settlement price on a daily basis. Deficiencies in margin requirements are called for the broker, through margin calls. Till now the concept of maintenance margin is not used in India.
ADDITIONAL MARGIN:
In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.
CROSS MARGINING:
This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.
MARK-TO-MARKET MARGIN:
It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market margin also called as variation margin for trading in the future contract
HEDGERS :
Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who don’t want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security.
PURPOSE:
“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”
Figure 1.1
Hedgers
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize
1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional
offload holding available risk latter by paying premium. cost is only
during adverse reward dependant 2)For Long, buy ATM Put premium.
market conditions on market prices Option. If market goes up,
as circuit filters long position benefit else
limit to curtail losses. exercise the option.
3)Sell deep OTM call option
with underlying shares, earn
premium + profit with increase prcie
Advantages
• Availability of Leverage
STRATEGY:
The basic hedging strategy is to take an equal and opposite position in the futures market to the spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor hedge their risk by taking the short position in the Index futures
HEDGING AND DIVERSIFICATION:
Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging is implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets).
ILLUSTRATION
Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is completed.
COST SELLING PRICE PROFIT
400 1000 600
However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.
Shyam defaults Shyam honors
400 (Initial Investment) 600 (Initial profit)
400 (penalty from Shyam (-100) discount given to Shyam
– (No gain/loss) 500 (Net gain)
Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment.
Now let’s see how investor hedge their risk in the market
Example:
Say you have bought 1000 shares of XYZ Company but in the short term you expect that the market would go down due to some news. Then, to minimize your downside risk you could hedge your position by buying a Put Option. This will hedge your downside risk in the market and your loss of value in XYZ will be set off by the purchase of the Put Option.
Therefore hedging does not remove losses .The best that can be achieved using hedging is the removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduce risk.
HEDGING WITH OPTIONS:
Options can be used to hedge the position of the underlying asset. Here the options buyers are not subject to margins as in hedging through futures. Options buyers are however required to pay premium which are sometimes so high that makes options unattractive.
ILLUSTRATION:
With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the investor excepts that price will fall by 100.So he decided to buy the put Option b y paying the premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered Rs.75 a share by buying ACC put.
HEDGING STRATEGIES:
? LONG SECURITY, SELL NIFTY FUTURES:
Under this investor takes a long position on the security and sell some amount of
Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position. Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the security, without any extra risk from fluctuations of the market index. Finally the investor has “HEDGED AWAY” his index exposure.
EXAMPLE:
? LONG SECURITY, SELL FUTURES
Here stock futures can be used as an effective risk –management tool. In this case the investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the risk the Hedger enters into a future contract and takes a short position. However the losses suffers in the security will be offset by the profits he makes on his short future position.
Spot Price of ACC = 390
Market action = 350
Loss = 40
Strategy = BUY SECURITY, SELL FUTURES
Two month Futures= 390
Premium = 12
Short position = 390
Future profit = 40(390-350)
As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures will trade at a price lower then the price at which the hedger entered into a short position.
Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made on his short futures position.
? HAVE STOCK, BUY PUTS:
This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price. Therefore the solution is buy put options on HLL.
The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the investor has two possible scenarios three months later.
1) IF PRICE RISES
Market action: 215
Loss : 17(232-15)
Strike price : 240
Premium : 08
Profit : 17(240-215-8)
Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option bought.
2) IF PRICE RISES:
Market share : 250
Loss : 10
Short position : 250(spot market)
Thus the investor has a limited loss(determined by the strike price investor chooses) and an unlimited profit.
? HAVE PORTFOLIO, SHORT NIFTY FUTURES:
Here the investor are holding the portfolio of stocks and selling nifty futures. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position.
Let us assume that an investor is holding a portfolio of following scrips as given below on 1st May, 2001.
Company Beta Amount of Holding ( in Rs)
Infosys 1.55 400,000.00
Global Tele 2.06 200,000.00
Satyam Comp 1.95 175,000.00
HFCL 1.9 125,000.00
Total Value of Portfolio 1,000,000.00
Trading Strategy to be followed
The investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge.
Formula to calculate the number of futures for hedging purposes is
Beta adjusted Value of Portfolio / Nifty Index level
Beta of the above portfolio
=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000
=1.61075 (round to 1.61)
Applying the formula to calculate the number of futures contracts
Assume NIFTY futures to be 1150 on 1st May 2001
= (1,000,000.00 * 1.61) / 1150
= 1400 Units
Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.
Short Hedge
Stock Market Futures Market
1st May Holds Rs 1,000,000.00 in stock portfolio Sell 7 NIFTY futures contract at 1150.
25th June Stock portfolio fall by 6% to Rs 940,000.00 NIFTY futures falls by 4.5% to 1098.25
Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00
Net Profit: + Rs 15,450.00
SPECULATORS:
If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. speculators are those who do not have any position and simply play with the others money. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. Here if speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.
SPECULATION IN THE FUTURES MARKET
• Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:
• Naked positions – Position in any future contract.
• Spread positions – Opposite positions in two future contracts. This is a conservative speculative strategy.
Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.
Figure 1.2
Speculators
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize
1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading& carry price change. 2) Buy Call &Put to premium
forward transactions. by paying paid
2) Buy Index Futures premium
hold till expiry. Advantages
• Greater Leverage as to pay only the premium.
• Greater variety of strike price options at a given time.
ILLUSTRATION:
Here the Speculator believes that stock market will going to appreciate.
Current market price of PATNI COMPUTERS = 1500
Strategy: Buy February PATNI futures contract at 1500
Lot size = 100 shares
Contract value = 1,50,000 (1500*100)
Margin = 15000 (10% of 150000)
Market action = rise to 1550
Future Gain:Rs. 5000 [(1550-1500)*100]
Market action = fall to 1400
Future loss: Rs.-10000 [(1400-1500)*100]
Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from the view. He study the market and play the game with the stock market
TYPES:
? POSITION TRADERS:
These traders have a view on the market an hold positions over a period of as days until their target is met.
? DAY TRADERS:
. Day traders square off the position during the curse of the trading day and book the profits.
? SCALPERS:
Scalpers in anticipation of making small profits trade a number of times throughout the day.
SPECULATING WITH OPTIONS:
A speculator has a definite outlook about future price, therefore he can buy put or call option depending upon his perception about future price. If speculator has a bullish outlook, he will buy calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If speculator’s view is correct he earns profit. In the event of speculator not being covered, he will loose the position. A Speculator will buy call or put if his price outlook in a particular direction is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn premium in the event of price situations.
ILLUSTRATION:
Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE TELEFILMS stock will come down then he will buy put on the stale price until he can write either call or put.
Finally Speculators provide depth an liquidity to the futures market an in their absence; the price protection sought the hedger would be very costly.
STRATEGIES:
? BULLISH SECURITY,SELL FUTURES:
Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator buys the shares of the company an makes the profit. At the same time the Speculator enters into the future contract i.e. buys futures and makes profit.
Spot Price of RELIANCE = 1000
Value = 1000*100shares = 1,00,000
Market action = 1010
Profit = 1000
Initial margin = 20,000
Market action = 1010
Profit = 400(investment of Rs.20,000)
This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.
Thus because of leverage provided security futures form an attractive option for speculator.
? BULLISH STOCK, BUY CALLS OR BUY PUTS:
Under this strategy the speculator is bullish in the market. He could do any of the following:
? BUY STOCK
ACC spot price : 150
No of shares : 200
Price : 150*200 = 30,000
Market action : 160
Profit : 2,000
Return : 6.6% returns over 2months
? BUY CALL OPTION:
Strike price : 150
Premium : 8
Lot size : 200 shares
Market action :160
Profit : (160-150-8)*200 = 400
Return : 25% returns over 2months
This shows that investor can earn more in the call option because it gives 25% returns over a investment of 2months as compared to 6.6% returns over a investment in stocks
? BEARISH SECURITY,SELL FUTURES:
In this case the stock futures is overvalued and is likely to see a fall in price. Here simple arbitrage ensures that futures on an individual securities more correspondingly with the underlying security as long as there is sufficient liquidity in the market for the security. If the security price rises the future price will also rise and vice-versa.
Two month Futures on SBI = 240
Lot size = 100shares
Margin = 24
Market action = 220
Future profit = 20(240-220)
Finally on the day of expiration the spot and future price converges the investor makes a profit because the speculator is bearish in the market and all the future stocks need to sell in the market.
? BULLISH INDEX, LONG NIFTY FUTURES:
Here the investor is bullish in the index. Using index futures, an investor can “BUY OR SELL” the entire index trading on one single security. Once a person is LONG NIFTY using the futures market, the investor gains if the index rises and loss if the index falls.
1st July = Index will rise
Buy nifty July contract = 960
Lot =200
14th July nifty risen= 967.35
Nifty July contract= 980
Short position =980
Profit = 4000(200*20)
ARBITRAGEURS:
Arbitrage is the concept of simultaneous buying of securities in one market where the price is low and selling in another market where the price is higher.
Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person and ready to take the risk He is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market.
JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where the investor buys the shares in the cash market and sell the shares in the future market.
ARBITRAGEURS IN FUTURES MARKET
Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.
Figure 1.3
Arbitrageurs
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize
1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
one and selling in whichever way the promising as still game.
another exchange. Market moves. in weekly settlement
forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price
• Fair Price = Cash Price + Cost of Carry.
Example:
Current market price of ONGC in BSE= 500
Current market price of ONGC in NSE= 510
Lot size = 100 shares
Thus the Arbitrageur earns the profit of Rs.1000(10*100)
STRATEGIES:
? BUY SPOT, SELL FUTURES:
In this the investor observing that futures have been overpriced, how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 1025.
This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.
• On day one, borrow funds, buy security on the spot market at 1000
• Simultansely, sell the futures on the security at1025
• Take delivery of the security purchased and hold the security for a month
• on the futures expiration date, the spot and futures converge . Now unwind the position
• Sa y the security closes at Rs.1015. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position
• Return the Borrow funds.
Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash – and- carry arbitrage.
? BUY FUTURES, SELL SPOT:
In this the investor observing that futures have been under priced, how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 965.
This shows that futures have been under priced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.
• On day one, sell the security on the spot market at 1000
• Mae delivery of the security
• Simultansely, buy the futures on the security at 965
• On the futures expiration date, the spot and futures converge . Now unwind the position
• Sa y the security closes at Rs.975. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position
Finally if the returns get investing in risk less instruments is less than the return from the arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash – and- carry arbitrage.
? ARBITRAGE WITH NIFTY FUTURES:
Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is
CASE-1
Spot Price of INFOSEYS = 1650
Future Price Of INFOSEYS = 1675
In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free profit Of Rs.25.
CASE-2
Future Price Of ACC = 675
Spot Price of ACC = 700
In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.
INTRODUCTION TO OPTIONS
It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.
MONTHLY OPTIONS :
The exchange trade option with one month maturity and the contract usually expires on last Thursday of every month.
PROBLEMS WITH MONTHLY OPTIONS
Investors often face a problem when hedging using the three-monthly cycle options as the
premium paid for hedging is very high. Also the trader has to pay more money to take a long or short position which results into iiliquidity in the market.Thus to overcome the problem the BSE introduced WEEKLY OPTIONS
WEEKLY OPTIONS:
The exchange trade option with one or weak maturity and the contract expires on last Friday of every weak
ADVANTAGES
? Weekly Options are advantageous to many to investors, hedgers and traders.
? The premium paid for buying options is also much lower as they have shorter time to maturity.
? The trader will also have to pay lesser money to take a long or short position.
? the trader can take a larger position in the market with limited loss. On account of low cost, the liquidity will improve, as more participants would come in.
? Weekly Options would lead to better price discovery and improvement in market depth, resulting in better price discovery and improvement in market efficiency
TYPES OF OPTION:
? CALL OPTION
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract.
ILLUSTRATION
Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market.
The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25
1. CALL BUYER
Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660.
Profit
30
20
10
0
590 600 610 620 630 640
-10
-20
-30
Loss
Unlimited profit for the buyer = Rs.35{(spot price – strike price) – premium}
Limited loss for the buyer up to the premium paid.
2. CALL SELLER:
In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.
Profit
30
20
10
0
590 600 610 620 630 640
-10
-20
-30
Loss
Profit for the Seller limited to the premium received = Rs.25
Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30
Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.
Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent
Thus call option indicates two positions as follows:
? LONG POSITION
If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option.
? SHORT POSITION
If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option.
? PUT OPTION
A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.
ILLUSTRATION
Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put seller) who is bullish in the market.
The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0
1) PUT BUYER(Dinesh):
Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer’s breakeven point is Rs.780(Strike price – Premium paid). The buyer will earn profit once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the seller at Rs.800
Profit
20
10
0
600 700 800 900 1000 1100
-10
-20
Loss
Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) – premium}
Loss limited for the buyer up to the premium paid = 20
2). PUT SELLER(Amit):
In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.
profit
20
10
0
600 700 800 900 1000 1100
-10
-20
Loss
Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 – 750 = 30
Limited profit for the seller up to the premium received = 20
Thus Put option also indicates two positions as follows:
? LONG POSITION
If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put option.
? SHORT POSITION
If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option
CALL OPTIONS PUT OPTIONS
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.
FACTORS AFFECTING OPTION PREMIUM
? THE PRICE OF THE UNDERLYING ASSET: (S)
Changes in the underlying asset price can increase or decrease the premium of an option. These price changes have opposite effects on calls and puts.
For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying asset’s value will generally have the opposite effect
Premium of the Premium of the
Price of the CALL Price of CALL
Underlying Underlying
asset asset
Premium of the
Premium of the PUT
PUT
? THE SRIKE PRICE: (K)
The strike price determines whether or not an option has any intrinsic value. An option’s premium generally increases as the option gets further in the money, and decreases as the option becomes more deeply out of the money.
? Time until expiration: (t)
An expiration approaches, the level of an option’s time value, for puts and calls, decreases.
? Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an option’s underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at- the- money options.
? Interest rate: (R1)
This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid.
Higher the interest rate, higher is the premium of the option as the cost of carry increases.
PLAYERS IN THE OPTION MARKET:
a) Developmental institutions
b) Mutual Funds
c) Domestic & Foreign Institutional Investors
d) Brokers
e) Retail Participants
FUTURES V/S OPTIONS
? RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.
In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.
? RISK
Futures Contracts have symmetric risk profile for both the buyer as well as the seller.
While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.
? PRICES:
The Futures contracts prices are affected mainly by the prices of the underlying asset.
While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset.
? COST:
It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.
? STRIKE PRICE:
In the Futures contract the strike price moves while in the option contract the strike price remains constant .
? Liquidity:
As Futures contract are more popular as compared to options. Also the premium charged is high in the options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated trading and investors in the options contract.
? Price behaviour:
The trading in future contract is one-dimensional as the price of future depends upon the price of the underlying only. While trading in option is two-dimensional as the price of the option depends upon the price and volatility of the underlying.
? PAY OFF:
As options contract are less active as compared to futures which results into non linear pay off. While futures are more active has linear pay off .
OPTION STRATAGIES:
1. BULL CALL SPREAD:
This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month. However, the total investment is usually far less than that required to purchase the stock.
Current price of PATNI COMPUTERS is Rs. 1500
Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of 1510 and receive 15 ticks per contract.
Premium = 10 ticks per contract(25 paid- 15 received)
Lot size = 600 shares
BREAK- EVEN- POINT= 1490+10=1500
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also reduce the premium received.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :
If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce the loss through receiving the net premium.
If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .
iii. AT STRIKE:
If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money.
If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10
iv. ABOVE HIGHER PRICE:
IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid.
v. BELOW PRICE:
IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid.
The pay-off table:
PATNI COMPUTERS AT EXPIRATION 1485
(below lower price)
1490
(At the lower price) 1495
(Between lower strike &BEP 1500
(At BEP) 1510
Intrinsic value of 1490 long call at expiration (a) 0 0 5 10 20
Premium paid (b) 25 25 25 25 25
Intrinsic value of 1510 short call at expiration (c) 0 0 0 0 0
Premium received (d) 15 15 15 15 15
profit/loss(a-c)-(b- d) -10 -10 -5 0 10
PATNI COMPUTERS AT EXPIRATION 1495
(below higher price)
1510
(At the higher price) 1505
(Between higher strike &BEP 1500
(At BEP) 1520
(Above BEP
Intrinsic value of 1510 short call at expiration (a) 0 0 0 0 10
Premium paid (b) 15 15 15 15 15
Intrinsic value of 1490 long call at expiration (c) 5 20 15 10 30
Premium received (d) 25 25 25 25 25
profit/loss(c-a)-( d – b) -5 10 5 0 10
Profit
20
10
0
1490 1500 1510 1520 1530 1540
-10
-20
Loss
2. BEAR PUT SPREAD:
It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares.
Current price of INFOSYS TECHNOLOGIES is Rs. 4500
Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract.
Premium = 10 ticks per contract(55 paid- 45 received)
Lot size = 200 shares
BREAK- EVEN- POINT= 5510-10 = 5500.
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option sold will expire worthless and also reduce the premium received.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :
If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the loss of Rs.10 through receiving the net premium.
If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium receive will generate profit .
iii. AT STRIKE:
If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received
If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium received between the strike price an premium paid.
iv. ABOVE STRIKE PRICE:
IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic value. while the 4490 put option sold result in maximum loss to the premium received.
If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic value. while the 5510 put option sold result in the maximum profit strike price – premium
v. BELOW STRIKE PRICE:
IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490 option sold will be assigned (strike price – premium paid) = profit .
The pay-off table:
INFOSYS AT EXPIRATION 5520
(Above strike)
5510
(At the strike) 5505
(Between lower strike &BEP 5500
(At BEP) 4480
Intrinsic value of 5510 long put at expiration (a) 0 0 5 10 30
Premium paid (b) 55 55 55 55 55
Intrinsic value of 4490 short put at expiration (c) 0 0 0 0 10
Premium received (d) 45 45 45 45 45
profit/loss(a-c)-(b- d) -10 -10 -5 0 10
INFOSYS AT EXPIRATION 5505
(Above strike)
4490
(At the strike) 4495
(Between strike &BEP 5500
(At BEP) 4480
(below strike price)
Intrinsic value of 4490 short put at expiration (a) 0 0 0 0 10
Premium received (b) 45 45 45 45 45
Intrinsic value of 5510 long put at expiration (c) 5 30 15 10 30
Premium paid (d) 55 55 55 55 55
profit/loss[(c-a)-( d – b)] -5 20 15 0 10
Profit
20
10
0
3000 3500 4000 4500 5000 5500 6000 6500 7000
-10
-20
Loss
3. BULL PUT SPREAD.
This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market to provide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited downside risk.
The current price of RELIANCE CAPITAL is Rs.1290
Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell one month put of 1310 (higher price) and receive 15 ticks per contract.
Premium = 10 ticks per contract (25 paid- 15 received)
Lot size = 600 shares
BREAK- EVEN- POINT= 1300-10 = 1290
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:
If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15
If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of 5.
iii. AT STRIKE:
If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless. While 1310 will have an intrinsic value of 10
If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t the premium received
iv. ABOVE STRIKE PRICE:
If the index is above1300 say 1310, the 1300 put option buyer has lost the premium while the 1310 put option seller receive premium to the limited profit
If the index is above 1310, say 1320 the 1290 put option buyer will have maximum loss results in deep out the money while the 1310 put option will have the limited profit.
v. BELOW STRIKE PRICE:
If the index is below 1300 say (1290) , the 1300 put option buyer will have an intrinsic value of 10 while the 1310 put option sold receive only premium as the profit is limited for the seller.
OPTION PAYOFF
Profit
Loss
4.BEAR CALL SPREAD:
This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. Here the investor buys a higher strike call and sells a lower strike call with the same expiration dates. However, the total investment is usually far less than that required to buy the stock or futures contract. The strategy has both limited profit potential and limited downside risk.
Current price of ACC is Rs. 1500
Here the investor buys one month call of 1510 at 25 ticks per contract and sell one month call of 1490 and receive 15 ticks per contract.
Premium = 10 ticks per contract (25 paid – 15 received)
Lot size = 600 shares
BREAK- EVEN- POINT= 1510+10=1520
Possible outcomes at expiration:
i. BREAK- EVEN- POINT:
On expiration if the stock of PATNI COMPUTERS is 1520 then the option will close at Breakeven. The call of 1510 will have an intrinsic value of 10 while the 1490 call option sold will expire worthless and also reduce the premium with the premium outflow.
ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :
If the index is between 1490 and 1500 then the 1510 call option will have no intrinsic value and expire worthless, While 1490 call option sold will not expire which will reduce the loss through receiving the net premium.
If the index is between 1500 and 1510 then the 1510 call option will have an intrinsic value of 0, while 1490 call option sold will have no intrinsic value the premium receive generate profit .
iii. AT STRIKE:
If the index is at 1510 the 1510 call option will have no intrinsic value and expire worthless. While 1490 call sold receive only premium
If the index is at 1490, the 1510 call option will have no intrinsic value result in deep out the money, While 1490 call sold will have no intrinsic value and expire worthless
iv. ABOVE HIGHER PRICE :
IF the underlying stock is above 1510 say 1520, the 1510 call option will be in the money of Rs.10 while the 1490 option will incur loss to the premium receive
IF the underlying stock is above 1490 say Below1510, the 1510 call option will not be exercised while the 1490 option will incur loss to the premium receive because seller is bearish in the market.
v. BELOW STRIKE PRICE :
IF the underlying stock is below 1510, the 1510 call option will result in deep out the money and 1490 option sold result in loss to the premium paid.
OPTION PAYOFF
Profit
Loss
5). STRADDLE:
In this strategy the investor purchase and sell the call as well as the put option of the same strike price, the same expiration date, and the same underlying. In this strategy the investor is neutral in the market.
This strategy is often used by the SPECULATORS who believe that asset prices will move in one direction or other significantly or will remain fairly constant.
TYPES:
LONG STRADDLE:
Here the investor takes a long position(buy) on the call and put with the same strike price and same expiration date. In this the investor is beneficial if the price of the underlying stock move substantially in either direction. If prices fall the put option will be profitable an if the prices rises the call option will give gains. Profit potential in this strategy is unlimited ,While the loss is limited up to the premium paid. This will occur if the spot price at expiration is same as the strike price of the options.
SHORT STRADDLE:
This strategy is reverse of long straddle. Here the investor write(sell) the call as well as the put in equal number for the same strike price an same expiration. This strategy is normally used when the prices of the underlying stock is stable but the investor start suffering losses if the market substantially moves in either direction .
Detailed example of a long straddle
Current market price of BAJAJ AUTO is Rs.600
Here the investor buys one month call of strike price 600 at 20 ticks per contract and two month put of strike price 600 for 15 ticks per contract.
Premium Paid = 35 ticks
Lot size = 400 shares
Lower Break- Even- Point = 600 – 35 = 565
Higher Break- Even- Point = 600 + 35 = 635
i. AT BREAK- EVEN- POINT:
If the stock is at 565 or at 635, this option strategy will be at Break- Even- Point. At 565 the 600 call will have no intrinsic value an expire worthless but the 600 put will have an intrinsic value of 35.
At 635 the 600 call will have an intrinsic value of 35, while the put 600 will expire worthless.
ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:
If the stock price goes to 550 then the 600 call will have no intrinsic value and expire worthless while 600 put will have an intrinsic value of 50.
iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:
If the stock price touches 650 the 600 call will have an intrinsic value of 50, while 600 put will have no intrinsic value an will expire worthless.
iv. BETWEEN LOWER BEP AND HIGHER BEP:
If the stock prices goes to 6oo then the both call and put option will expire worthless which results in the loss of 35(premium).
The pay-off table:
BAJAJ AUTO AT EXPIRATION 550
(BELOW STRIKE AN D BELOW BEP )
600
(At the strike) 618
(BETWEEN STRIKE & HIGHERBEP 635
(At BEP) 650
(ABOVE STRIKE AN D ABOVE HIGHER BEP
Intrinsic value of 600 long call at expiration (a) 0 0 18 35 30
Premium paid (b) 20 20 20 20 20
Intrinsic value of 600 long put at expiration (c) 50 0 0 0 10
Premium paid (d) 15 15 15 15 15
profit/loss(a+c)-(b+ d) 15 -15 -17 0 5
BAJAJ AUTO AT EXPIRATION 550
(BELOW STRIKE AN D BELOW BEP )
600
(At the strike) 583
(BETWEEN STRIKE & LOWER BEP 565
(At LOWER BEP) 650
(ABOVE STRIKE AN D ABOVE HIGHER BEP
Intrinsic value of 600 long call at expiration (a) 0 0 0 0 30
Premium paid (b) 20 20 20 20 20
Intrinsic value of 600 long put at expiration (c) 50 0 17 35 10
Premium paid (d) 15 15 15 15 15
profit/loss(a+c)-(b+ d) 15 -15 -18 0 5
Profit
40
30
20
10
550 560 570 580 590 600 610 620 630 640 650
-10
-20
-30
-40
Loss
6. STRANGLE:
In this strategy the investor is neutral in the market which involves the purchase of a higher call and a lower put that are slightly out of the money with different strike price and with the different expiration date. The premiums are lower as compared to straddle also the risk is more involved as compare to straddle which not leads to the profit.
TYPES
1) LONG STRANGLE:
Here the investor purchases a higher call and a lower put with different strike price and with the different expiration date. A long strangle strategy is used to profit from a volatile price an loss from stable prices.
2) SHORT STRANGLE:
In this the investor sells a higher call and a lower put with different strike price and with the different expiration date. A short strangle strategy is used to profit from a stable prices an loss starts when price is volatile.
Detailed example of a short strangle
Current market price of BSE INDEX is Rs.4000
Here the investor sells a two month call of strike price 4050 for 20 ticks per contract and two month put of strike price 3950 for 15 ticks per contract.
Premium Received = 35 ticks
Lot size = 300 shares
Lower Break- Even- Point = 3950 – 35 = 3915
Higher Break- Even- Point = 4050 + 35 = 4085
On Expiration:
i. AT BREAK EVEN POINT:
If the stock is at 3915 or at 4085, this option strategy will be at Break- Even- Point. At 3915 the 4050 call will have no intrinsic value and expire worthless but the 3950 put will have an intrinsic value of 35
At 4085 the 4050 call will have an intrinsic value of 35, while the put 400 will have no intrinsic value and expire worthless.
ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:
If the stock price goes to 3900 then the 4050 call will have no intrinsic value and expire worthless while 3950 put will have an intrinsic value of 50.
iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:
If the stock price touches 4100 the 4050 call will have an intrinsic value of 50, while 3950 put will have no intrinsic value and will expire worthless.
iv. BETWEEN LOWER BEP AND HIGHER BEP:
If the stock prices goes to 4000 then the both call and put option will expire worthless and limited profit up to the premium received.
v. AT STRIKE PRICE:
If the price is settled at 4050 then 4050 call and 3950 put will have limited profit upto the premium received
The pay-off table:
BSE INDEX AT EXPIRATION 3900
(BELOW STRIKE AN D BELOW BEP )
4050
(At the strike) 4070
(BETWEEN STRIKE & HIGHER BEP) 4085
(At HIGHER BEP) 4100
(ABOVE STRIKE AN D ABOVE HIGHER BEP
Intrinsic value of 4050 Short call at expiration (a) 0 0 20 35 50
Premium Receive(b) 20 20 20 20 20
Intrinsic value of 3950 short put at expiration (c) 50 0 0 0 0
Premium Receive (d) 15 15 15 15 15
profit/loss(a+c)-(b+ d) 15 -35 -15 0 15
BSE INDEX AT EXPIRATION 3900
(BELOW STRIKE AN D BELOW BEP )
3950
(At the strike) 3930
(BETWEEN STRIKE & LOWER BEP 3915
(At LOWER BEP) (ABOVE LOWER STRIKE AN D ABOVE LOWER BEP
Intrinsic value of 600 Short call at expiration (a) 0 0 0 0 0
Premium Receive(b) 20 20 20 20 20
Intrinsic value of 400 short put at expiration (c) 50 0 20 35 0
Premium Receive (d) 15 15 15 15 15
profit/loss(a+c)-(b+ d) 15 -35 -15 0 -35
Profit
20
10
0
3900 3925 3950 3975 4000 4025 4050 4075 4100
-10
-20
Loss
7) COVERED CALL:
Under this strategy investors buys the shares which shows that they are bullish in the market but suddenly they are scared about the market falls thus they sells the call option. Here the seller is usually negative or neutral on the direction of the underlying security. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated.
Thus if price rises he will not participate in the rally. However he has now reduced loss by the amount of premium received, if prices falls.Finally if prices remains unchanged obtains the maximum profit potential.
EXAMPLE:
Portfolio: 100 shares purchased at Rs.300
Components: Sell a two month Reliance call of 300 strike at 25
Net premium: 25 ticks
Premium received: Rs.2500 (25*100, the multiplier)
Break-even-point: Rs.275:Rs.300-25 (Premium received)
Possible outcomes at expiration:
If the stock closes at 300, the 300 call option will not exercised and seller will receive the premium.
If the stock ends at 275, the 300 call option expires worthless equilant to the premium received results into no profit no loss.
If the stock ends above 300, the 300 call option is exercised and call writer receives the premium results into the maximum profit potential.
The payoff diagram of a covered call with long stock + short call = short put
Profit
:
50
25
0
250 275 300 325 350
-25
-50
Loss
8) COVERED PUT:
Here the writer sell stock as well as put because he overall moderate bearish on the market and profit potential is limited to the premium received plus the difference between the original share price of the short position and strike price of the put. The potential loss on this position, however is substantial if price increases above the original share price of the short position. In this case the short stock will suffer losses which will be offset by the premium received.
Profit
:
Premium Received
Lower
Loss
9) UNCOVERED CALL:
This strategy is reverse of the covered call. There is no opposite position in the naked call. A call option writer (seller) is uncovered if the shares of the underlying security represented by the option is not owned by the option writer.
The object of an uncovered call writer is to realize income by writing (selling) option without committing capital to the ownership of the underlying shares.
This shows that the seller has one sided position in the contract for this the seller must deposit and maintain sufficient margin with the broker to assure that the stock can be purchased for delivery if option is exercised.
RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE AS FOLLOWS:-
• If the market price of the stock rises sharply the calls could be exercised, while as far as the obligation is concerned the seller must buy the stock more than the option strike price, which results in a substantial loss.
• The rise of buying uncovered calls is similar to that of selling stock although, as an option writer, the risk is cushioned somewhat by the amount of premium received.
ILLUSTRATION:
Portfolio: Write reliance call of 65 strike
Net premium: 6
Lot size: 100 shares
Market action: price settled at 55
Therefore the option will not be assigned because the seller has no stock position and price decline has no effect on the profit of the premium received.
Suppose the price settled at Rs.75 the option assigned and the seller has to cover the position at a net loss of Rs.400 [1000 (loss on covering call)- 600(premium income)]
Finally the loss is unlimited to the increase in the stock price and profit is limited to the declining stable stock price.
10) PROTECTIVE PUT:
Under this strategy the investor purchases the stock along with the put option because the investor is bearish in the market. This strategy enables the holder of the stock to gain protection from a surprise decline in the price as well as protect unrealized profits. Till the option expires, no matter what the price of underlying is, the option buyer will be able to sell the stock at strike price of put option.
SCENARIO
Price of HLL: 200
Components: Buy a one-month put of strike 200
Net premium: 10 ticks per contract
Premium paid: 1000 (10*100 multiplier)
Break-even-point: 210 (Rs.200+10, Premium paid)
Here the investor pays an additional margin of Rs.10 along with the price of Rs.210 combining a share with a put option is referred as a Protective Put.
Possible outcomes at expiration
• AT BREAK-EVEN-POINT:
Previously if the price rises to 200 the investor will gain but now the investor pays an margin of Rs.10. If price rises to Rs.210 then only the investor will gain.
• BELOW STRIKE PRICE:
In case of fall in the stock price the loss is limited to Rs.18. This means that he maximum loss that the investor would have to bear is limited to the extent of premium paid.
If the price falls at 190 the investor will sell at 200.
• ABOVE STRIKE PRICE :
In case of rise in prices then the put option will expire worthless and the investor will benefit from rise in the stock price.
Finally uncertainty is the biggest curse of the market and a protective put helps override the uncertainty in the markets. Protective put removes the uncertainty by limiting the investor loss at Rs.10. In this case no matter what happens to the investor is protected by the loss of Rs.10. The put option makes the investor life by telling the investor in advance how much it stands to loss. This is also referred to as PORTFOLIO INSURANCE because it helps the investor by insuring the value of investment just like any other asset for which the investor would purchase insurance.
profit
:
20
10
0
180 190 200 210 220
-10
-20
Loss
PRICING OF AN OPTION
? DELTA
A measure of change in the premium of an option corresponding to a change in the price of the underlying asset.
Change in option premium
Delta = ——————————–
Change in underlying price
FACTORS AFFECTING DELTA OPTION:
? Strike price
? Risk free interest rate
? Volatility
? Underlying price
? Time to maturity
ILUSTRATION
The investor has buys the call option in the future contract for the strike price of Rs.19. The premium charged for the strike price of 19 at 0.80 The delta for this option is 0.5.Here if the price of the option rises to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.
Here in the money call option will increase the delta by 1.which will make the value more and expensive while at the money option have the delta to 0.5 and finally out the money call option will have the delta very close to 0 as the change in underlying price is not likely to make them valuable or cheap and reverse for the put option
Delta is positive for a bullish position (long call and short put) as the value of the position increases with rise in the price of the underlying. Delta is negative for a bearish position (short call and long put) as the value of the position decreases with rise in the price of the underlying.
Delta varies from 0 to 1 for call options and from –1 to 0 for put options. Some people refer to delta as 0 to 100 numbers.
ADVANTAGE
The delta is advantageous for the option buyer because it can tell him much of an option and accordingly buyer can expect his short term movements by the underlying stock. This can help the option of an buyer which call/put option should be bought.
? GAMMA
A measure of change in the delta that may occur corresponding to the rise or fall in the price of the underlying asset.
Gamma = change in option delta
__________________
change in underlying price
The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying. For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased. suppose the delta changed to 0.5-0.04 = 0.46 thus the rate of premium will decreased .
In simple terms if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying.
Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices
? THETA:
A measure of change in the value of an option corresponding to its time to maturity. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.
Change in an option premium
Theta = ————————————–
Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases.
ILLUSTRATION
Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs.4.5.
ADVANTAGE
Theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.
DISADVANTAGE
Theta is always negative for the buyer of an option, as the value of the option goes
down each day if his view is not realized.
In simple words theta tells how much value the option would lose after one day, with all the other parameters remaining the same.
? VEGA
The extent of extent of change that may occur in the option premium, given a change in the volatility of the underlying instrument.
Change in an option premium
Vega = —————————————–
Change in volatility
ILLUSTRATION
Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatility of the
underlying is 35%. As the volatility increases to 36%, the premium of the option
would change upward to Rs15.6.
Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put).
ADVANTAGE
Simply put, for the buyer it is advantageous if the volatility increases after he has
bought the option.
DISADVANTAGE
For the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility.
In simple words Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.
DERIVATIVES PRODUCTS OFFERED BY BSE
? SENSEX FUTURES
A financial derivative product enabling the investor to buy or sell underlying sensex on a future date at a future price decided by the market forces
First financial derivative product in India.
Useful primarily for Hedging the index based portfolios and also for expressing the views on the market
? SENSEX OPTIONS:
A financial derivative product enabling the investor to buy or sell call or put options (to be exercised on a future date) on the underlying sensex at a premium decided by the market forces
Useful primarily for Hedging the Sensex based portfolios and also for expressing the views on the market.
? STOCK FUTURES:
A financial derivative product enabling the investor to buy or sell underlying stock on a future date at a price decided by the market forces
Available on ____ individual stocks approved by SEBI
Useful primarily for Hedging, Arbitrage and for expressing the views on the market.
? STOCK OPTIONS:
A financial derivative product enabling the investor to buy or sell call options(to be exercised at a future date) on the underlying stock at a premium decided by the market forces
Available on ____ individual stocks approved by SEBI
Useful primarily for Hedging, Arbitrage and for expressing the views on the market.
CONTRACT SPECIFICATIONS
PARTICULARS SENSEX FUTURES AND OPTIONS STOCK FUTURES AND OPTIONS
Underlying Asset Sensex Corresponding stock in the cash market
Contract Multiplier 50 times the sensex (futures)
100 times the sensex (options) Stock specific E.g. market lot of RIL is 600, Infosys is 100 & so on
Contract Months 3 nearest serial months (futures)
1, 2 and 3 months(options) 1, 2 and 3 months
Tick size 0.1 point 0.01*
Price Quotation Sensex point Rupees per share
Trading Hours 9:30a.m. to 3:30p.m. 9:30a.m. to 3:30p.m.
Settlement value In case of sensex options the closing value of the sensex on the expiry day In case of stock options the closing value of the respectative in the cash segment of BSE
Exercise Notice Time In case of sensex options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant. In case of stock options Specified time (exercise session) on the last trading day of the contract. All in the money options would deem to be exercised unless communicated otherwise by the participant.
Last Trading Day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day
Final Settlement On the last trading day, the closing value of the Sensex would be the final settlement price of the expiring futures/option contract. The difference is settled in cash on the expiration day on the basis of the closing value of the respectative underlying scrip in the cash market on the expiration day
DERIVATIVES PRODUCTS OFFERED BY NSE
? INDEX FUTURES
Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index future
Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation. The S&P 500 futures products are the largest traded index futures product in the world.
Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000
ADVANTAGES OF INDEX FUYTURES
? The contracts are highly liquid
? Index Futures provide higher leverage than any other stocks
? It requires low initial capital requirement
? It has lower risk than buying and holding stocks
? Settled in cash and therefore all problems related to bad delivery,
forged, fake certificates, etc can be avoided.
? INDEX OPTIONS
An index option provides the buyer of the option, the right but not the obligation to buy or sell the underlying index, at a pre-determined strike price on or before the date of expiration, depending on the type of option.
Index option offer investors an opportunity to either capitalize on an expected market move or hedge price risk of the physical stock holdings against adverse market moves.
NSE introduce index option in June 2001.
? FUTURES ON INDIVIDUAL SECURITIES
A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001.
NSE defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.
CONTRACT SPECIFICATIONS
PARTICULARS INDEX FUTURES AND OPTIONS FUTURES AND OPTIONS ON INDIVIDUAL SECURITIES
Underlying S&P CNX Nifty and CNX IT
Individual Securities, at present 53 stocks
Contract Size S&P CNX Nifty Futures / Permitted lot size 200 and multiples
S&P CNX Nifty Options there of (minimum value Rs.2 lakh)
Futures / Options on Minimum value of Rs 2 Lakh for each
individual securities Individual Security
Strike Price Interval S&P CNX Nifty Options Rs. 10/-2.
Options on individual Between Rs.2.50 and Rs. 100.00
securities : depending on the price of underlying
Trading Cycle Maximum of three month trading cycle- near month(one), the next month (two)and the far month (three). New series of contract will be introduced on the next trading day following expiry of near month contract Maximum of three month trading cycle- near month(one), the next month (two)and the far month (three). New series of contract will be introduced on the next trading day following expiry of near month contract.
Expiry Date The last Thursday of the expiry month or the Previous trading day if the last Thursday of the month is a trading holiday
The last Thursday of the expiry month or the Previous trading day if the last Thursday of the month is a trading holiday
Settlement Basis Index Futures / Futures Mark to Market and final settlement on individual securities be settled in cash on T+1 basis
Index Options Premium settlement on T+1 Basis and
Final Exercise settlement on T+1 basis
Options on individual Premium settlement on T+1 basis and
securities option Exercise settlement on T+2 basis.
Settlement Price S&P CNX Nifty Futures / Daily settlement price will be the closing value of the underlying index
Index Options The settlement price shall be closing value of underlying index
Final settlement price shall be the closing value of the underlying security on the last trading day
The settlement price shall be closing on individual security price of underlying security.
OPEN INTEREST(OPTIONS)
Open Interest is a crucial measure of the derivatives market. The total number of options contracts outstanding in the market at any given point of time. In short Sum of all positions taken by different traders reflects the Open Interest in a contract. Opposite positions taken by a trader in a contract reduces the open interest. However, opposing positions taken (in the same contract) by two different traders are added to the open interest.
Assuming that the market consists of three traders only following table indicates how Open Interest changes on different day’s trades in PATNI COMPUTERS with a call American option at a strike price of Rs. 180
DAY TRADER 1 TRADER 2 TRADER 3 OPEN INTEREST
1 LONG 1200 SHORT 2400 LONG 1200 4800
2 NO TRADE LONG 1200 SHORT 1200 2400
3 LONG 1200 NO TRADE SHORT 1200 2400
4 SHORT 2400 LONG 1200 LONG 1200 0
OPEN INTEREST(FUTURES)
The total number of net outstanding futures contracts is called as open interest i.e. long minus short contracts. A decline in open interest of the near term futures indicates a short-term weakness whereas an increase in the open interest in the long term futures indicate that the markets may bounce back after some time provided this trend persists for a long time
A rising open interest in an uptrend is Bullish
A declining open interest in an uptrend is Bearish
A rising open interest in a downtrend is Bearish
A declining open interest in a downtrend is Bullish
“RELIANCE ADD 5LAKH SHARES IN THE OPEN INTEREST”
This shows that total number of option contracts comprising of 5lakh shares are outstanding in the market. There has been no square off positions(opposite positions) in the market. Thus from the open interest we come to know long and short positions made by the investor.
RELATIONSHIP OF OPEN INTEREST WITH MARKET VOLUMES
? If open interest and market volumes increases but the market is bullish this shows that there has been buying positions in the market, which results into the positive open interest.
? If open interest and volumes increases but the market is in the bearish phase this shows that there has been selling positions made by the investor which results into the negative open interest
? If open interest remains constant and volumes are increasing and market is also bullish this shows that there has been intra day trading in the market.
RELATIONSHIP OF OPEN INTEREST WITH PRICES
? If both open interest and prices are increasing, this shows that the buyers have entered in the market unfolding. Expect the uptrend to continue.
? If on the other hand, open interest is increasing while prices decline, sellers are expecting for the price rise in a technically weak market. As open interest is growing while prices decline, buyers are obviously the more aggressive party.
? In the event of open interest declining while prices are also slipping, liquidation by long positions is the implication, therefore suggesting a technically strong market overall. In other words, the market is strong as open interest declining suggests no new aggressive shorts, as this would entail an increase in open interest.
? When open interest is declining and prices are increasing, short covering is the most likely cause suggesting that overall the market is weak – i.e. attracting new buyers would be required for a technically strong market and consequently open interest would rise.
ILLUSTRATION
Suppose there are only two brokers Mr. A and Mr. B in the market. A buys and B sells contracts on Index futures on a specific day. At the end of the day , we may say that open interest in the market is 10 contracts and volume for the day is 10 contracts.
Now, if next day a new trader Mr. C comes from Mr. A, open interest at the endo f the 2 day of trading remains same 10 contracts and volume for the day is again 10 contracts. Understand that on the second day, Mr. C assumes Mr. A’s position on first day of trading. But for the market as a whole, at the end of the 2nd day all only 10 contracts remain open.
COST OF CARRY
The relationship between futures and spot prices can be summarized in terms of what is know as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
Cost of carry gives us an idea about the demand-supply forces in the futures market. It basically indicates the annualized interest cost which players are willing to pay (receive) for buying (selling) a futures contract.
In the Indian markets the cost of carry marketing varies between a negative 35% per annum to a positive 35 % per annum. It can even be higher or lower than the 35% figure but that would be an extraordinary event. We all know that at expiry the futures price closes at the cash price of the security or an index.
The cost-of-carry model in financial futures, thus, is
Futures price = Spot price + Carrying cost — Returns (dividends, etc.)
RELATIONSHIP OF FUTURES PRICE WITH SPOT PRICE
? FUTURES PRICE HIGHER THAN THE CASH PRICE
Here futures price exceeds the cash price which indicates that the cost of carry is negative and the market under such circumstances is termed as a backwardation market or inverted market.
EXAMPLE
Suppose the RELIANCE share is trading at Rs.400 in the spot market. While RELIANCE FUTURES is trading at Rs.406.Thus in this circumstances the normal strategy followed by investors is buy the RELIANCE in the spot market and sell in the futures. On expiry, assuming RELIANCE closes at Rs 450, you make Rs.50 by selling the RELIANCE stock and lose Rs.44 by buying back the futures, which is Rs 6 in a month. Thus Futures prices are generally higher than the cash prices, in an overbought market.
? CASH PRICE HIGHER THAN THE FUTURES PRICE
Here cash price exceeds the futures price which indicates that the cost of carry is positive and this market is termed as oversold market. This may be due to the fact that the market is cash settled and not delivery settled, so the futures price is more a reflection of sentiment, rather than that of the financing cost.
EXAMPLE
Now let us assume that the RELIANCE share is trading at Rs.406 in the spot market. While RELIANCE FUTURES is trading at Rs.400.Thus in this circumstances the normal strategy followed by investors is buy the RELIANCE FUTURES and sell the RELIANCE in the spot market. So at expiry if Reliance closes at Rs 450, the investor will buy back the stock at a loss of Rs 44 and make Rs 50 on the settlement of the futures position. This is applied when the cost of carry is high.
Thus the arbitrageur can apply this strategy and make the profits
VOLATILITY
Volatility is one of the most important factors in an option’s price. It measures the amount by which an underlying asset is expected to fluctuate in an given period time. It significantly impacts the price of an option’s premium and heavily contributes to an option’s time value.
In basic terms, volatility is merely a term used to describe how fast a stock, future or index changes with respect to change in the price. It can be viewed as the speed of change in the market, although the investor may prefer to think of it is as market confusion. The more confused a market is the better the chance an option of ending up “in the money”. A stable market moves slowly. Volatility measures the speed of change in the price of the underlying instrument or the option. Higher the volatility the more the chance an option of becoming profitable by expiration
RELATIONSHIP OF PRICE VOLATILITY WITH PREMIUM
Higher the price volatility of the underlying stock of the put option, higher would be the premium.
Lower the price volatility of the underlying stock of the call option, lower would be the premium.
TYPES OF VOLATILITY
? HISTORICAL VOLATILITY:
This (also called statistical volatility) measures price movement in terms of past. Historical volatility is calculated by using the standard deviation of underlying asset price changes from close to close of trading for a given period – month, half yearly, annualized
? IMPLIED VOLATILITY:
It is the option market predication of volatility of the underlying instrument over the life of the option. It helps in determining what strategies are to be used.When implied volatility is high, the market price of the option will be greater than their theoretical price.
Example
Stock Price: Rs 280
Strike Price: Rs 260
Annual volatility: 50%
Days to expiry 20 days
Interest rate 12% annual
The price of the Option applying Black-Scholes Model comes to Rs 26.28. But the actual price of that Option in the market might be (say) Rs 29.50. This means that the market is imputing another volatility to that option going forward. Now instead of providing the volatility figure yourself, you can provide the Option price instead. Now if the investor work backwards and find out what is the volatility that would support the price of Rs 29.50, that volatility comes to 65 per cent.
While the value of a call option is an increasing function of the value of its underlying, it is also an increasing function of the volatility of its underlying. That is, the more uncertain the underlying, the more the option is worth.
From the above scenario it is possible that the players are expecting the scrip to increase another possibility is that the market is mis-pricing the option and could fall. It could also be possible that the market is anticipating some development, which could push the stock higher. If you believe that volatility would rise and the underlying then you may go in for a bull strategy or if you are an aggressive player you could sell the option with a belief to buy them at a later date.
Most traders, however, use a general rule of thumb: Buy options in low volatility and sell options during periods of high volatility.
If you see low implied volatilities, you should buy the At the Money (ATM) option and sell an Out of the Money (OTM) option. You can also create a similar position using puts. In this case, you should buy ATM and sell In the Money (ITM) put options. If you see high implied volatilities, you should buy an In the Money (ITM) Call and sell an ATM call. You will find that both the calls are expensive, but the ATM will be in most circumstances more expensive than the others. Thus, by selling the ATM call, you can realize a good price.
Finally implied volatility can increase or decrease even without price changes ion the underlying security. This is because implied volatility is the level of expected volatility i.e. it is also based not on actual prices of the security, but expected price trends. Implied voltility also declines, as the option gets closer to expiration, as changes in volatility become less significant with fewer trading days
BEST STRATEGY TO BE FOLLOWED IN CASE OF IMPLIED VOLATILITY
SHORT STRADDLE:
These involve simultaneously selling put and call options for the same stock, same strike price and with the same expiration date. In contrast, a short strangle involves simultaneously selling both a put and call on the same stock and same expiration date, but with the different strike price.
ILLUSTRATION
Let’s choose the strike price 165 in Satyam for the June contracts. Satyam is one of the most actively traded contracts in the NSE F&O segment.
The IV for the call is 97.66 per cent and that of put is 99.40 per cent on April 25, 2005 Since the IV is high, it is a premium-selling time. (a good time to sell calls and puts)
# On May 25, the investor `short straddle’ the Satyam by selling the 165 call and put for Rs 27.
# The inflow in this strategy is Rs 54 (2X27).
# The underlying spot has been trading within a range of 157-177.
# However, the call IV has ranged from 99.40 – 63.36 and that of put has ranged from 97.66-46.01
# On May 29, 2003 the IV of call and put are low, hence the investor can square off positions.
# The respective IV was 63.36 for call and 46.01 for put. The underlying Satyam was Rs 169.50.
# The call closed at Rs 11.45 and the put closed at Rs 9.50.
# Square-off position by buying call and put of the same strike. Your outflow would be 20.95 (11.45+9.50). Hence, your net profits would be Rs 33.05 (54-20.95).
Here the strategy has “limited profit and unlimited losses”. Here the Profit is limited to the premiums received. Losses would be unlimited if you are wrong on the stock outlook and the volatility outlook.